RRA '93 ELIMINATED A
VALUABLE RESTRUCTURING TOOL

By Patrick G. Dunleavy

The Omnibus Budget Reconciliation Act of 1993 (OBRA '93; RRA '93) repealed the provision under IRC Sec. 108 (e) that allowed a debtor not to recognize any gain, nor to reduce tax attributes, when stock was exchanged for debt in a Title 11 case, or to the extent that the debtor was insolvent.

With the repeal of this stock-for-debt exception, financially troubled companies, their creditors, and their consultants have lost a valuable restructuring tool. Now, troubled companies must recognize as income the amount by which the debt forgiven exceeds the fair market value of the stock issued. The only exceptions to this are Title 11 bankruptcy cases filed prior to January 1, 1994.

The only way to offset such cancellation of debt (COD) income is to reduce the tax attributes by the amount of the COD income.

Undoubtedly, one objective of Congress in repealing the stock-for-debt exception was to generate additional tax revenues, especially in a political climate where bankruptcy law was perhaps thought of as "too lax." Unfortunately, the repeal may place an undue burden on smaller, mostly nonpublic companies, not the large, public companies that were involved in the highly publicized bankruptcies of the late 1980s and early 1990s.

Before looking at some reasons why the exemption should be restored, it is helpful to review some history of the provisions.

How this Strategy Worked Before 1993

The guiding principle where the exchange of stock for debt does not require the recognition of income was codified in IRC Sec. 108(e) by the Bankruptcy Tax Act of 1980. Many years earlier, in 1942, the Board of Tax Appeals had held that the exchange of preferred stock for debentures did not give rise to a cancellation of debt, because the exchange had merely substituted a capital stock liability for a debt liability [Capento Securities Corp. v. Commissioner, 47 B.T.A. 691 (1942) aff'd 140 F.2d 382 (sit Cir. 1944)]. Other cases extended this holding to common stock, so that after the 1940s, it was generally assumed that the stock-for-debt exception applied. [See e.g., Moter Mart Trust v. Commissioner, 156 F.2d 122 (1st Cir. 1946).]

Thus, the Bankruptcy Tax Act of 1980 codified customary tax practices, providing that two basic conditions were satisfied: 1) The stock issued was not nominal or token, and 2) the stock issued satisfied a proportionality rule.

Some Fine-Tuning Prior to 1993

In the early 1980s, many public corporations entered into stock-for-debt swaps with investment bankers, who would buy debt, exchange it for stock, and then sell the stock to the public. This practice was curtailed by the Deficit Reduction Act of 1984, which restricted the stock-for-debt transactions to debtors in bankruptcy or insolvent debtors. (Insolvency for tax purposes exists to the extent that the liabilities of the debtor exceed the "fair market value" of the debtor's assets.)

Not much later, in 1986, Congress introduced special provisions for companies in Title 11, relating to net operating loss (NOL) carryovers under IRC Sec. 382. In situations where certain creditors and shareholders owned 50% or more of the restructured loss company, the NOL remained intact. The amount of the loss available, however, was reduced by the amount of interest expense deducted during the three years prior to the ownership change for all debt converted to stock and 50% of the gain from the discharge of debt with the issuance of stock.

This provision was in effect unless the debtor elected not to have this provision apply, in which case the utilization of the NOL was limited annually to the loss corporation's equity times a long-term tax-exempt rate. Overall, the provision encouraged companies using the stock-for-debt restructuring method to issue large amounts of stock in exchange
for debt.

Finally, the Revenue Reconciliation Act of 1990 provided that the stock-for-debt exception does not apply to the issuance of redeemable preferred stock for debt.

RRA '93's Impact

As noted, with the passage of RRA '93, reorganizing companies (except those filing before January 1, 1994) must now recognize COD income in transactions involving the exchanges of stock for debt.

In addition, RRA '93 expanded the list of tax attributes eligible to offset the COD income to include not only any available NOL carryovers, but passive activity loss carryovers and credits, as well as alternative minimum tax credit carryovers.

The attributes, in the order in which they are to be reduced are as follows: 1) NOLs for, or those which carry forward to, the tax year of discharge, 2) general business credits, 3) minimum tax credits, 4) capital loss carryovers, 5) the basis of property, 6) passive activity loss and credit carryovers, and 7) foreign tax credit carryovers.

Some Reasons for Restoring the Exception

Despite the long-established nature of stock-for-debt exchanges, its repeal was incorporated with little fanfare into some 1992 special interest tax legislation, becoming part of a budget reduction package. There was no opportunity for public hearings.

Now that RRA '93 has been in place for some time, and some of the furor that led to it has died down, perhaps it's time to reexamine some of the advantages of stock-for-debt exchanges. These relate to achieving a successful reorganization, "workdown" of debt, and net operating losses.

First, use of the stock-for-debt exception allows troubled companies to amortize debt principal out of pretax dollars, instead of after-tax dollars. Without the exception, companies have much less cash available to pay off debt principal during the critical five years after completion of a restructuring. This can lead reorganized companies into liquidation, with attendant loss of jobs.

The repeal also dissuades creditors from taking stock in a Chapter 11 reorganization. This has the effect of encouraging both creditors and corporate debtors to leave more debt in place after a restructuring, threatening, again, long-term success of the reorganization.

Third, the repeal encourages debtors to issue as much debt as possible, reducing the gain from debt discharge while preserving NOL carryovers. For example, if a debtor has the option to 1) issue stock for debt that would result in COD income or 2) eliminate the difference (and hence, COD income) between the market value of the stock and the tax basis of the debt, the debtor will choose the latter. Incidentally, the latter could be achieved by the issuance of a very long-term note with a face amount equal to the COD income that has the minimum allowed interest rate.

Where Do We Go from Here?

One of the reasons cited in the committee report for the elimination of the stock-for-debt exception was that the "...rules surrounding the eligibility for, and the mechanics of, the stock-for-debt exception are complex and cumbersome." However, by having eliminated the stock-for-debt exception, hasn't Congress merely created another administrative issue by requiring that a fair market value be assigned to the stock issued to replace the debt in order to determine the COD income? Historically, the value of stock, particularly in the case of a closely held company, has been a highly contested issue with the Internal Revenue Service, as evidenced in the area of estate taxation.

In October 1994, Congress passed a law setting up a nine-member commission to study the bankruptcy system. Hopefully, this issue among other taxation issues will be considered by the commission.

In conclusion, the stock-for-debt exception allowed companies to emerge from bankruptcy with much better capital structures. This can lead to a higher percentage of "sustainable" workouts, which is in the interest of creditors, business owners, long-time customers, and employees. Perhaps it's time to reexamine, and restore, stock-for-debt exceptions. *

Patrick G. Dunleavy, CPA, is a partner at Conway MacKenzie & Dunleavy, a Birmingham, Michigan based financial and management consulting firm,
specializing in turnaround management, debt restructuring, profit enhancement for nonperforming businesses, mergers and acquisitions, and litigation-support services.

Editor:Edwin B. Morris, CPA, Rosenberg, Neuwirth & Kuchner

Contributing Editor:Richard M. Barth, CPA