Restructuring debt

Nation's Business, Dec, 1991 by Albert B. Ellentuck

Many small-business owners who are having financial difficulties because of the recession are "restructuring" their bank or other debt. Such restructuring can help relieve the pressure of debt payments until a company's cash flow improves.

Some of the tax consequences of debt restructuring are fairly straightforward, but there are a few traps.

For example, "Hamburger Happiness Inc." is having difficulty making payments on a $500,000, 10-year note at 11 percent. After negotiations, the bank agrees to accept $400,000 in cash to settle the debt. To obtain the cash, the company sells a building at one of its locations.

Under the tax rules regarding "cancellation of indebtedness," the $100,000 written off by the bank would generally be considered taxable income to Hamburger Happiness unless one of a number of exceptions applied. Among these exceptions is debt that a company incurred when acquiring an asset. Other exceptions are insolvency or bankruptcy at the time of the cancellation.

Note the potential for a double tax impact: Besides the tax on the canceled portion of its debt, the firm may also have a taxable gain on the sale of the building.

Consider another option: Instead of canceling the debt, the bank reduces the interest rate from 11 percent to 6 per-cent. This would not seem to be a cancellation of indebtedness, but the 1990 Tax Act could cause it to be treated as such, generating as much as $35,000 of income to Hamburger Happiness.

Tax rules here can be tricky. What's critical is the federal government's borrowing rate. If the modified interest rate is below the federal rate (it was 8 percent when the Hamburger Happiness debt was restructured), there could be income from cancellation of indebtedness. The income is determined by comparing the value of the interest payments at the new rate and the value they would have had at the higher federal rate.

A way to avoid cancellation-of-indebtedness income is to set the interest rate for the new debt at a level no lower than the federal rate. Your accountant or tax lawyer can tell you the current monthly rate for the debt maturity involved.

Tax lawyer Albert B. Ellentuck is a partner in the Washington law firm of Colton and Boykin. Readers should see tax and legal advisers on specific cases.