Remember: Troubled Debt Restructurings Have Tax Consequences

With most offices and businesses aside from “essential” ones closed in the New York City area (and for that matter, across the country and around the world), there are hardships being placed on everyone. With that in mind, information on distressed debt and troubled debt restructurings (TDRs) may be useful in case you are confronted with a post-COVID-19 pandemic situation where you need to seek a modification of your debt and/or request concessions from the lender due to financial difficulties. Anyone who finds themselves in this situation should consult with their tax advisor, as TDRs have tax consequences.

It is important to note that the federal financial institution regulatory agencies and the state banking regulators issued an interagency statement this past Sunday (March 22, 2020) encouraging financial institutions to work with borrowers affected by the COVID-19 virus. Examiners were asked to use judgment in reviewing modifications to manage and mitigate the impact of this pandemic. As such, short-term loan modifications like payment deferrals, fee waivers and extensions of repayment terms will not be considered TDR.

Down the road, in situations where TDR is necessary, remember that there are tax considerations to keep in mind, so include your tax advisor in the process. Certain TDRs can result in a deemed taxable exchange of the existing debt for a newly issued loan instrument where the newly issued debt is substantially different from the existing debt. Treasury Regulations governing these rules provide six tests for analyzing whether a loan modification rises to the level of being significant or not. They are as follows: 1) facts and circumstances, 2) changes in yield, 3) changes in payment timing, 4) changes in obligor or security, 5) changes in debt instrument security, and 6) changes in accounting for financial covenants. Under the circumstances, if the loan modification is deemed significant, both the lender and borrower should consult with their transactional tax advisor to determine the potential tax consequences. Adverse tax consequences include recognition of cancellation of debt (COD) income and the accrual of original issue discount (OID) deductions over the remaining term of the debt to the borrower and immediate gain/loss recognition and OID income to the lender. Interest limitations may also affect the deductibility of the OID. 

If you find yourself negotiating TDR now or in the future, Marks Paneth remains available to provide you with more clarity on the six attributes mentioned above or additional tax technical guidance on this matter. Stay safe, everyone, and let’s keep the conversation going...

For more information on business and tax issues related to the COVID-19 crisis, visit Marks Paneth’s Pandemic Resource Center.

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