The American Bar Association Section of Taxation has outlined how Treasury and the IRS can offer safe harbors and clarify tax rules for financially distressed companies exploring out-of-court restructurings.
“Our Comments are based on the belief that tax policy should not preclude a workout or compel a company (or person) into bankruptcy,” the ABA said in an August 17 letter to Treasury and the IRS.
The group said it was responding to a request from IRS Chief Counsel Michael Desmond. “We understand that Chief Counsel Desmond requested the Section’s input to help the [IRS] understand, and potentially issue appropriate guidance with respect to, the most pressing issues that are arising (or are likely to arise) in workouts and restructurings pursued in connection with the COVID-19 emergency,” the ABA said.
The letter suggests ways the government can address traditional workout issues faced by financially distressed businesses and their workout partners, as well as how individuals and businesses can better resolve outstanding tax debts with the IRS.
Working Out the Kinks
For workout issues faced by finally distressed companies, the ABA recommended that Treasury and the IRS issue guidance providing that a responsible person who miscalculates an employee retention tax credit under the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) or a paid family leave credit under the Families First Coronavirus Response Act (P.L. 116-127) won’t be held liable for a section 6672 trust fund recovery penalty to the extent liability is attributable to a good-faith miscalculation of the credit.
The ABA said there is “a very real possibility” that some companies that opt to take advantage of those credits and whose employees in good faith miscalculate credit amounts could become distressed and unable to satisfy later-determined underwithholdings.
“In this circumstance, individuals at the companies in question could potentially be exposed to personal liability, depending upon whether they are ‘responsible persons’ who ‘willfully’ failed to collect, truthfully account for, and pay over any trust fund tax,” the letter said.
The ABA said it would also be helpful if Treasury and the IRS clarify whether “good faith” includes cases in which an employer that was originally eligible for a credit later becomes ineligible because of a change in circumstances. The group gave as an example an employer that buys a company that received a Paycheck Protection Program loan; under the aggregation rules, they might be treated as a single employer.
“In such a situation, we understand that Treasury and the Service might take the position that the employer no longer would be eligible for an Employment-Related Credit and might have underfunded the employee’s share of employment taxes,” the letter said. “Guidance would be helpful as to the extent of the liability the employer faces, if any, for underfunding the trust fund taxes.”
The ABA also suggested that the government clarify the uncertainty about how to calculate the extent of a company’s insolvency when determining the amount of cancellation of debt income excluded from gross income.
“Specifically, we recommend a safe harbor in which the value of public debt is presumptively the value of the debt for purposes of the insolvency calculation,” the letter said. “We also recommend a safe harbor in which a debtor will be presumed to be insolvent with respect to any workout in which the equity is completely eliminated and the creditors take all of the assets or equity of the company.”
Other Helpful Guidance
The ABA also suggested that Treasury and the IRS clarify the interaction between sections 163(j) and 108 by issuing guidance stating that the forgiveness of accrued interest for which a deduction was deferred under section 163(j) doesn’t give rise to cancellation of debt income, but instead reduces the excess business interest expense carryover under section 163(j).
The government should also issue guidance confirming that an elective change in entity status won’t be treated as a modification of a debt instrument under section 1001, and any change in obligor or the recourse nature of debt as a result of an elective change in entity status won’t be taken into account in determining whether related modifications to a debt instrument are “significant” for section 1001 purposes, the ABA said. It further suggested that guidance be issued under reg. section 1.1001-2 clarifying the treatment of recourse debt of a disregarded entity.
Other recommended guidance would clarify that the payment ordering rule applies only to interim payments and not to a payment in satisfaction of or termination of a debt; clarify that a holder of an instrument with original issue discount doesn’t need to accrue additional OID when the collectability of the OID is doubtful, and that a holder of an instrument with market discount doesn’t need to accrue additional market discount under the same circumstances; clarify when the section 1273 investment unit rules apply to situations in which some elements of the investment unit are publicly traded and other elements are not; and clarify that trading in distressed debt won’t cause the debt to be treated as stock for purposes of section 382.
Treasury and the IRS should also formally announce that they don’t intend to finalize the proposed section 382(h) regulations (REG-125710-18), issued in September 2019, until at least 2021, the ABA said. “If finalized in their proposed form, these proposed regulations would change the landscape of current law in ways that have significantly adverse impacts for affected taxpayers, including certain taxpayers engaged in workouts and restructurings,” the group said.
OIC Fixes
The ABA offered suggestions on how financially distressed individuals and businesses can better work out their tax debts through the IRS’s offer in compromise program.
The agency could adopt a streamlined OIC by tweaking some existing tools and processes, according to the group. It noted that after taxpayers use the OIC Pre-Qualifier Tool, which calculates “reasonable collection potential,” the taxpayer is directed to a 32-page paper form that collects the same financial data already provided in the Pre-Qualifier Tool.
“We believe that this time-consuming process could be streamlined considerably if the Service made greater use of the Pre-Qualifier Tool for taxpayers with income and assets that are easily verified and valued,” the ABA said. “Service employees could then focus their efforts on scrutinizing the income and assets of relatively higher-income taxpayers who have more realistic collection potential.”
The IRS should also redefine the OIC asset valuation criteria included in the calculation of reasonable collection potential by carving out the value of assets that are protected by current federal exemption laws, the ABA said. “We believe this will benefit taxpayers and the Service by making the OIC process a more realistic alternative to bankruptcy,” it said.
Another helpful change would be to revise the five-year compliance period, the ABA said. It noted that many taxpayers faced with the choice between a bankruptcy and an OIC favor the true “fresh start” of a bankruptcy. “Against this background, we recommend that the Service close an OIC once it has been paid-in-full and cease monitoring during the five-year post-OIC-acceptance date,” the group said.
The ABA further recommended that the IRS suspend the recoupment of refunds, including income-based credits, for pending and accepted OICs through at least the end of 2020, or permanently. The group said the IRS should also clarify that refunds won’t be recouped to the extent they are attributable to economic impact payments, and those payments won’t be treated as available assets for purposes of computing a taxpayer’s available individual equity in assets.