In today’s economic environment, businesses are looking to modify and re-structure debt to pull through until the economy turns around. Rather than allowing so many loans to go bad, lenders are working with debtors to re-structure loans in a manner that allows the debtor to stay in business. For example, a lender may allow a debtor to cease making payments for six months in exchange for increasing the interest rate for the life of the loan. Another example would be a lender who might agree to reduce the principal amount of a loan increasing the probability of receiving some return of capital rather than risking that the borrower would stop paying altogether.

In re-structuring debt, a borrower (debtor) needs to be aware of potential tax consequences that will cause the debtor to recognize taxable income even though not receiving any additional payments. If a debtor is relieved of a valid debt (or any portion of a loan), the debtor must recognize ordinary income in the amount of the debt cancelled. Although there are some situations where such “cancellation of indebtedness income” or “CODI” may be excluded, in many situations a debtor must pay tax when relieved of debt.

For example, business X owes Bank $500,000 and Bank agrees to accept $400,000 in full payment of the loan. Because Bank has forgiven $100,000 of indebtedness for X (and no exclusion from income applies), X must recognize $100,000 of ordinary income in the year the debt is forgiven. If X is an individual or the sole owner of a pass through entity (such as a limited liability company), and if X pays tax at the highest income tax rates, the forgiveness of debt results in $35,000 of tax payable to the IRS (plus additional tax for state income tax).

Although the example above appears bad (with the accrual of phantom taxable income), at least the taxpayer can see it coming and try to take steps to avoid it. There are other situations where CODI can accrue even though no actual debt was forgiven. This problem is most severe, and perhaps least fair, in certain debt modifications. Thats right, a business can modify a debt, maybe agree to a higher interest rate, and have to pay tax because the statute will deem CODI to arise.

Accrual of CODI will not occur in all debt modifications, but in some cases such accrual of income can surprise everyone involved. If the debt is traded on an “established market”, then any significant modification to the debt will be deemed to be the re-purchase of the debt by the debtor at the debts fair value and then the re-issuance of new debt to the lender. When such debt is deemed to be re-purchased by the debtor, the debt’s fair value will most likely be less than the face amount. For example, business X owes Bank $1,000,000, but at the time of the modification, the fair value of the debt is $700,000. X will be deemed to have purchased the debt for $700,000, and accrue CODI for the remainder of the debt of $300,000. The debtor is then deemed to have issued to the lender new debt. Therefore, even if the only debt modification is that X agreed to an adjusted interest rate, X will have to be tax on $300,000 of phantom income.

The problem described above occurs only if the debt is traded on an established market. However, the meaning of “traded on an established market” can be broader than it at first appears. The Treasury Regulations describe a debt as traded on an established market if: (i) it is traded on a registered national securities exchange, interdealer quotation system, or certain foreign exchanges; (ii) it is traded on a designated contract market or “interbank market”; (iii) it appears on a system of general circulation . . . that provides reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent sales transactions (a quotation medium); or (iv) it is a debt instrument for which “price quotations are readily available from dealers, brokers, or traders”. Although the description contained above is somewhat simplified, in today’s banking environment, many loans taken from large national banks will fall into one of the categories listed above and therefore the debt will be deemed to be “traded on an established market”.

Although it is unclear what modifications will be deemed to be “significant modifications”, clearly an interest rate change will qualify. Also, some modifications to the number or terms of payment will qualify.

Congress has taken action to provide some relief for taxpayers getting caught in this CODI trap during the current economic conditions by adding new Section 108(i) to the Internal Revenue Code. New Section 108(i) allows taxpayers to elect to defer taxation of CODI on “applicable debt instruments” on transactions which occur in 2009 or 2010. If a taxpayer accrues CODI during 2009 or 2010, the taxpayer can elect to defer recognizing such income (and thus deferring the obligation to pay tax on such income), until 2014. The taxpayer can then further defer the recognition of such income by recognizing only a pro rata portion for each of the years 2014 – 2018. Therefore, even though the taxpayer will eventually have to pay the tax on such income, the taxpayer can elect to defer that obligation to later years (and spread out the pain over a 5 year period).

An “applicable debt instrument” is any debt instrument issued: (i) by a corporation; or (ii) by either an individual or a pass through entity (such as a partnership or limited liability company) if such debt was issued in connection with a trade or business.

The moral is that you need to involve your tax advisor in most business transactions that involve loan modifications. Even if you simply agree to pay more interest (and thus not receive any increase to your net wealth), you could suffer an adverse tax consequence.

Just this week, another big financial company — CIT Small Business Lending Corporation — filed bankruptcy. CIT filed a “prepackaged” filing, in which terms for restructuring are negotiated before the bankruptcy case is filed. In more conventional bankruptcy filings, it can take a year or more before a plan is confirmed; in a pre-pak, filers may have a plan confirmed in a month or two.

Having a confirmed plan, of course, achieves the desired reorganization, and allows the company to continue in business under a new business plan or model, with workable debt load and other stable financial underpinnings. The faith of investors and vendors must be strong for the enterprise to exit and prosper. During the negotiations prior to the filing, the terms can be worked out in a mutually-acceptable manner, rather than with the heavy leverage that courts often apply when they control whether a firm exits intact or is dissolved.

On Tuesday CIT was granted Bankruptcy Court approval to immediately tap $125 million of a debtor-in-possession loan through Bank of America Corp. when Judge Allan Gropper of the U.S. Bankruptcy Court for the Southern District of New York signed off on numerous routine “First-Day” motions. Included was permission to continue making intercompany loans and pay essential employees and vendors. There is a December 8 hearing date to consider approval of CIT’s reorganization plan, which reportedly already has secured the preliminary approval of 90 percent of eligible debt-holders who signed off on the prepackaged chapter 11 plan.

We sincerely hope that CIT can exit and get back to the essential role of lending to small business quickly. In this economy where glimpses of recovery compete with reports of continued losses in employment and consumer purchasing, a stable and friendly source of capital may be the only sure salvation of many of our best small companies and entrepreneurs.

What else can be done to help small business survive and thrive in the tough times we’re in?

(Hat tip to Stefan Calos for contributions to this article.)

The first two provisions of the Credit Card Accountability, Responsibility, and Disclosure (“CARD”) Act of 2009 went into effect Thursday, August 20, 2009.  The CARD Act is designed to protect consumers from unfair and deceptive practices by credit card companies. 

These provisions are:

1. 21-day grace period.  Beginning on August 20, credit card issuers must mail your bill at least 21 days before it is due instead of the current 14 days.  This gives consumers who pay attention a little more time to get their payment in on time. 
2. 45-day advance notice of interest rate increases.  Also beginning on August 20, credit card issuers will be required to give consumers at least 45 days notice about interest rate increases, instead of the current 15-day advance notice requirement. This allows consumers additional time to contact credit card issuers or to move balances – if consumers open and read these notices. 

The bulk of the protections go into effect in February 2010, with a few final changes coming in July 2010.

According to the White House, the key elements of the CARD Act are:

• Bans Unfair Rate Increases
• Prevents Unfair Fee Traps
• Plain Sight /Plain Language Disclosures
• Accountability
• Protections for Students and Young People

 The CARD Act will also limit over-limit fees, apply payments over the minimum payment to the balance with the highest rate, and spell out more clearly how long it will take a consumer to repay a debt.  ,

The Center for Responsible Lending has looked at credit card issuer practices since the legislation was proposed and found that while issuers are voluntarily implementing some of the CARD provisions, they are also suddenly cutting credit limits and raising all sorts of fees.  Some of these practices will be forbidden next year. 

What are your recent experiences with credit?  Have your accounts been closed, credit limits been lowered or additional fees imposed?  Are you able to get business credit?  If so, we’d love to know who’s interested in doing business.

In Wednesday’s Business Week, Ben Steverman’s anaylsis of the possiblities of upcoming bankruptcy activity indicates that filings, rather than slowing as the economy gains its footing again, will instead swell with the failure of numerous entrepreneurial and high-debt companies. His opinion is that this will be due largely to the continuing spin-down in consumer demand and tight credit markets.

I don’t know if Mr. Steverman is right, but the fact is his article concerns me. Granted, I could just look forward to another busy sixteen to eighteen months. After all, business failures contribute to the activity in my practice. But the part of me that is hopeful about our financial system and small business in general wonders if another long and sustained decline in employment and the lost wages, profits and taxes that those jobs represent will cause our government to borrow even more against our country’s future and add inflationary pressure to the other effects of the recession from which we suffer.

On the other hand, maybe the doom and gloom that Business Week predicts will be made less credible by the recovery of financial standing by large businesses which have slashed debt and costs as a survival strategy. How are you feeling about your business’s prospects over the next year or so?

As a business attorney, I tell clients they should have a trusted “kitchen cabinet” of professionals to go to for advice:  attorney, accountant, insurance agent and financial planner.  It is nice to know someone and feel comfortable before you have a problem.  Yet, finding a trustworthy professional in these fields can be daunting.  How can you find reputable professionals and develop a relationship?

As with any service provider, word-of-mouth referrals are the most powerful.  Ask other business owners, friends, church members and colleagues who they use and why.  If you already have a trusted insurance agent or accountant, ask them for referrals for the other professionals.  You can also meet many professionals at Chambers of Commerce and similar business networking groups. This is nice because you will be able to observe their personalities and learn a little about them in an informal setting. 

Then do some research. 

Each of these professionals is licensed by a state regulatory board, such as the State Bar for attorneys, a Board of CPA Examiners or the Insurance Commission.  Financial planners can be merely brokers who sell various financial products and are licensed by the Financial Industry Regulatory Authority (FINRA) or they can obtain a voluntary additional credential known as a Certified Financial Planner, which means the certificant’s first duty is to the client as a fiduciary, ensuring that recommendations are in the client’s best interests. The broker’s first duty is simply to make sure that the client’s situation can reasonably handle the recommendation, and the further duty of the broker is to sell a product.  

It is wise to make sure your advisor is currently licensed. 

Many professionals will have a web site listing their area of expertise, practice philosophy, education, etc., although insurance agents tend to have fairly generic sites featuring one of the companies they represent.  Look through the site and see if their philosophy and geography mesh with yours.  I also conduct an online search to see if the professional has been in the news, has been published, is active in the community, etc.  They may have a blog with interesting information that helps you know them better. 

Call and set up an introductory meeting with your potential professional.  Ask ahead of time if there is a fee for this.  At that meeting, you will want to ask about what services are offered, how they are priced, what payment terms are offered, and who will actually be doing your work.