Distressed S Corporations: Tax Issues Involved in Restructuring

This article provides tax practitioners with guidance, planning opportunities, and awareness of a few traps for the unwary when dealing with distressed S corporations.

April 2009
by Stewart S. Karlinsky and R. Chris Province/The Tax Adviser

The recent economic downturn, coupled with the tightening of the credit market, is affecting all types of businesses, including S corporations. A financially distressed S corporation may have to work with its creditors to restructure debt or satisfy indebtedness in various creative ways in order to ease its financial difficulties. These transactions may include subordinating shareholder debt to a third-party loan, issuing stock to creditors, or soliciting additional capital contributions. This article highlights tax issues and planning opportunities that may arise relative to a distressed S corporation, its shareholders, and its creditors.

Cancellation of Debt

The general rule of income tax law is that if a taxpayer is relieved of or forgiven indebtedness, it will give rise to ordinary taxable income. However, Sec. 108 lays out exceptions to this rule, such as cases in which the taxpayer is bankrupt under title 11, is insolvent, or has qualified real estate indebtedness. The trade-off for this exclusion from income recognition is that certain taxpayer tax attributes such as net operating losses (NOLs), general business credits (GBCs), minimum tax credits (MTCs), or capital losses (C/Ls) must be reduced. Alternatively, the taxpayer may elect to reduce basis in depreciable assets. Note that the creditor is allowed a tax deduction for the loss even though the debtor may not recognize income.


Another tax provision that often comes into play in debt restructuring is the E reorganization under Sec. 368(a)(1)(E). This rule allows an entity and its creditors and shareholders to restructure the liabilities and equity section of the balance sheet. Some common applications of an E reorganization are converting debt to equity to avoid violating loan covenants or moving shareholder debt from senior to junior status to raise cash. These transactions may be done without triggering recognized gain.

This article has been excerpted from The Tax Adviser. Read the full article here.