S Corp Issues & Restructuring Obligations In and Out of Bankruptcy
A company facing mounting debt and shrinking business opportunities needs to quickly put in place financial management tools to monitor the entities current financial health as well as react to the legacy obligations of the company.
The implementation of the tools to manage the ongoing operations, and most importantly cash flow, are vital to successfully navigating a reorganization. By the same token, dealing with the existing debt and equity structure of the company takes a significant amount of planning to achieve the desired result not only from an operational perspective, but also to manage the potential tax impact to the entity and its ownership.
An S corporation’s unique ownership requirements impact potential decisions. The decision to convert debt to equity may be impacted by the numerical shareholder limitations as well as the debt holder’s ability to be a qualified shareholder. The S corporation must also be careful not to issue a second class of stock when considering stock warrants and rights, which would serve to terminate the S election. Another complicating factor may be the entity’s prior existence as a C corporation. In these instances, the entity must consider the impact of the built-in gains tax as well as limitations on the use of tax attributes.
The restructuring of debt obligations that can occur not only when the debt is forgiven in whole or part, but also when the terms are modified, carries the issue of forgiveness or cancellation of debt. The Internal Revenue Code calls for the cancellation to be included in income. There are exceptions to the inclusion; the most notable are entities in bankruptcy or those that are insolvent. The exclusion is not without cost, however, as the entity will need to adjust tax attributes to the extent that the cancellation is not included in income. Accordingly, debt modifications of any type require a review of the entity’s solvency status at the time of the modification as well as the impact associated with availing itself of the exclusions available.
Shareholder basis also becomes a key issue as new debt structures are considered in order to maximize the shareholder’s ability to recognize the losses incurred. Basis is also a factor where accumulated earnings and profits exist from a prior C corporation status. In these instances, an election under IRS §1368(e)(3), known as the leapfrog election, may be a consideration.
The final consideration is utilizing the reorganization provisions under the Internal Revenue Code §368. The E-Type involves the restructure of the debt and equity sections of the balance sheet; the D-Type provides for parent subsidiary structures; the G-Type provides for the transfer of assets; and all can be successfully utilized.
The successful navigation of a reorganization of an S corporation is not a do-it-yourself undertaking. Having a team of knowledgeable finance, tax and legal professionals is indispensible to your success.
If you have any questions please contact a Partner in our Insolvency, Reorganization and Bankruptcy Services Team:
Ken DeGraw, CPA, CFE, CFP®, CRFA®
Team Leader
908.526.6363 ext. 3310
[email protected]
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