Tax planning opportunities for LLCs and S Corps that restructure their debt?

Two recent developments impact the tax consequences of debt restructuring for insolvent entities that are pass-through entities for tax purposes, such as LLCs or S Corps.

When debt is restructured or paid back at less than its face amount, income can be triggered from the cancellation of the debt. This can have adverse tax consequences for entities that have borrowed money, and now must renegotiate its debts. There is an exception for debtors that are insolvent, but the practical application of the insolvency exception to pass-through entities has not always been clear.

The Treasury Department recently finalized Regulations explaining how the insolvency exception applies in this situation, which clarify that the insolvency exception applies if the owner of the entity is insolvent, not just the entity itself. This can cause the owner of an insolvent entity to trigger a personal tax liability when the entities debt is re-negotiated.

Although the newly-issued regulations make it more likely that individuals may become subject to tax, a recent court decision may help them avoid this result. In Majestic Star Casino, the Third Circuit concluded that a shareholder of a bankrupt corporation had the right to revoke a Subchapter S election retroactively, reversing the holding of the Bankruptcy Court that the revocation constituted an unlawful transfer of the property of the bankrupt entity. This revocation had the effect of trapping the tax impact of the cancellation of debt at the entity level, effectively shifting the adverse tax consequences from the shareholder to the creditors.