october 1, 2010...do you apply extinguishment or modification accounting? is there an extinguishment...

October 1, 2010

What Accounting Applies? Troubled Debt Extinguishment Modification

Restructuring Accounting Accounting

Is Debtor

experiencing

financial

difficulty?

Has Creditor

Granted a

Concession?

ASC 470-60

Troubled Debt

Restructuring

Apply

Modification

Accounting

per

ASC 470-50-40

Yes

Yes

No

Gain/Loss on

Extinguishment of

Debt

ASC 405-20-40 OR

ASC 470-50-40

Was there an

exchange of

cash/assets to

settle Debt

obligation?

No

Yes

No

Yes

Contemporaneous

exchange between same

debtor & creditor?

Substantial Change in

Terms of Debt per ASC

470-50-40 or 470-50-40-21?

No

Yes

No

Troubled Debt Restructuring,

Extinguishment, or

Modification?

�Satisfaction of existing debt obligation?

�How was it satisfied ?

� Issuance of new debt obligation?

� Is transaction troubled debt

restructuring?

�Contemporaneous exchange?

�Between same debtor and creditor?

�Do instruments have substantially

different terms?

Troubled Debt Restructuring,

Extinguishment, or

Modification? (cont’d)

Is it Troubled Debt Restructuring?

�Is debtor experiencing financial

difficulties? AND

�Creditor deemed to have granted a

concession ?

� Apply guidance in ASC 470-60

� Accounting from Debtor’s perspective.

Troubled Debt Restructuring

May include:

�Foreclosure / Repossession

�Issuance or granting of

equity interest to creditor

Troubled Debt Restructuring (cont’d)

May include (cont’d):

�Modification of terms of following:

�Reduction of interest rate

�Stated interest rate < current market

rate w/ similar risk

�Reduction of face or maturity $ of

original debt

�Reduction of accrued interest.

Creditor Concession: Is it Troubled Debt Restructuring?

Creditor granted concession if:

�New effective borrowing rate < prior .

�Effective rate of restructured debt

includes:

�New or revised sweeteners

�Projected cash flows w/ new terms

impacting effective rate

�Consider recent earlier restructuring

TDR Considerations:

Effective Interest Rate & Sweeteners

What are sweeteners?

�Options

�Warrants

�Guarantees

�Letters of credit

TDR Considerations:

Effective Interest Rate & Sweeteners

Determining effect of new/revised

sweeteners:

�Current value of new

�Change in FV of revised

� Include in day-one cash flows

�Consider exercisability of instruments in

FV estimate.

Is it Troubled Debt Restructuring?Troubled Debt Extinguishment Modification


Is Debtor

experiencing

financial

difficulty?

Has Creditor

Granted a

Concession?

ASC 470-60

Troubled Debt

Restructuring

Yes

Yes

No

No

Accounting for TDR

Record gains/losses on:

�Restructuring of Payables

�Debt Carrying $ less FV assets given

�Transfer of Assets-

� Carrying $ of transferred assets less

FV of transferred assets

Do You Apply Extinguishment

or Modification Accounting?

� Is there an extinguishment or modification for accounting purposes?

� If NOT TDR per ASC 470-60.

� Apply guidance in:

� ASC 405-20-40-1: exchange of cash by debtor to acquire or settle debt obligation

� ASC 470-50-40: changes/exchanges non-revolving debt.

� ASC 470-50-40-21: changes/exchanges lines-of-credit & revolving debt arrangements

Extinguishment of Liability?

� Exchange of cash to settle Debt obligation?

�Modification/Exchange of debt?

� Between same debtor and creditor?

� 3rd party principal or agent involved?

�Extinguishment accounting

� If Obligation Settled with Cash or Assets

� If Obligation Settled with New Creditor

�Apply ASC 405-20 Liabilities: Extinguishment

of Liabilities

Extinguishment of Liability

Accounting Troubled Debt Extinguishment Modification


Is Debtor

experiencing

financial

difficulty?

Has Creditor

Granted a

Concession?

ASC 470-60

Troubled Debt

Restructuring

Yes

Yes

No

Gain/Loss on

Extinguishment of

Debt

ASC 405-20-40 OR

ASC 470-50-40

Was there an

exchange of

cash/assets to

settle Debt

obligation?

No

No

Yes

Extinguishment or Modification?

�Modification/Exchange of new debt

obligation?

�Between same debtor and creditor !

�Substantially different terms?

�ASC 470-50 Debt: Modification and

Extinguishment

Extinguishment or Modification?

�Debt changes/exchanges “Substantial”?

�Substantial = Extinguishment

Gain/Loss

�Non-substantial = Modification

Accounting

�More than1 creditor?

�ASC 470-50 Debt: Modification and

Extinguishment

What is a substantial change?

“Substantial” =

- PV of amended/new debt cash flows >

10% different PV of old debt remaining

cash flows.

�Use effective interest rate of original debt

Components of Substantial

Change Analysis

Cash flows affected by changes in:

�Principal $

� Interest rates

�Maturity dates

�Fees between debtor & creditor


Change Analysis (cont’d)

�Fees :

�Cash

�Options/warrants

�Stock

�Change in BC feature

�Guarantees

�Other

�Changes to Conversion Features

� 2 step approach

� If 10% CF test is “modification”- add step#2

� Step #2-Change in FV of conversion option

> 10%= Extinguishment OR

� Substantive conversion option

removed=Extinguishment

� Increase in FV charged to debt.





�Other modifications / changes w/in 1 year � AND not deemed substantially different

�Debt terms existing year ago used for 10% test.

�Callable (by issuer) or puttable (by holder) � Separate cash flow analyses performed

� Cash flow test w/ smaller % change= threshold

“Extinguishment” Accounting

for Changes/Exchanges of Debt

� “Substantial” change w/ same lender

� > 10% change

�Regardless of legal form

�Extinguishment of original debt

�New debt recorded at FV.

Extinguishment Gain or Loss

�Net Carrying Amount of extinguished debt

less Reacquisition Price

�Reacquisition price is:

� FV of new debt +

� Call premium +

� Costs paid/given to lenders +

� FV of any securities issued

Extinguishment Gain or Loss (cont’d)

�Net Carrying Amount is:

�Carrying value of debt +� including unamortized discounts/premiums :

� extinguished debt

� bifurcated derivatives

� beneficial conversion feature

� allocation due to warrants issued w/ debt

�Any bifurcated derivatives --

�Unamortized debt issue costs

What Accounting Applies? Troubled Debt Extinguishment Modification


Is Debtor

experiencing

financial

difficulty?

Has Creditor

Granted a

Concession?

ASC 470-60

Troubled Debt

Restructuring

Apply

Modification

Accounting

per

ASC 470-50-40

Yes

Yes

No

Gain/Loss on

Extinguishment

of Debt

Was there an

exchange of

cash/assets to

settle Debt

obligation?

No

Yes

No

Yes

Contemporaneous

exchange between same

debtor & creditor?

Substantial Change in

Terms of Debt per ASC

470-50-40 or 470-50-40-21?

No

Yes

No

Accounting for Debt Modification

�Debt is not substantially different

�Original debt continues to be outstanding

�New effective interest rate is determined

�Consider carrying $ of original debt

�Revised cash flows

�Sweeteners

�Amortize over new term, (if applicable)

October 1, 2010

Modification of Debt

Instruments� A significant modification of a debt

instrument under Reg. 1.1001-3 results in a

deemed exchange of a new debt for the

original debt.

� Two part analysis:

� Is there a modification?

� Change in legal rights and obligations

� If so, was the modification a "significant

modification"?


Instruments� Step 1 – Is there a modification?

� Is there any alteration in the legal

rights or obligations of the borrower or

lender under the debt instrument.

� Changes pursuant to the operation of

the terms of the debt are generally not

modifications


Instruments� Step 2 – Is the modification significant?

� Specific tests

� Change in yield

� Deferral of payments

� Change in obligor

� Change in recourse nature of the instrument

� Change in accounting/financial covenants

� General rule in Treas. Reg. § 1.1001-

3(e)(1)

� Economically significant

Consequences of Debt Modification

�New debt considered to have been issued

in exchange for property (i.e., the old

debt).

�Determine issue price of new debt.

� IRC § 1274 applies for non-traded debt.

� IRC § 1273 applies for traded debt.

� If stated interest is at or above the Applicable

Federal Rates (AFR), issue price equals principal

� If neither the modified nor the original debt is

publicly traded and the stated interest rate is equal

to or greater than the applicable federal rate (AFR),

then there is no COD income unless principal is

reduced or made contingent.


� Bottom Line

� Non-publicly traded debt

� interest rate equal to or greater than AFR

� principle amount same

� NO COD INCOME


October 1, 2010

Taxation of Cancellation of Debt� Cancellation of debt (COD) is taxable as ordinary

income

� Unless Bankrupt

� Or Insolvent

� Or Qualified Real Property Business Indebtedness

Qualified Real Property

Indebtedness� Sec 108(a)(1)(D) allows basis in depreciable real property to be reduced in lieu of recognizing COD income.

� Applies primarily to rental real estate with a debt restructuring.

� Debt must be secured by real estate.

� Not available to C Corporations.

Homeowners� Qualified Principal Residence Indebtedness –

108(a)(1)(E)

� Maximum debt excluded $2,000,000 and must be

acquisition indebtedness.

� Taxpayer must apply excluded amount to reduce

basis of the principal residence but not below zero.

Cancellation of Debt – Bankrupt

or Insolvent Taxpayer

� Under IRC § 108(a), COD income is excluded from

gross income.

� In the case of a partnership, the determination is

made at partner level.

� For corporations, the determination is made

without regard to shareholder status.

Cancellation of Debt – Bankruptcy

� Discharge of debt occurs under the jurisdiction of

the court in a case filed under Title 11 of the U.S.

Bankruptcy Code.

� All discharged debt is excluded from taxable gross

income.

� Tax attributes of the taxpayer are transferred to the

bankruptcy estate.

Bankruptcy Example

� Corporation A owns one asset, unencumbered

land with a FMV of $500,000

� Corporation A also has unsecured debt of

$750,000, which is discharged under a Chapter

7 Bankruptcy case

� How much is included in Corporation A’s gross

income upon cancellation of debt?

Bankruptcy Example, cont’d

Zero

All discharged debt from bankruptcy is

excluded from income under IRC § 108

Cancellation of Debt – Insolvency

� COD income is only excluded from taxable gross

income to the extent of insolvency before the debt

discharge transaction.

� Any COD income in excess of insolvency may be

taxable.

� Insolvency is the excess of total liabilities over the

FMV of assets immediately before the debt is

discharged.

Determining Insolvency � All assets of the entity are included – including

assets exempt from creditors at FMV.

� Nonrecourse debt is only treated as a liability to the

extent of the FMV of the property securing the debt.

� Contingent liabilities are only included in the

determination of insolvency if “it is more probable

than not” that the taxpayer will be called on to pay

the liability.

Insolvency Example� Taxpayer owns one asset, unencumbered land with

a FMV of $500,000.

� Taxpayer has unsecured debt of $750,000.

� The bank discharges $350,000 of the debt in a

voluntary workout.

� How much of the discharge does the taxpayer

include in taxable income?

Insolvency Example (cont)

� The total amount of the discharge excludable

under IRC § 108 is:

$250,000

Insolvency Example (cont)

� Just before the debt discharge, the taxpayer was

insolvent by $250,000 ($750,000 of debt) less land

with a FMV of $500,000.

� Taxpayer will have $100,000 of ordinary income as

a result of the COD income.

Deferral of taxable COD income

� AJJA added a provision that allows the deferral of

COD income arising from the reacquisition of an

applicable debt instrument in 2009 or 2010.

�When elected, the taxation of the COD income is

deferred until 2014, and then included in income

ratably between 2014 and 2018.

Deferral of taxable COD income (cont’d)

� “Applicable Debt Instrument” is broadly

defined.

� “Reacquisition” includes:

� The purchase for cash or equity

� Exchange or substantial modification of debt

instrument

� Complete forgiveness of the debt instrument

Deferral of taxable COD income (cont’d)

Deferred COD income is accelerated:

� If the taxpayer dies

� Liquidates or substantially sells all of its

assets

� Ceases to do business

Reduction of Tax Attributes

No Free Lunch

� Discharged debt can be excluded from taxable gross income by bankrupt and insolvent taxpayers, certain tax attributes may be lost.

� In most cases, tax attributes are reduced dollar for dollar to the extent of excluded COD income.

Planning for Attribute Reduction

� Taxable income or loss is computed with out regard

to excluded COD Income.

� All attributes are available for use in year of

discharge.

� NOL’s & other carryforwards first offset other taxable

income before being reduced.

� Depreciation is allowed up to time of disposition.

� Property sales during year are not subject to basis

reductions.

Reporting of Reduction of Tax Attributes Due

to Discharge of Indebtedness

� Form 982

� Under IRC §1017, may elect to reduce basis of depreciable property first

� Reduction occurs first day of the tax year following

discharge.

Ordering of Reduction of Tax

Attributes� Amounts excluded from income must reduce certain

tax attributes in the following order:

1.Current NOL or NOL carryover

2.General business credit allowable under IRC §38

3.Minimum tax credit allowable under IRC §53(b)

4.Capital loss carryover

5.Basis reduction of property

6.PAL and credit carryovers

7.Foreign tax credit carryovers

Ordering of Basis Reductions in

Business Property1. Real property used in trade or business or

held for investment that is used to secure

debt

2. Personal property used in trade or

business or held for investment that

secured debt

Ordering of Basis Reductions in

Business Property (cont’d)3. Basis of remaining trade or business property,

other than inventory, accounts receivable, or notes

receivable, to extent discharge exceeds above asset

classes.

4. Adjusted basis of inventory (including real property

held as inventory), accounts receivable, and notes

receivable

5. Any remaining business or investment property

Partnership vs. S CorpPartnership

� Income inclusion or exclusion

is determined at the partner

level

� Depends on each individual’s

circumstances

� Partnership recognizes full

income

� Partner can elect to reduce

basis in entity’s depreciable

property to extent of

ownership interest in that

property

S Corporation

� Income inclusion or exclusion

is determined at the entity

level

� Income excluded does not

increase the basis of any

shareholder (See: D.A. Gitlitz

v Commissioner)

October 1, 2010

Type of Debt� Recourse

� All assets of the entity are subject to claims of the creditor.

� Non-Recourse

� Creditor can only obtain the collateral subject to the debt.

� Guarantee

� Does not impact the type of debt.

Debt Discharge with Property Transfers -

Non - Recourse Debt� There will never be COD income!

� Debt satisfied by a transfer of property is

treated as a sale of the property.

� Sales price is amount of outstanding debt.

� Gain or loss is recognized and is not excludible

from income.

Debt Discharge with Property Transfers –

Recourse Debt�When a transfer and discharge occurs,

bifurcation between the debt discharge and

the property disposition is required.

� Transfer of property is treated as a sale of the

property for FMV.

� Gain or loss is recognized and is not excludible

from income.

Debt Discharge with Property Transfers –

Recourse Debt� If Debt > FMV then COD.

� COD may be excludible under IRC § 108.

� Timing is an issue

� Supreme Court ruled that the time for fixing a

loss is the foreclosure sale itself. (Helvering v. Hammel, 311 U.S. 504 (1941))

� Other Courts have found exceptions.

COD Income and Importance of

Characterization

� COD Income is always treated as ordinary

income.

� Very important to consider with Recourse

Debt.

� Could wind up with capital loss on sale and

ordinary income from COD.

� Capital Loss would not offset ordinary income.

Other Accounting & Tax Issues:

Extinguishment & Modification of DebtEXTINGUISHMENT MODIFICATION

AccountingIncome

Tax Accounting Income Tax

Unamortized premium/ discount-old (including BCF)

Extinguishment Gain(loss)-old debt

Deduction Amortize (new debt term)

Amortize (new debt term)

Debt issue costs -3rd

parties



Expensed as incurred


Debt issue costs - Lender


Deduction Capitalize & amortize (new debt term)


Pre-existing debt issue costs





Extinguishment & Modification of Debt (cont’d)

EXTINGUISHMENT MODIFICATION

AccountingIncome

Tax AccountingIncome

Tax

Unamortized premium/ discount-old debt (including BCF)

Gain(loss) on Extinguishment-(old debt)






AccountingIncome

Tax Accounting Income Tax

Debt issue costs -3rd

parties



Expensed as incurred





AccountingIncome

Tax AccountingIncome

Tax

Debt issue costs -Lender


Deduction Capitalize & amortize (new debt term)


Pre-existing debt issue costs




October 1, 2010

Foreclosure- Example 1� S Corporation holds real property as an

investment.

� Carrying amount of property is $2,200,000.

� Unpaid principal of debt is $1,800,000.

� Fair market value of property is $1,500,000.

� Taxpayer's adjusted basis in the property is

$2,200,000.

Foreclosure-Example 1 (cont’d)

ACCOUNTING

Gain(Loss) on Transfer

Property:

Carrying amount ($2,200,000)

Fair Value 1,500,000

Loss on transfer ($ 700,000)

Gain on Restructuring of Debt

Debt relieved $1,800,000

Property FV (1,500,000)

$ 300,000

Income Statement


Gain on restructuring 300,000

Total Net loss ($ 400,000)

TAXATION

Nonrecourse Debt

Amount Realized $1,800,000

Less Asset Basis (2,200,000)

Realized Loss (400,000) (Capital Loss)

Recourse debt

Balance of debt $1,800,000

FMV (1,500,000)

COD Income 300,000 (Ordinary

Income)

FMV $1,500,000

Less AB (2,200,000)

Realized Loss (700,000) (Capital

Transfer of Asset/ Extinguishment / COD-

Example 2

� XYZ, Inc., an S Corp, holds investment

property w/ recourse debt of $1,000,000.

� Bank repossesses property with $500,000 FV

on 11/1/xx.

� Bank later sells property for $600,000 on

12/15/xx.

� XYZ pays bank $100,000 cash.

� Bank forgives excess recourse debt of $300,000.

*XYZ has not changed ownership since inception

Transfer of Asset/ Extinguishment / COD

Example 2 (cont’d)

At date of discharge, XYZ B/S was as follows:Assets:

Cash $ 100,000

Inventory 100,000

Investment property 1,000,000

$ 1,200,000

Total Liabilities $ 1,400,000

Shareholder Deficit $ 200,000

Other taxpayer information:

AAA ($ 3,000,000)

Capital Stock/APIC $2,800,000

Transfer of Asset/ Extinguishment/

COD Example 2– ACCOUNTING

Gain(Loss) on Transfer

Investment Property:

Carrying amount($1,000,000)

Fair Value 500,000


Gain on Restructuring of Payables

Debt relieved $ 900,000

Property FV ( 500,000)

$ 400,000

Income Statement


Gain on restructuring 400,000

($ 100,000)


Example 2 – INCOME TAXES


Example 2 – INCOME TAXES

�Reduction in Attributes-� Suspended loss- $200,000

� Capital loss- $400,000 (no basis to take)

� Inventory -$100,000

Debt Modification or

Extinguishment?- Example 3

�Modified terms of 2 convertible

debentures:

� deferral of principal & interest

payments,

� extension of principal maturity,

� increased interest rate to 20%

� Issued 6.5 million shares of common

stock to lender


Extinguishment?- Example 3a

Debenture Modification Analysis A B C ((B+C)-A)

PRIOR AFTER at $0.10

Debentures Modified:

Principal O/S

Principal + Accr Interest

PV of Cash Flow

PV of Cash Flow

Stock Issued

FV Stock

Modification CF and other

consideration

$ Change %

New Debt FV

$1,000,000 Debenture 953,750 1,178,127 1,035,774 1,251,858 2,600,000 260,000 1,511,858 476,084 46% 1,100,000

$1,500,000 Debenture 1,500,000 1,821,873 1,702,957 1,904,588 3,900,000 390,000 2,294,588 591,631 35% 1,560,000

2,453,750 3,000,000 2,738,731 3,156,446 6,500,000 650,000 3,806,446 2,660,000


Extinguishment?- Example 3

�What is the Loss on Extinguishment:�$ 310,000

� ($3m CV debt-$2.66m FV new debt+.65m

stock FV)

�How would you record this transaction?Conv Debenture $340,000

Extinguishment loss 310,000

C/S $650,000

�What are the income tax implications?

October 1, 2010

Complex Debt Extinguishment

& COD -ExerciseFacts:

�Deal, Inc., a privately-held C Corp, held:

� Assets w/ CV= $25.3m

� Liabilities =$ 45.8 million

�Major lender sold $40 million of notes payable +

$2m of accrued interest to 3rd Party Lender.

Complex Debt Extinguishment &

COD Exercise (Cont’d)Facts (cont’d):

� Deal, Inc. exchanged $15 million note payable to 3rd Party

Lender in exchange for 3rd Party Lender’s forgiveness of

$25 million of $40 million note purchased from Major

Lender + $2 million accrued interest payable

� Deal, Inc. has $12 million of NOL carryforwards

(including year of debt forgiveness).

� Fees Paid:� 10,000,000 warrants w/ FV of $250,000 to 3rd Party Lender.

� Fees of $250,000 paid to 3rd Party Lender.

Complex Debt Extinguishment & COD

Exercise (cont’d)

Deal, Inc. Balance Sheet, day of transaction:

Total Assets $25,300,000

Total Liabilities 45,800,000

Shareholder Deficit 20,500,000

Other Info:� FV of total assets $18,650,000

� Carrying $ of Old Debt + interest $41,350,000

� ($40m- $.650m)

� Face/FV of New Debt $15,000,000

� Additional costs of reacquisition of debt

� Modification for leases ($ 7,000,000)

� Leased inventory assets $ 1,000,000


Exercise (cont’d)

�Major Lender- Filed bankruptcy.

� 3rd Party Lender's purchase of Debt due to this

fact.

�Deal Inc. executed a) loan modification

agreement, and c) stock warrant and registration

rights agreements.

� 3rd Party Lender executed a) an asset purchase

agreement, and b) loan modification agreement


Exercise (cont’d)

�Deal, Inc’s assets after the forgiveness of debt included:� $ 4m of inventory

� $ 13m of finance receivables

� $ 600k of fixed assets

� $ 450k of cash

� $ 350k of other assets


Exercise (cont’d)

1.Is Extinguishment Accounting appropriate? Why?

2.What is the Accounting Gain on Extinguishment

of Debt?

3.How should Gain be classified in Statement of

Operations?


Exercise (cont’d)

5. How insolvent was Deal, Inc on date of

transaction?

6. Should Deal, Inc. recognize COD Income for

Income tax purposes?

7. If so, how much COD income can be excluded?

8. What tax attributes, if any, should Deal, Inc.

reduce?

Complex Debt Extinguishment &

COD Exercise (cont’d)- INSOLVENCYDEAL, INC.

Insolvency Computation

Insolvency as of Date of Debt

Forgiveness

Solvency Subsequent to Debt

Forgiveness

Consolidated

Balances

Fair Value

Adjustments Adjusted

Consolidated

(Date of

Forgiveness)

Forgiveness

Transaction

Adjustments

Balances

Subsequent to

Forgiveness

Transaction

Assets

Cash 700,000 700,000 700,000 (250,000) 450,000

Financing

Receivables 20,000,000 (7,000,000) 13,000,000 20,000,000 (7,000,000) 13,000,000

Deferred fin costs 650,000 (650,000) - 650,000 (650,000) -

Inventory 3,000,000 1,000,000 4,000,000 3,000,000 1,000,000 4,000,000

Fixed Assets 600,000 600,000 600,000 600,000

Oth Assets 350,000 350,000 350,000 350,000

25,300,000 (6,650,000) 18,650,000 25,300,000 18,400,000

Liabilities

AP/Accruals (3,000,000) (3,000,000) (3,000,000) 2,000,000 (1,000,000)

Notes Pay- Old (40,000,000) (40,000,000) (40,000,000) 40,000,000 -

Notes Pay-New - - (15,000,000) (15,000,000)

Other Notes

Payable (2,500,000) (2,500,000) (2,500,000) (2,500,000)

Other Liab (300,000) (300,000) (300,000) (300,000)

-

(45,800,000) (45,800,000) (45,800,000) (18,800,000)

(Equity) Deficit 20,500,000 6,650,000 27,150,000 20,500,000 (20,100,000) 400,000

-


Exercise (cont’d)

1.-

2.-

3.-

4.-

5.-

6.-

7.-

8.-

91

Questions?Questions?Questions?Questions?

Contact InformationBarry M. Weins, CPA Cherry, Bekaert, & Holland

813-251-1010

[email protected] Diane J. Reich, CPA

Reich CPA, LLC

813-405-6164

[email protected]

october 1, 2010...do you apply extinguishment or modification accounting? is there an extinguishment...

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