Final IRS Regulations Hurt Consolidated Groups

Background

Where a corporation is in financial distress, a restructuring or reduction of its indebtedness may result in cancellation of indebtedness. Cancellation of indebtedness (COD) is generally taxable, but is not taxable if the distressed corporation is in bankruptcy or is insolvent (but only to the extent of the insolvency). When cancellation of indebtedness is not taxable because the distressed corporation is bankrupt or is insolvent (“excluded COD”), the amount of COD is applied against and reduces the corporation's tax attributes, starting with net operating losses (“NOLs”) and ending with the tax basis of assets (eg, fixed assets, inventory and receivables). If the amount of excluded COD of a distressed corporation exceeds its tax attributes, however, the excluded COD “disappears” and has no further tax effect. Thus, although the distressed corporation will avoid current taxation with respect to excluded COD, the mechanism of reducing tax attributes by excluded COD may serve to increase its corporation's future tax liability by reducing the NOLs and the tax basis of assets (and depreciation with respect thereto) that offset taxable income. Under long-standing rules, the distressed corporation's tax attributes are reduced on the first day of the tax year following the event that resulted in excluded COD. This means that the distressed corporation's tax attributes remain available in determining tax liability for the tax year in which it realizes excluded COD.