Navigating the State Tax Rules on CODI When Buying a Struggling Target
Navigating the State Tax Rules on CODI When Buying a Struggling Target
For those of you who have performed tax work in the restructuring space, it is clear that sometimes tax is the dog and sometimes it’s the tail. Knowing which one it is helps chart the course of the tax work in a particular situation. Understanding the tax consequences of various restructuring alternatives allows the holders in interest to maximize value. This includes understanding what happens to the company’s tax attributes and estimating post-restructuring cash taxes. To fully understand the tax consequences, the state tax impact must also be considered. While there are numerous different sets of rules (i.e., 50 states, D.C., and various localities), there is fortunately some consistency based on the state tax laws themselves as well as federal legislation under the bankruptcy laws.
In 1978 and again in 2005, the U.S. Congress addressed state and local tax rules as part of federal bankruptcy legislation. The 2005 bankruptcy code legislation was a major milestone and made substantial changes relating to the state and local tax consequences of bankruptcy to provide greater conformity with the federal tax rules. In general, state income tax calculations start with federal taxable income. However, while some states follow the Internal Revenue Code (IRC), including amendments as they occur (rolling conformity), other states only incorporate the IRC as of a particular date (static conformity), and some states only follow specific federal laws (selective conformity). Regardless of each state’s differing conformity rules, most state tax laws conform to federal income tax laws by incorporating the federal computation of taxable income as the starting point for calculating state taxable income. Accordingly, the state income tax consequences of bankruptcy transactions and the calculation of state taxable income for workouts in most jurisdictions follow the federal tax consequences. However, there remain some state and local tax nuances, especially with state and local jurisdictions that do not use federal taxable income as the basis for their tax. In those jurisdictions, the tax impact of restructuring requires special attention.
Below, we briefly review the federal tax consequences of debt restructuring that form the basis of many state tax consequences and then review some of the most material state tax considerations in workouts. These include whether a state bases the tax impact of workouts on the federal rules, the apportionment or allocation of cancellation of debt income (CODI), the sourcing of CODI, the state tax attribute reduction rules, and certain other important rules.
Brief Overview of Federal Taxation of CODI
A company is generally taxed on its canceled debt when the debt is cancelled for no consideration. To mitigate the financial hardship on struggling companies, federal tax rules generally do not impose cash tax on CODI if the company is in bankruptcy or to the extent the company is insolvent (i.e., the fair market value of all of the company’s tangible and intangible assets is less than the overall debt immediately before the forgiveness).
As a quid pro quo for allowing the company to avoid cash tax on the CODI, the company’s tax attributes must be reduced, including net operating losses (NOLs), tax credits, and the tax basis of assets (including accounts receivable and inventory), passive activity losses and carryforwards, and foreign tax credit carryovers. Tax attributes are reduced at the start of the tax year following the cancellation of the debt. This allows the company to use these attributes if needed in the year CODI is triggered. The federal tax rules also assist financially distressed companies by providing a limitation on the reduction of the tax basis of the property based on the amount of indebtedness retained by the company.
State Tax Law Conformity With Federal Tax Rules
As noted above, while most states start the calculation of their taxable income with federal taxable income, states do not always conform to federal rules regarding recognition of income and deductions. As noted above, states have varied conformity laws, with some automatically following federal law (rolling conformity), following as of a specific date (static conformity), or only following specific federal laws (selective conformity).
Approximately half of the states have rolling conformity to the IRC for corporate and individual income tax. The remaining states adopt the IRC via static or selective conformity language. It’s important to note that while some states may have rolling conformity for corporate income tax, they don’t have rolling conformity for individual tax, such as Massachusetts and Pennsylvania. Approximately 22 have static conformity for individual or corporate taxes, and the others have selective conformity.
The state conformity rules became much more complicated as a result of the Tax Cuts & Jobs Act (TCJA); the Coronavirus Aid, Relief, and Economic Security Act (CARES Act); and the American Rescue Plan Act (ARPA) because the states more actively chose whether or not to adopt the federal rules, including the business interest expense limitation rule of Section 163(j), changes to the net operating loss rules under Section 172, whether to tax forgiveness of loans under the Paycheck Protection Program (PPP), and the deductibility of expenses paid for with PPP loan proceeds.
Another area that may create a difference in state tax in workouts is group tax reporting. For federal income tax purposes, corporations can elect to file a consolidated income tax return, which means that a single income tax return includes all of the U.S. corporations that are connected through a certain level of common ownership (excluding certain ineligible corporations, such as real estate investment trusts [REITs], tax-exempts, and S corporations). While some states allow or require combined return filing for related corporations, others require separate returns for each entity. This adds to the complexity of understanding the state tax impact of CODI.
State Tax Rules on CODI Generally Follow Federal Rules
States generally do not impose income tax on CODI when a company is in bankruptcy or to the extent it is insolvent. This results from the states’ conformity with the federal tax rules, including application of the federal tax rules on CODI in Section 108. This is also consistent with BC Section 346(j), which provides that there is no state income tax on CODI on a bankrupt debtor, unless it is also subject to tax under federal tax law.
Akin to the federal rules, in exchange for not taxing CODI, states require the company to reduce their state tax attributes. Again, this results from state tax law conformity with the federal tax laws, as well as the application of BC Section 346(j). Only after tax attributes are reduced under the federal concepts adopted by the states, including the “Liability Stop” under Section 1017(b)(2) in the case of basis reductions, can other tax attributes be reduced under state or local tax laws.
PPP Loan Forgiveness as CODI
Many businesses took advantage of PPP loans during the COVID-19 pandemic. One of the most attractive features of the loans is that they are forgivable and that the forgiveness is not subject to federal tax. However, this exclusion from federal tax is not codified within the IRC. As a result, conformity does not determine whether a state follows the federal rule.
Many states do not impose tax on PPP loan forgiveness, though there may be differences in treatment between so-called “First-Draw” and “Second-Draw” PPP loans. The question is whether the states either follow the federal statute, not part of the IRC, in excluding forgiveness of the PPP loans from taxable income or otherwise adopt a subtraction modification. A number of states follow the federal exclusion from tax, including Illinois, Massachusetts (excluding personal income taxes), and New Jersey, while Rhode Island does tax some PPP loan forgiveness. New York follows the federal rules for PPP loan forgiveness for tax purposes. Oregon, which recently adopted a modified gross receipts tax, excludes PPP loan forgiveness from its Corporate Activity Tax. Particular attention should be paid to states that have static conformity with effective dates prior to enactment of the PPP program, including Michigan taxpayers who elect to use the IRC in effect on January 1, 2018.
Is CODI Business or Non-Business Income?
Once the relevant state conformity dates have been determined, understanding the state tax impact of CODI requires further analysis.
The first issue is to determine whether the state treats CODI as business or non-business income. When a company operates in more than one state, it must apportion its business income among those states. Non-business income, on the other hand, is not apportioned among the states but rather is generally allocated to a single state.
Some states still define “business income” the same as the 1957 Model Act, the Uniform Division of Income for Tax Purposes Act (UDITPA), as follows: ‘[I]ncome arising from transactions and activity in the regular course of the taxpayer’s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations.
States have commonly interpreted the UDIPTA definition of “business income” to include “transactional” and “functional” tests. The transactional component is whether the income arises from a transaction or activity in the regular course of the taxpayer’s trade or business. The functional component is focused on whether the acquisition, management, and disposition of the income generating property constitutes an integral part of the taxpayer’s regular trade or business operations.
Some states have amended their “business income” definition to include all income that is constitutionally apportionable.
In 1990, the Wisconsin Tax Appeals Commission held that the extinguishment of debt was not “business income” because the taxpayer was engaged in manufacturing - not acquiring and disposing of debt instruments. Plus, the transaction at issue was not from the sale of any asset, rather, there was simply a reduction of debt.
That said, it’s important to note that states – including Wisconsin – may treat CODI as apportionable business income. Unfortunately, treatment can be unclear in many states, as no explicit guidance has been provided.
In states where CODI is treated as business income, CODI must generally be apportioned among the states in accordance with the company’s normal apportionment methodology in the year of discharge. Also, for purposes of apportionment, the CODI must be “sourced” to a state. In other words, in applying the various states' apportionment rules, it must be determined in which state the CODI “sales” or “income” belong.
States generally apportion income based on a fraction. Historically, this fraction included equally weighted property, payroll, and sales factors. However, in recent years, the trend has been toward a heavily weighted or single sales factor. The sales factor generally represents the business revenue of the company sourced to the state (numerator) over total revenue (denominator). However, although CODI may be exempt from tax if the taxpayer is in bankruptcy or is insolvent, the forgiveness of debt is an accretion of wealth and is taxable if not exempt under one of the specific provisions. This raises the question of how CODI should be sourced for purposes of the sales factor. If such income is classified as “nonbusiness” or “non-allocable” income, such income should generally be sourced to the state of commercial domicile. Florida advised that cancellation of indebtedness is excluded from the apportionment formula. For Texas franchise tax purposes, CODI should be sourced to Texas if the payor (the creditor) is located in Texas.
Other methodologies to source CODI include treating CODI as income from an intangible property right or sourced based on the location of the costs of performance. For federal tax purposes, CODI is sourced based on geographic tracing of the use of the debt proceeds. Again, some states specifically exclude CODI from the sales factor. States may adopt this rule pursuant to an “alternative apportionment.” Other states may consider that including CODI in the sales factor does not properly reflect income under UDIPTA concepts. Some states exclude CODI from the sales factor where the debt is between combined group members.
If there is no specific rule regarding the inclusion of CODI in the sales factor, some states have a default rule for “other receipts.” Some states include other receipts in the sales factor, while other states may or may not include other receipts (“it depends”). Unfortunately, many states do not provide guidance, creating uncertainty in the state tax treatment.
Some states do not impose a tax on income but rather impose gross receipts or a gross receipts-based tax. Examples include Nevada, Ohio, Oregon, Texas, and Washington state. In these states, CODI may be included in the gross receipts base. Nevada imposes a Commerce Tax that includes CODI, other than CODI as a result of a bankruptcy proceeding. CODI is sourced to Nevada if that is the business situs. Ohio imposes a Commercial Activity Tax (CAT) and considers debt forgiveness as part of gross receipts for CAT purposes.
Oregon includes CODI in the definition of “amounts realized” for purposes of its CAT, which became effective January 1, 2020. Texas imposes its franchise tax on the taxable margin of every business and generally follows the federal treatment for CODI. The rules in Washington state are unclear.
Because there is uncertainty in this area, substantial work may be required to confirm a technically supportable approach, with a view to maximize value to the holders in interest.
State Tax Attribute Reduction Rules
As with the tax treatment of CODI itself, most states follow the federal tax treatment of reducing tax attributes. Most states conform to these rules without modification. At this stage, it is important to reiterate that the amount of NOLs and the amount of tax basis in assets for state purposes may differ from the federal amounts. For tax basis, material differences from federal and state may exist, particularly with respect to states that have decoupled from the federal bonus depreciation rules. In addition, substantial revisions to the federal NOL rules were made in TCJA and then in CARES and, since then, many states have decoupled from some or all of these revisions.
It should also be emphasized that the quality of the company’s state NOLs should be reviewed to confirm whether they are likely to be respected by the tax authorities. This may include determining whether the company filed returns in the jurisdictions where it claims a NOL, filed correctly in each jurisdiction, and applied the proper apportionment rules. In addition, it should be confirmed whether the cancelled debt was properly treated as bona fide debt under debt versus equity principles. Further, certain shareholder and creditor actions can essentially extinguish NOLs. If that occurs, all is not lost because the bankruptcy courts have the power to void such actions if the NOLs constitute a valuable asset of the bankruptcy estate.
Once you have determined the tax attribute amounts for state purposes, additional complexity may exist. While most states follow the federal attribute reduction rules in Sections 108 and 1017, some states have their own attribute reduction rules. The federal attribute reduction rules follow a specific order in reducing attributes. Under those rules, NOLs are reduced first, followed by general business and minimum tax credits, the tax basis of property (including A/R and inventory), passive activity credit losses and carryforwards, and foreign tax credits.
In reducing NOLs, it must be determined first whether income is allocable or apportioned to the state. Further, some states provide for pre-apportioned NOLs, while others provide for post-apportioned NOLs. In addition, it must be determined whether to use the apportionment of the year the NOLs were generated or the year of the discharge. Some states will seek to match so that post-apportioned NOLs are reduced by post-apportioned (and not pre-apportioned) CODI.
A minority of states reduce attributes on a pre-apportionment basis (e.g., Massachusetts, New Jersey, and New York). This means they apportion the NOLs to the state based on the apportionment methodology for the year utilized (not the year incurred).
Most states follow the Section 1017(b)(2) “Liability Stop” that limits the amount by which the tax basis of property is reduced under these rules.
To add another layer of complexity, the federal rules allow an election to file corporate income tax returns on a consolidated basis. A number of states conform to these regulations. Some states require combined reporting for “unitary” groups, while others do not allow combined reporting. Accordingly, any situation involving a federal consolidated return group will require particular state and tax scrutiny.
The federal consolidated return rules are notoriously complex. This area of the tax law is so complex that Congress, which drafts most federal tax laws, delegated the authority to draft the consolidated return regulations to the Treasury. Where a consolidated group member has CODI, its tax attributes will be reduced under the tax attribute rules. In addition, the basis of its subsidiaries may be reduced, and the subsidiaries’ tax attributes reduced under the so-called “look-through” rule. States that impose tax on a separate legal entity basis generally do not follow the federal consolidated return “look-through” rule for attribute reduction.
With respect to the cancelation of debt between members of the same consolidated tax group, different rules apply. Section 108’s general rule of exclusion from gross income does not apply to cancellation of a debt between members of a consolidated group. Instead, CODI is included in the debtor member's taxable income, and a bad debt deduction is allowed in determining the creditor member’s taxable income. This should generally be a wash for federal income tax purposes, with the CODI and bad debt expense offsetting one another within the consolidated return filing. While some states follow the federal rules, there may be substantial differences under the various state tax laws, especially in states that do not follow combined/unitary return filing.
Combined or consolidated reporting is required in a few of the gross receipts tax states, including Ohio, Oregon, and Texas.
IRC Section 382 - State Loss Limitation Rules
Often with financial restructurings comes a change in ownership. For tax purposes, that generally means there will be a limitation on the use of the corporation’s NOLs for federal income tax purposes. While the exclusion for current tax on CODI applies to both bankrupt and insolvent companies, only companies in bankruptcy are afforded special treatment under the loss limitation rules of Section 382.
Under the general rule of Section 382, a corporation’s use of its NOLs is limited after a 50-percentage point change in ownership over a three-year lookback period. The limitation is based on the “equity value” of the company immediately before the ownership change, multiplied by the long-term, tax-exempt rate published monthly by the IRS. For an insolvent company, the equity value immediately before the ownership change is zero, so the limitation will be zero.
For companies in bankruptcy, there are two special Section 382 rules, Sections 382(l)(5) and 382(l)(6). Under Section 382(l)(5), the use of a company’s NOLs are not subject to limitation under Section 382. This rule applies only where the equity holders and “qualified” creditors own at least 50% of the company’s equity post-emergence as a result of their ownership of the equity or debt before the bankruptcy. If Section 382(l)(5) applies, the company’s NOLs must be reduced by three years of interest expense deductions in addition to any reduction under the attribute reduction rules. Further, the Section 382 limitation will become zero if there is another ownership change within two years of emergence.
Under Section 382(l)(6), the equity value of the company will include the amount of debt converted into equity as part of the bankruptcy process. Under this rule, the company’s equity value immediately before the ownership change will be greater than zero.
As a result, if the company anticipates having material NOLs post-workout and can derive value from them through generating taxable income, it may make sense to use the bankruptcy process to take advantage of the special Section 382 bankruptcy tax rules rather than rely on a CODI exclusion using the insolvency exception.
Many states conform to the federal NOL loss limitation rules, including the availability of the special bankruptcy rules of Sections 382(l)(5) and 382(l)(6), though the various states pronouncements may not specifically refer to those subsections. In addition, some states may explicitly modify or reject the federal Section 382 rules. That being said, the rules in the state or states where the company has material NOLs should be carefully reviewed, particularly because some states do not follow the federal Section 382 rules or have modifications.
State sales and use taxes generally apply to 'receipts' from retail sales or other transfers of tangible personal property, as well as enumerated services. If sales tax was charged, collected, and remitted on an accrual basis, the creditor may be allowed a deduction for its bad debt. But, if sales tax is administered on a cash basis, then the retailer may still possibly be allowed a bad debt deduction if the retailer prepaid the sales tax.
As a general proposition, buyers prefer to buy assets because an asset acquisition “cleanses” many liabilities from the business. This is an even more important consideration for buyers of assets from a bankruptcy estate, and the expectation to acquire the assets “free and clear' is codified in the bankruptcy code.
Successor liability is a state law doctrine that allows creditors to seek recovery from a purchaser of assets where the purchaser did not assume the liabilities in the purchase agreement. The bankruptcy rules generally provide that all pre-plan confirmation liabilities are discharged under the plan, including state and local taxes. These two rules create a conflict between providing the purchaser out of bankruptcy a “fresh start while there may be countervailing reasons to allow a creditor of the debtor to collect from the purchaser.
BC Section 363(f) generally provides that the debtor’s sale of assets is “free and clear” of interests, which has been interpreted to mean that tax liabilities, including unremitted sales tax, are discharged. BC Section 1141(d)(6) provides that tax liabilities of a debtor are not discharged as a result of emergence from bankruptcy pursuant to a plan where a return was not filed or a fraudulent return was filed. Accordingly, it may be argued that post-confirmation, a state is not precluded from seeking to collect taxes for pre-confirmation periods if no returns or fraudulent returns were filed. In addition, a state should be allowed to seek to collect taxes if it did not receive, and was not deemed to receive, proper notice of the bankruptcy.
The IRS may use the transferee rules to collect tax from a successor. Many states also provide for successor liability in general and in particular for sales tax on the sale of a business. An issue often arises for state purposes whether successor liability applies to assets acquired by a secured creditor through foreclosure or similar enforcement actions.
In the M&A context, there are four general exceptions to the rule that buyers acquire assets free and clear of seller liabilities. Under tax law concepts, transferee liability may be imposed under equity or law. While the IRS and states most often use a fraudulent conveyance concept for pursuing transferee at equity, they may also use the “trust-fund” theory.
In addition to the rules noted above, many states provide for an exemption from the bulk sales notification provisions, which generally include successor liability for failure to comply, for transfers in bankruptcy. However, the issue is not free from doubt, and specific state rulings or cases should be considered. For example, the Second Circuit held that the successor after a BC Section 363 sale of GM’s assets was liable for certain tort liabilities.
A view of successor liability in the BC Section 363 context has been recently articulated: In order to prove a successor liability claim against a purchaser in a Section 363 sale, the claimant must not only show that it has a claim that is not barred by the sale order but must also prove that the purchaser is liable under an applicable theory of successor liability. To address this issue, the sale order should include a finding that the purchaser is not the debtor's successor and findings of fact that support that conclusion. For example, in the recent asset sale in the case of Quicksilver Resources Inc., the sale order contained findings that, among other things:
- there was no common identity of the directors or stockholders between the purchaser and seller;
- the purchaser was not purchasing all the assets of the debtor;
- the purchaser was not holding itself out to the public as a continuation of the debtor; and
- the transactions were not being undertaken for the purpose of escaping liability for the debtor’s debts.
Although such findings would not ensure that the purchaser would be able to avoid successor liability, they would provide an additional layer of protection to the purchaser.
Personal Liability for Trust-Fund Taxes
While it may be difficult for management to focus on taxes when the company is undergoing a financial crisis, management should carefully consider the rules regarding “trust-fund” taxes. The general rule is that a bankrupt company must remit all postpetition trust-fund taxes. Management should be aware that individuals responsible for the tax function, as well as potentially certain corporate officers and the bankruptcy trustee, may be held personally responsible for the nonpayment of these taxes.
Like the IRS, most states impose personal liability on corporate officers and employees involved in the remittance of trust-fund taxes and other “responsible” persons (the so-called “100% penalty”) whether the money was collected or withheld or not. Some states go beyond this to impose personal liability on non-trust-fund taxes.
The Bankruptcy Code provides procedural rules for reporting and collecting state and local taxes, which are generally consistent with the federal procedures. For example, a company in bankruptcy generally must file its tax returns the same as if it had not entered bankruptcy. However, a company in bankruptcy is prohibited from paying taxes for pre-petition periods, including any state or local taxes required to be withheld or collected prior to the bankruptcy case with respect to trust-fund taxes.
Like all other creditors, the IRS and the state and local taxing authorities must file a proof of claim with the bankruptcy court before the bar date for any pre-petition taxes to qualify as a creditor in a bankruptcy procedure. All taxing authorities have a minimum of 180 days after the petition date to file a proof of claim. BC Section 108(c) tolls most statutes of limitations on collection of taxes, and states are prohibited from collecting taxes during this period.
As you can see from the above, determining the state tax impact of a financial workout can be extremely difficult to navigate. Accordingly, substantial attention should be focused on state tax impact when reviewing and modeling the consequences of CODI.
Originally published in Journal of Taxation. Some footnotes have been removed. The authors also thank Eric Fader, Special Counsel in the Chicago office of Duane Morris LLP, for his contributions to this article.