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Here’s an interesting ramification of Covid 19 we at Abo and Company / Abo Cipolla Financial Forensics were recently reminded of. Many business attorneys and accountants, like us, have clients who, due to the COVID-19 pandemic or other factors, have modified (or are trying to modify) existing loans to avoid a foreclosure or other action by the lender. For various reasons, lenders are working with borrowers who can't make their loan payments, hoping that government stimulus will tide things over until the economy improves and the loan is eventually repaid (or mostly repaid).
Many lenders are providing forbearance (not taking certain actions available to them under the terms of the loan, such as waiving an acceleration clause when the borrower misses a payment) for a certain time period. Others are lowering the interest rate or extending the loan's maturity date. While these actions are certainly beneficial for the borrower and may help get the loan repaid, the trouble is that a loan modification that is "significant" can result in a deemed Cancellation of Debt (COD) that, unless an exception applies (such as the taxpayer's bankruptcy or insolvency), is taxable income to the borrower. Ouch.
As an aside, we are limiting our comments to our world of “non-publicly traded debt” but, still, the debt modification rules are complex. We just wanted to alert our colleagues to recognize some common situations where the client may have taxable income, as well as those where a loan restructuring is not a significant modification. We’ll keep our comments general but appreciate that this can impact a whole array of case types you just hadn’t envisioned would be affected (yep, even matrimonial, damages, shareholder disputes, valuation and other cases).
Recognizing a Debt Modification -
The first step is determining whether a modification has occurred. Our legal colleagues tell us that a debt modification is any change to a borrower's or lender's right or obligation under a debt instrument, whether or not made in accordance with an express oral or written agreement. Examples we’ve seen include deferral of interest payments, extension of the maturity date, changes to the interest rate, subordination of the debt, or changes to the collateral.
Certain transactions, by definition, are not modifications. A change that occurs under the terms of the loan (such as an interest rate that changes because it is tied to an index) is generally not a modification. Of course, even if it occurs under the terms of the loan, a change in the borrower or in the recourse nature of the loan is a modification.
Also, as long as there is not an agreement (written or oral) to change other terms of the loan, a lender's agreement to stay collection or to waive an acceleration clause or similar default right (forbearance) for two years or less is not a modification for these tax purposes. However, while temporary forbearance for the two-year period (starting with the borrower's first failure to perform under the debt) alone is not a modification, if payments are deferred along with forbearance, a modification (potentially significant) could occur. Also, a borrower's failure to perform obligations under a loan is not itself a change to the obligation or to the parties' legal rights and is therefore not a modification.
When is a Modification Significant? -
If a modification occurs, the next step is to determine whether it is significant. This can get rather technical but, fortunately, the IRS regulations provide five bright-line tests for determining whether a debt modification is significant and a general "catch-all" test.
Does the Modification Result in COD Income? -
If a significant loan modification occurs, borrowers are treated as if they settled the old debt for an amount equal to the new (modified) debt's issue price. If the new debt's issue price is less than the amount of the old debt, COD income is realized.
The new debt's issue price is its principal balance, provided it has adequate stated interest. A loan has adequate stated interest if its principal amount is less than or equal to the net present value of all the payments due under the loan (including stated interest) discounted at the Applicable Federal Rate (AFR). The AFR is announced monthly and depends on the loan's term, but for May 2021, the highest AFR that could apply for this test is 2.15%.
COD income will generally not be recognized if the modified loan's principal balance is the same as the original loan's and the modified loan bears adequate interest. However, a modification of the principal balance can trigger COD income.
An Abo Take Away -
In many cases, a modification of a non-publicly traded debt, even if significant, will not trigger COD income. However, rather than assume that's the case, we want to be armed with the information we all need to get the facts and run the numbers if our client has modified (or is planning to modify) a loan. If you run the traps and find out that a transaction doesn't trigger COD income, your client will be happy (even if they grumble about fees). But, on the flip side, being informed by the IRS after the fact that they owe tax on a loan modification that nobody addressed will probably make them do more than grumble.
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