Episode 24: A Look at Debt Instruments

Transcript

IRIS LAWS

On this episode, we're focusing on debt instruments. More specifically, we look at what happens when debt is amended or modified, which can provide some unwelcome surprises. We welcome Howard Wagner, managing director from our Washington National Tax Office, and Jack Gillespie from our Tax Specialty group to break down what you should be thinking about, to work through deals and manage cash flow. From your one stop for tax updates and analysis, I'm Iris.

DEVIN TENNEY

And I'm Devin.

IRIS LAWS

It's Tuesday, April 21, and this is “Tackling Tax.”

We are so excited to have our two guests today join us to talk about debt instruments. So, we have Howard Wagner, a friend of the pod who's been on previous episodes. He's our colleague in the Washington National Tax Office here at Forvis Mazars and focuses on M&A and debt instruments, so he’s a natural fit for our episode today.

And then we're also joined by Jack Gillespie, a member of our Tax Specialty group, and someone who I've had the pleasure to work with on some projects before. So, thank you for joining us, Jack and Howard.

HOWARD WAGNER

Glad to be here.

JACK GILLESPIE

Thanks for having us.

IRIS LAWS

Howard, let me go ahead and start with you. If we were to step all the way back, right, and talk through some background, what do you mean by debt instruments? I mean, we all know what debt is, but what do you mean by debt instruments specifically?

HOWARD WAGNER

As a general rule, indebtedness, you know, is something that comes up when one party gives money to another party and the party receiving the money has an obligation to pay that back, typically with interest. Sometimes, or more typically, debt instruments are created when money is loaned. You can also have a debt instrument from the purchase of property. If Jack sells property to me in exchange for a note, that note payable is a debt instrument.

So, it doesn't really matter what you call it: installment obligation, note, debenture. The label really doesn't matter; if fundamentally one side has provided property and the other side has an agreement to pay it back in the future, generally with interest, that's going to be a debt instrument.

DEVIN TENNEY

Well, thanks for that overview, Howard. Jack, I do want to move to you. So, we have a debt instrument, but let's say there's been a change in the circumstance and now, for one reason or another, the parties want to modify the terms, maybe like the maturity date or repayment schedule. What are some situations that you've seen where terms have been modified, and what should someone consider when they are wanting to modify a debt instrument?

JACK GILLESPIE

Yeah. You know, I'd say in reality, debt after it's issued almost never stays static. Situations where we see terms modified tend to fall into a few buckets. I'd say the most common is probably liquidity stress. So, cash gets tight, parties agree to extend maturity or defer principal payments, or maybe even restructure the payment schedule entirely. Another big one is covenant pressure.

So, say your EBITDA dips or leverage ticks up, lenders will often agree to loosen financial covenants or waive defaults. And then there's your strategic changes. So, refinancing, acquisition, or just a change in the capital structure that requires a debt to be reshaped to fit the new business purpose. From a tax perspective, I think the key thing people often miss is that changing debt terms isn't just a business decision, it can be a taxable event.

So, the IRS looks at debt modifications through a two-step process. You know, first was there a modification at all? Second, was it significant? Modification is pretty broadly defined. So, basically any change to legal rights or obligations under the agreement. If that change is economically meaningful, it can be treated as if the old debt was exchanged for brand new debt. And that deemed exchanged, that's where the tax consequences can show up.

So, a significant modification can trigger taxable gain or loss if you're the lender. You could have cancellation of debt income or a premium, if you're the borrower. And either way, you have a reset of how the interest is taxed going forward.

HOWARD WAGNER

And, you know, Jack, I guess just to clarify, one of the things we face all the time is there's a test for when there's a modification or, not a modification of a debt instrument for GAAP for your financial statements. This test is independent of that. It's a separate test that applies for GAAP. So, you could have a modification for GAAP and not for your financial statements or vice versa. But I think a lot of times people will assume that they're okay for tax if they don't have a modification for GAAP, when that may not be the case.

JACK GILLESPIE

Yeah, and that's a really good point, Howard. I think the first thing we want to do a lot of time is determine exactly what is changing under the agreement. The tax law kind of outlines several, terms that can change. That's you know, maturity, payment timing, interest rate, the principal amount, even collateral or the obligors on the debt. Those are all specifically tested under the tax rules. And you can easily cross this significant threshold.

DEVIN TENNEY

Howard, I want to circle back to you. I've seen a lot of indirect tax consequences in my practice as a result of debt modifications like with deferred comp. But what are some other, you know, indirect collateral tax issues that also could, you know, spring up as a result of these modifications?

HOWARD WAGNER

Yeah. You know, every time you have a debt modification, the question that's invariably asked is this: when you took out the original debt instrument, you incurred debt costs, you know? After you do an analysis to figure out what's deductible, what's OID, and what's debt cost, those debt costs get amortized over the term of the loan, effectively. The question invariably comes up,

I've had a debt instrument on the books for three years. I do a modification and there's enough of modification that I'm deemed to satisfy and reissue the debt. And now it's got another five years to run, and I might have some more debt cause I'm doing the modification. You know, it's very clear that the new debt costs get amortized over the term of the new debt loan.

But let's take an example where you had, you know, $1 million of debt costs on your original loan. After amortization for a few years, that's now down to $500,000, and you've got another $250,000 on your new debt. And you know, that new debt has a new term of five years. To simplify using straight line method, you're going to take the $250,000 of the new debt costs; five years, $50,000 a year. The $500,000 that's outstanding, you really have to do some analysis to find out if those are going to be deductible currently, or if those are going to be capitalized still and amortized over the new loan.

If you've got all the same lenders in before and after and the debt's not publicly traded under an expansive IRS definition of publicly traded, then you're typically going to take those old debt costs as well as any unamortized OID on the original loan and amortize it over the term of the new loan.

If the debt is publicly traded or there's a lot of new cash in the deal because the change in the mix of lenders with, you know, the restructuring or the rework there, in some cases those old debt cost and OID can be deducted currently, but you really have to do some analysis to see what the answer to that is.

IRIS LAWS

So, you mentioned publicly traded companies in that example, right? Any other special considerations for a publicly traded entities at this point?

HOWARD WAGNER

The distinction here is really not if the company is publicly traded; the distinction is whether the debt instrument is publicly traded under the IRS rules. The issue you have is that when you think of publicly traded, you typically think of people buying and selling on a stock exchange or something like that. The IRS definition of publicly traded is expansive enough that a debt that is never publicly traded in the common meaning of publicly traded can be treated as publicly traded for these purposes.

As crazy as it seems, if you can go to a Bloomberg terminal and look up that debt instrument, and if that debt instrument has a price quote on it on the Bloomberg terminal or on a similar pricing service, that debt is going to be considered publicly traded. That has its good points and its bad points. If the debt is publicly traded and it's trading at 100 cents on the dollar, or this magic quote is 100 cents on the dollar, then you're deemed to pay off the old loan with the new loan for 100 cents on the dollar, and you can deduct all of your old costs and all of your old OID.

The flip side, and Jack’s going to talk a little bit more about this a little bit later, is let's say you do a modification of one of those debts that isn't publicly traded in the real sense but has one of these quotes out there. And that quote on the Bloomberg terminal or on a similar pricing service says that the debt is worth $0.85 on the dollar.

If you modify that debt in a way that triggers, you know, a tax exchange, and that pricing service says it's worth $0.85 on the dollar, you're deemed to pay off the old loan for $0.85 on the dollar. And if, say, that old loan had $200 million of principal, you're going to have $30 million of CODI, cancellation of indebtedness income.

So, whether or not a debt is publicly traded under this, rather, I think obtuse definition is a good way I’d describe it, can really have some material consequences when you have a debt modification.

IRIS LAWS

So, lots to think about there. I mean I think another thing that people are worried about, right, you just talked about exposure to cancellation of debt income, but also the thing that they're thinking about is cash flow, right? Whether it's the burden of paying interest or financing deals or whatnot. Companies might want an option, you know, that's not just shelling out actual cash. So, you mentioned payment in kind, or PIK, interest before when we were talking. Could you give us a little background on what that is?

HOWARD WAGNER

Yeah. I mean, PIK stands for payment in kind. What it really means is on an interest payment date, and it could be on every interest payment date in the debt instrument, it could only be for a period of time, the obligor has the ability to, instead of paying the interest in cash, to issue a new note that, you know, adds to the balance.

So, if I owe a quarterly interest payment of $500,000, I can give the lender a check for $500,000 cash, or I can add that PIK amount, payment in kind amount, to my note. I keep running interest on that $500,000 and it becomes part of my principal. And I pay it all off at the end or pay it off later based on whatever the payment schedule is.

The tax rules basically say, look, once you're in this PIK realm, you have something known as original issue discount, or OID. What that means is for both the obligor, me, who owes somebody the money, and the person who holds that instrument, it forces a ratable daily accrual of interest income and interest expense. So, from the company standpoint, it really doesn't make much difference.

They're going to continue to deduct the interest. From a holder standpoint, especially if it's a cash method holder, they're going to be picking up interest income even though they're not getting any cash. So, that's payment in kind or PIK interest in a nutshell.

DEVIN TENNEY

Well, Jack, Howard touched on, you know, some of the consequences of PIK interest. But from your perspective, are there any others that, companies should be aware of?

JACK GILLESPIE

Yeah, Devin. In addition to kind of phantom economics that Howard touched on, PIK can also have this twofold effect where it can raise the yield on the debt, as well as defer cash payments. So, this can pull the debt into a tax regime, which has pretty restrictive limitations on interest deductibility. And some of these can be permanent.

So, clients are often surprised to learn that a significant portion of their interest deductions are deferred until cash is paid or even disallowed entirely. One resolution to this problem is to make a large cash payment after five years. But this can have pretty severe cash flow applications.

HOWARD WAGNER

You know, a lot of companies look to avoid this potential problem under what's known for tax as the EIDL rules. But then when you have the conversation with them about the impact on cash flow to avoid the deferrance or disallowance, sometimes the business decision is to live with the deferral or disallowance because they might not have the cash to solve the problem.

JACK GILLESPIE

Yeah, those are good points, Howard. I'd say the other thing that I kind of think about with PIK is, when interest isn't being paid in cash year after year, it naturally raises this question of whether the instrument still looks like true debt or if it starts shifting towards an equity instrument. That matters a lot for deductibility.

It can matter for withholding taxes if you've got, you know, foreign parties involved in the debt. And it also matters for how the IRS would view a restructuring down the road. So, I'd say the bottom line with PIK interest is that it's a great liquidity tool. It buys time, but it also compounds risk. And that comes out in increased leverage, tax complexity, and in future restructurings. So, the key is to treat PIK as a strategic bridge and not as a long-term solution you can just forget about.

IRIS LAWS

Well, certainly an opportunity but not without its warning signs is what I'm hearing. So, you know, I come from the real estate tax world originally and one thing we would see every now and then is debt being forgiven. Whether it's, you know, a reduction of principal and restructuring, or foreclosure, just settling debt for less than face maybe. But what came of that is cancellation of debt income, which we did talk about earlier. But, Jack, to keep with you just for a minute, could you explain to us why the IRS made taxpayers pay for cancellation of debt?

JACK GILLESPIE

Yeah, I guess it feels counterintuitive, right? You're struggling, lender cuts you a break and suddenly there's a tax bill. This basic idea comes from a pretty simple economic principle. And that's when you borrow money, you don't pay tax on it because you have an obligation to give it back. So, it's not income.

But when that obligation goes away, something real has happened economically. The company's better off. Assets that were previously spoken for by creditors are now free to belong to the shareholders. So, from the government's perspective, that's an increase in economic wealth. And I think for all of us who, you know, work in the tax world, when you have an increase in wealth, it's generally taxable, right? Congress does, however, recognize a fairness problem here.

So, if you're in bankruptcy or you're clearly insolvent, taxing that phantom income could actually impose a pretty unfair tax burden on the company. And that's why the tax code doesn't completely eliminate cancellation of that income, but instead may defer or soften it in certain situations. A lot of times that comes at the cost of your tax attributes. I say the policy balance kind of looks like debt forgiveness is income because the company's economically better off.

But the tax law tries not to tax companies out of existence wherever possible. So, I'd say the key takeaway for the listeners is that COD isn't really a punishment. It might feel like it, but it's the tax system trying to treat debt forgiveness consistently with other ways a business becomes wealthier, while still giving distressed companies a way to recover.

HOWARD WAGNER

And, you know, what's interesting, Jack, is a lot of this depends, from a federal tax standpoint, as to whether the company is solvent or insolvent immediately before the debt is discharged. The way you measure solvency is what's the fair market value of my assets—willing buyer and seller, if I were to sell the whole business—and is that more or less than what I owe?

If the value of my assets is more than what I owe, I'm considered to be solvent. And the amount of debt that's canceled is taxable. Now, in a lot of cases, you'll have net operating losses and things like that, other carryforwards that you can use against that to offset the income. The real problem is, at least for NOLs incurred in 2018 or later, they can only offset 80% of your taxable income for the year.

Any NOLs from before 2018 can offset 100%. So, if you are a company that has been in existence only since 2018 and you have a taxable debt discharge, even though you've got enough NOLs to cover it, you're still going to end up paying tax on some piece of it. If you're insolvent, you know, let's say the value of my assets is $75 and I owe $100, and I'm discharged of exactly $25.

I'm insolvent by $25. I'm discharged of $25. I don't pay tax currently, but there is a process where you go through and reduce your tax attributes, dollar-for-dollar in most cases, whether it's net operating losses or potentially asset basis. The difference being now that you can only use 80% of your NOLs, you can only offset 80% of your income with NOLs, you're much better off in insolvency rather than being solvent because of this little bit of tax you're going to pay.

Where you often have the fun, though, is in the example of somebody has $100 of debt and $75 fair market value of assets, you're typically going to have a forgiveness of, let's say, $40, because you need to make sure that the company has some room to, you know, operate going forward. There you're going to have a discharge of $40, $25 would be excluded from income because of insolvency and $15 is going to be taxable. So, you really have to do a lot of valuation work to understand what the actual effect is going to be of a debt forgiveness.

JACK GILLESPIE

Yeah, those are great points, Howard, and I think one thing I'd like to point out is that attribution reduction occurs on the first day following the year of the exclusion. So, it's actually, you know, that there's an opportunity in the code to use some of those attributes against any CODI you might have.

HOWARD WAGNER

Great point.

IRIS LAWS

So, regardless, though, right, we're planning to avoid cancellation of that income, like that's the goal. So, Howard, are there ways to structure transactions or just planning in general to avoid cancellation of debt income?

HOWARD WAGNER

Yes and no. I mean, you may have some flexibility. You know, for example, there's, in the regulations there are certain tests that are deemed to create a modification of the debt instrument. And again, we're really focused on the situations where a modification of the debt instrument will create CODI. In a lot of cases, the reality is the company needs to do the debt relief deal.

And they're just going to do the best they can from a tax standpoint, you know, within the realm of debt relief. You know, I think one thing Jack is going to be talking about, which is an option that a lot of companies look at, is how to convert that debt to equity. There's a couple different ways to do it from a tax code standpoint, and it can have significantly different consequences.

Do you want to talk about that, Jack?

JACK GILLESPIE

Yeah, Howard. This is a rare place in the tax code where the form of the transaction kind of drives the outcome. So, if you issue new stock in exchange for the debt, then we look to the value of that stock that was issued. If the debt being forgiven is larger than the value of the stock issued, Congress views that difference as economic relief.

And that relief can show up as taxable COD. Now, if new stock is not issued, the transaction looks more like a contribution to capital, in which case you look to the holder’s basis in the debt. And if their basis is less than the amount of debt outstanding, that's, you know, that's where you can also have CODI arise.

That's why you'll hear advisors say, a lot of times with these deals, the structure or the form of the deal matters. Two deals that look identical economically, it can be the same debt, the same equity in the same targeted outcome, they can have very different tax results depending on the form that the transaction takes.

HOWARD WAGNER

So, to highlight what Jack was saying, let’s say Jack owns 100% of the stock of a company, and Jack has loaned them $50 million and wants to convert that to equity. And let's say the stock of the company, the value of the stock of the company, after you do all the capital contributions would be $1 million. If Jack simply contributes that equity to the equity of the company and doesn't take back any stock, the company will be deemed to satisfy that $50 million debt for $50 million and won't have any CODI.

If, instead, Jack contributes that debt to the company in exchange for one share of stock, and let's just say the stock is worth $1 million. Jack’s got, the company has $49 million of cancellation of indebtedness income. And even if it doesn't have to pay tax because it's insolvent, it's burning up a lot of its tax attributes. It's a really interesting situation where form controls. Jack owns 100% before and 100% after, but he can structure this in a way that you maintain all the company's attributes. It's a bit of an extreme example, but it highlights the way things work there.

JACK GILLESPIE

Yeah, I think a good takeaway is that debt for equity exchanges are pretty powerful restructuring tools, but they're not automatically tax-free. The tax outcome turns on form and sometimes valuation. So, that's why in these deals you need to have tax in mind and not just economics.

IRIS LAWS

Well said. Howard, if we could switch gears just a little bit, you know, I think one thing that companies always try to minimize is interest. So, debt clearly is a part of a company's financial strategy, but that inevitably comes with paying interest to lenders, right? So, for listeners that might not love code section references as much as you, help explain what the interest limitation under section 163(j) is and why it was implemented, maybe how it works, some of the background there.

HOWARD WAGNER

Well, I don't want to get into the why it was implemented because there's a lot of different things out there as to what the policy goals of this really were in 2017, in the Tax Cuts and Jobs Act. But what it basically does is place an overall limitation on the amount of interest you can deduct in a year. Starting in 2025, your deduction for interest is limited to 30% of tax basis EBITDA.

We can get into a lot of the wonky definitions, but if you just look at it this way, your interest deduction is limited to 30% of tax basis EBITDA. Prior to the One Big Beautiful Bill Act last summer, up through 2024, that was limited to 30% of tax basis EBIT. You didn't get the depreciation and amortization piece.

So, what it does for a lot of highly leveraged companies is limit their interest expense deduction. It does carry forward and it's available in future years. But usually once you get on the train of interest expense limitation, it's hard to get off it.

IRIS LAWS

Well, with that, thank you both for all of your insights on this one. It's a complicated area and you really worked some of that out for us. So, really appreciate you being here.

DEVIN TENNEY

Each episode we’ll bring you what we call a “Focused FORsight of the Week,” an article or webinar that might be of interest to you. Today we're going to shamelessly plug a prior episode of our podcast where Howard also made an appearance. Episode 15 of “Tackling Tax” features a discussion about Section 1202, which is a code section that allows qualifying corporations to exclude certain gains. More corps are now eligible for this gain exclusion, and it could be a powerful planning point, so go check it out.

IRIS LAWS

And that's our show. Thanks for joining. Remember to subscribe and listen in for the next episode of the podcast. Until next time.

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