IRS Issues Taxpayer-Favorable Debt Workout Ruling

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In PLR 202050014, the IRS ruled that a parent would not recognize taxable gain when its disregarded entity transferred a newly formed corporation’s stock to creditors in satisfaction of its debt pursuant to a “G” reorganization.

Background

The cancelation of recourse debt generally results in “cancelation of debt” (COD) income to the borrower in an amount equal to the amount of debt canceled. The transfer of property to satisfy a nonrecourse debt generally is treated by the borrower as a sale of the property for an amount equal to the face amount of the debt. In either case, the borrower generally recognizes income or gain without receiving a corresponding amount of cash.

Under section 108 of the tax code, COD may be excepted from income when the borrower is bankrupt. However, many taxpayers borrow through wholly owned LLCs that are treated as disregarded entities (DREs) for U.S. tax purposes. The debt of a DRE usually is treated as nonrecourse debt of its parent, since the creditor has recourse only to the assets of the DRE. Section 108 does not apply to nonrecourse debt.

The PLR

PLR 202050014 addresses a plan of reorganization under which a bankrupt parent transfers its assets to a newly formed corporation (Newco) in exchange for Newco stock, and then causes Newco stock to be transferred to the creditors of its DRE in satisfaction of the DRE’s debt (with the creditors accepting less than full repayment). The IRS ruled that, if the transaction qualified as a “G” reorganization (generally, an asset transfer by a bankrupt corporation to a new corporation), then the parent would not be taxed on the transfer of Newco’s stock to the DRE’s creditors. Even though the DRE’s debt was nonrecourse to the parent (and the parent thus could not rely on section 108), the transfer of Newco stock to the DRE’s creditors qualified as a tax-free distribution pursuant to the reorganization.

The PLR offers a potential planning opportunity for taxpayers in bankruptcy.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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