Taxing forgiveness

In this tough business environment, sometimes the easiest way to deal with overwhelming financial challenges is to walk away. As interest rates rise and demand for certain goods and services slackens, some companies might find that their existing debt obligations are simply too much to deal with.

That situation leaves organizations looking for alternatives to paying off the debt directly, choosing bankruptcy or another debt forgiveness approach such as consolidation, or loan modification.

In fact, bankruptcy is a step that a growing number of companies are taking. Commercial Chapter 11 filings grew 105% from May 2022 to May 2023, according to research by Epiq Bankruptcy. Corporate bankruptcies reached a 12-year high at the beginning of 2023, according to S&P Global Market Intelligence.

But modifying or canceling debt can come with a range of tax issues—especially with regard to taxes for cancellation of debt income (CODI) and companies may end up unexpectedly owing money on discharged debt.

Businesses that are seeking a debt cancellation or modification need to be aware of the potential for different tax treatment, depending on how the deal is structured, Jennifer Galstad-Lee, senior manager of tax at GRF CPAs & Advisors, told CFO Brew.

“Watch out for how things can be classified for tax purposes,” she said, adding “tax planning wherever debt is forgiven can be very important.”

Pressing issue. Many companies, Galstad-Lee noted, have likely dealt with a similar issue in recent years, even if they’re doing well: Loan forgiveness from the pandemic-era Paycheck Protection Program led to a range of complications, including how to recognize potential revenue, what counts as covered expenses, and determining the timing of loan forgiveness, for businesses filing their taxes.

Probably the most important issue for businesses to be aware of, Galstad-Lee said, is “the difference between federal and state taxation.” A popular policy you might have heard of in the national news might be different in your state, or the reverse might be true. And multi-state corporations could have a variety of obligations to consider.

A common problem Galstad-Lee cited is determining when, exactly, a debt was forgiven, and when the resulting taxes are owed. Due to all the vagaries of accounting and legal practice on the part of the lender, a tax document indicating debt forgiveness “may not come in the year when the debt is actually forgiven.”

Businesses also need to be aware of tax treatment for loans they make to shareholders or employees. If a company closes with those loans on the books, Galstad-Lee said, the individual could be on the hook for taxes related to CODI.