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By Bergin Fisniku and Nick Annan
Corporate bankruptcies in the U.S. are at a 12-year high, according to data from S&P Global. More specifically, the total number of bankruptcy filings in January and February of 2023 was the highest since the same period in 2011. The consumer discretionary sector leads the way at nearly 30% of the total filings, followed by industrials (17.5%), healthcare (15.8%), and financials (12.3%). Interestingly, the Commerce Department’s reports show that consumer spending continues to increase. So, what is causing the uptick in bankruptcies and distressed debt? Could it be interest rates?
Interest rates are up, and the Federal Reserve will likely drive them higher in the near term if consumer spending continues to increase. Higher interest rates can have a significant impact on the economy, particularly on businesses that rely on debt financing to operate. When interest rates rise, the cost of borrowing increases, making it more expensive for companies to access the capital they need to fund their operations and invest in growth. This can lead to a decrease in business activity, lower profits, and ultimately, an increase in corporate bankruptcies. The resulting increase in bankruptcies can further exacerbate any economic downturn, as it can lead to job losses, reduced consumer spending, and a decline in investor confidence. However, a bankruptcy filing does not have to be the end of the road or even entirely negative. In many cases, it can be a powerful tool for companies experiencing economic hardship and seeking a lifeline to a future with a cleaner balance sheet.
Chapter 11 of the Bankruptcy Code is designed to allow businesses to restructure their debt and emerge from bankruptcy as a viable and profitable entity. When a business files for Chapter 11 bankruptcy, it typically seeks to reorganize its debts, reduce expenses, and improve its financial position. However, in addition to the financial considerations, there are also important tax consequences for the debtor, its creditors, and the debtor’s shareholders that must be considered in any Chapter 11 bankruptcy restructuring.
The first thing to understand is that filing for bankruptcy does not eliminate tax obligations. Taxes are considered priority claims in bankruptcy and are not dischargeable. Therefore, taxes must be paid in full or paid under a payment plan approved by the court.
When a business files for Chapter 11 bankruptcy, it can continue to operate while it restructures its debt. During this time, the business may be required to pay taxes on income earned during the bankruptcy process. This income is subject to the same tax rules as income earned outside of bankruptcy. In addition, the business must continue to pay payroll taxes, sales taxes, and other taxes that may be owed.
One of the primary tax consequences of a Chapter 11 bankruptcy restructuring is the potential for cancellation of indebtedness (COD) income. When a debtor is released from paying all or part of a debt, the amount of the debt forgiven is generally treated as income for tax purposes. This is known as COD income, which can result in a significant tax liability for the debtor. During a Chapter 11 bankruptcy, the business will usually negotiate with its creditors to reduce, eliminate, or modify its debt. When this occurs, the business may be required to report additional income.
Nevertheless, there are several exceptions and exclusions that, if established, may reduce or eliminate the tax liability associated with COD income. For example, and importantly, if the discharge of indebtedness occurs as part of a Chapter 11 case proceeding, the COD income may be excluded. COD income may also be excluded if the debtor is insolvent immediately before the discharge of indebtedness. These exclusions can be complex, so it is important to consult with a tax professional to determine their applicability in a specific situation.
Another likely tax consequence of a Chapter 11 bankruptcy is the potential loss of net operating losses (NOLs). NOLs are losses that a business incurs in a tax year that exceed its income. These losses can be carried forward to future tax years to offset future income and reduce the business's tax liability. Unfortunately, the business may lose all or a portion of its NOLs (along with other valuable tax attributes, such as credit carryovers and asset basis) if it experiences a COD event and the COD is excluded through one of the available exceptions or exclusions. Moreover, any remaining NOLs could be subject to certain limitations or restrictions if the business undergoes a change in ownership during the bankruptcy process. A change of ownership is common in a Chapter 11 restructuring where creditors may take an ownership stake in return for their agreement to reduce, eliminate, or modify debt as part of the reorganization plan. The rules for tax attribute reductions and ownership change are highly complex and nuanced, requiring specialized tax expertise.
In addition to the tax consequences for debtors, Chapter 11 bankruptcies can also have tax consequences for creditors. For example, if a creditor receives new securities or equity in exchange for its debt as part of the reorganization plan, the creditor may be required to recognize gain or loss on the exchange. This gain or loss may be either ordinary or capital, depending on the nature of the creditor's investment.
Another tax consequence for creditors is the treatment of interest income or deductibility of bad debt. If a creditor holds debt that is subject to the bankruptcy proceedings, the interest income that accrues on that debt may be subject to different tax treatment depending on whether the debt and the associated interest is ultimately repaid or discharged. If repaid, the creditor will generally recognize interest income as ordinary income. Conversely, if the debt is discharged in whole or in part, the creditor recognizes no income and may qualify for a deduction equal to the portion of the debt deemed worthless.
Shareholder consequences of Chapter 11 bankruptcy reorganizations should also be observed. For instance, a shareholder may be personally at risk for the COD income discussed above, depending on the legal and tax structure of the debtor. Additionally, where the reorganization plan requires shareholders to exchange their old shares for new, the exchange could result in the recognition of gain or loss. In the case of small business stock, such a loss could be characterized as ordinary and offset a shareholder’s ordinary income, but the use would be subject to certain limitations.
Of course, a Chapter 11 filing does carry the inherent risk that a plan of reorganization with creditors cannot be reached. Therefore, shareholders do face the plain reality of losing their investment in the company. In such a case, shareholders may be able to claim a loss on the worthlessness of their investment; however, the rules for deducting such losses are complex and subject to significant limitations, including complete disallowance.
It is also important to consider the tax consequences of any assets that are sold or transferred as part of the restructuring process. There may be tax implications to consider depending on the type of asset and the circumstances of the sale or transfer.
In some cases, a Chapter 11 bankruptcy may result in the creation of a new entity to operate the business going forward. In this situation, it is important to consider the tax implications of the new entity's structure and ownership. For example, if the new entity is classified as a partnership for tax purposes, the partners may be subject to additional tax reporting requirements and potential liability for the entity's taxes.
As part of ongoing financial management, a business should be monitoring a variety of key financial and non-financial performance indicators to assess overall performance and growth. Metrics that gauge organizational health can also indicate if bankruptcy is a near-term concern. Financial metrics should include ratios like short-term liquidity, long-term solvency, and profitability. Liquidity ratios look at the most liquid assets of a company, such as cash, receivables, and inventory, whereas solvency ratios look at all assets of a company.
RatioPurposeCommon ratiosMeaningLiquidityMeasure a company's ability to meet its short-term obligationsCurrent, quickA current or quick ratio of less than one indicates that a company may struggle to pay its immediate obligations.SolvencyMeasure a company's ability to meet its long-term obligationsDebt-to-equityA high debt-to-equity ratio indicates that a company is heavily reliant on debt financing, which may lead to financial instability if the company is unable to meet its debt obligations. A low solvency ratio may be a warning sign that a company is in financial trouble and may be at risk of bankruptcy.ProfitabilityMeasure a company's ability to generate profitsGross profit, operating profit, net profitIf a company is consistently generating low profit margins, it may be a sign that it is struggling to compete in its market and may be at risk of bankruptcy.
A Chapter 11 bankruptcy restructuring can provide a struggling business with a much-needed opportunity to reorganize and emerge as a stronger entity. However, the tax consequences of a Chapter 11 bankruptcy can be significant and must be carefully considered. By working closely with tax advisors to plan and carefully manage tax liabilities, businesses can ensure that they are taking full advantage of the benefits of a Chapter 11 bankruptcy while minimizing the potential tax consequences. Monitoring liquidity, solvency, and profitability ratios can help a company proactively determine if it is at risk of bankruptcy. In these uncertain economic times, proper planning and a thorough understanding of the current and future financial and tax landscape is imperative to the future success of your business.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
