The last year and a half has been nothing short of tumultuous. Virtually all businesses have had to adjust during the worldwide recession. While many surviving companies are now operating at a positive cash flow, some have sustained such significant losses that it would take many years of profits to repay their debts in full.
In past downturns, one survival tactic was to sell idle assets and use the proceeds to pay off secured debt, using any excess money to fund the business. In more dire circumstances, an alternative was to sell the entire company; frequently, this occurred at amounts greater than liquidation value, which allowed secured debts and personal guarantees to be extinguished. The final traditional alternative was to file a bankruptcy petition and use this process to reorganize the company and renegotiate its liabilities.
Today, however, these alternatives are decidedly less attractive for many companies. The value businesses could expect from the sale of idle assets is now lower than the outstanding secured debt. What few buyers exist for distressed companies want a bargain price that may leave owners stuck on personal guarantees and no future income. Finally, the bankruptcy process is lengthy, expensive, and too difficult for a middle-market company to survive.
The reality of today’s business world is that there are fewer options than in the past. One of the remaining viable options is to use an out-of-court debt settlement process to negotiate a compromise with creditors. This process tends to be less expensive than bankruptcy court and provides more control to the company, since a judge is not required to approve the deals. However, it still requires a significant investment of time by company management, sharing of confidential company information, and agreement by most if not all affected creditors.
Step by Step
An out-of-court debt settlement includes the following steps:
- Estimate the value of the enterprise, the major individual assets, and the amount of debt needing to be reduced.
- Determine if new and/or additional financing is available on company assets.
- Identify any excess assets that could be sold to provide funds for settlement.
- Determine how much cash flow is available to service debt.
- Present the business case for compromise with creditors; expect several negotiating sessions to ensue.
- Settle on price and terms, and execute agreements.
- Make settlement payment(s).
The debt settlement process typically takes anywhere from several weeks to several months to achieve executed agreements. During this process, creditors are trying to evaluate their other options. Should they put the company on cash on demand payment terms? Would they be better off filing an involuntary bankruptcy petition against the company? Should they try to force the company to sell itself?
How can companies get creditors to agree to a debt settlement? First, they must prove an inability to make payments in full. Second, it’s important to demonstrate that a sale of the business or assets will yield less overall value for the creditors. Successful prior working relationships with strong trust are a plus as well.
It’s also important to be transparent; the more open a company is with its financial information and circumstances, the more likely creditors will trust the process. Predictability of future performance is also a factor; the more certainty companies provide on financial results and how that translates into payments under a negotiated settlement, the better.
Planning Is Paramount
The economy has hurt many businesses, but that doesn’t mean a company cannot be saved through an out-of-court debt settlement process. These are high stakes negotiations, so being prepared with a well-thought-out negotiating plan is paramount.
What’s Tax Got to Do With It?
If a business is successful in obtaining debt relief concessions from any of its lenders, the amount of this relief is generally taxable as ordinary income to the business at the time it’s forgiven. If the business has a net operating loss, this loss may offset the cancellation of debt (COD) income. If it doesn’t, the business may be required to use its precious cash to pay federal and state income tax due on this COD income.
There are several exclusions from recognizing this COD income provided under IRC Section 108. If the business is in bankruptcy proceedings or to the extent it is insolvent (on a fair market value basis), the debt forgiveness is not taxable. There are additional exclusions for purchase money or seller-financing debt, debt incurred in connection with business real property (except for C corporations), and certain farm debt. For a partnership or limited liability company taxed as a partnership, these exclusions are applied at the partner or member level. The toll charge for these exclusions is that the business must reduce certain tax attributes, such as net operating losses, tax credits, or the tax basis of property, as of the first day of the succeeding tax year.
Special rules also apply when a creditor forgives debt in exchange for company stock or other ownership interests. The forgiveness is tax-free to the extent of the fair market value of the stock or other equity interest issued to the creditor; the excess amount of the forgiven debt is COD income to the business.
If none of these exclusions is available and the debt is forgiven in 2009 or 2010, the business may elect to defer the recognition of this COD income until 2014. The deferred COD income is reported ratably over a five-year period commencing in 2014 when the business may be in a better cash position to pay the income tax on this deferred COD income. This deferral may be accelerated if substantially all of the assets are sold, the business activity ceases, a bankruptcy court petition is filed, or in several other circumstances.