Partnership Debt Restructuring Should Deploy Tax-Aware Planning

A restructuring or modification of a partnership’s debt could be as modest as relaxing some financial covenants (also referred to as loan covenants), to more substantial changes, such as reducing the interest rate on the debt, extending the scheduled debt payments, or even forgiving and canceling a portion of the debt.

There are both potential adverse tax consequences as well as valuable planning opportunities associated with the restructuring or modifying partnership debt.

Significant Modification

The restructuring or modification of partnership debt may result in cancellation of indebtedness, or COD, income for the partnership and gain or a deduction for the lender. Generally, such tax consequences will arise if a “significant modification” is made to the existing partnership debt.

The Treasury’s regulations define a significant modification to debt, including changes to the interest rate, deferring payments on the debt, or a change in financial covenants.

To illustrate, assume a partnership issues, for $1,000 cash, an eight-year note with a principal amount of $1,000, paying 10% interest annually. The partnership negotiates with the lender to reduce the interest rate to 9.75% annually.

While such a reduction in the interest rate is a modification of the debt, it isn’t a significant modification under Treasury guidelines, defined as a change in the interest rate that is greater than 0.25% per year or 5% of the annual rate of the debt. As a result, no immediate tax consequences arise on the 0.25% reduction in the interest rate.

But if the negotiations result in the interest rate being reduced to 9.25%, such 0.75% reduction is a significant modification of the debt and could trigger tax consequences to the partnership and lender.

As part of a debt restructuring, it’s common to defer scheduled debt payments. Such deferral may result in a significant modification to the existing debt.

But under Treasury guidelines, there’s a safe-harbor period in which the deferral of the scheduled debt payments won’t be treated as a significant modification. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the instrument.

Consider the partnership in the above example. When the principal payment is due at the end of eight years, the partnership and lender agree to extend the maturity date by three years with the partnership continuing to pay 10% interest annually.

Extending the maturity date by three years isn’t a significant modification, as it is a period equal to the lesser of five years or four years (50% of eight years). So, no immediate tax consequences arise on the extension of the maturity date. But if the maturity date is extended by five years, such extension is a significant modification and could result in tax consequences to the partnership and lender.

Partnership debt commonly has financial covenants, which are generally restrictions that lenders place in lending agreements to limit the actions of the borrower. Under Treasury guidelines, a modification to such debt that adds, deletes, or alters customary accounting or financial covenants isn’t a significant modification. Many taxpayers believe that baskets—dollar limits for an exception to a loan restriction—and leveraged ratios fall within such classification.

COD Income Issues

If a significant modification occurs with respect to partnership debt, then the partnership will have COD income equal to the excess of the principal amount of the existing debt over the principal amount of the modified debt.

No COD income is generated if neither the existing debt nor the modified debt is publicly traded, an adequate amount of interest (generally market rate of interest based on Treasury guidelines) is being paid on the debt, and there is no change in the principal amount of the debt. This allows for a significant modification of the debt, such as substantially decreasing the interest rate, without triggering COD income to the partnership.

Going back to the earlier example, assume the partnership and the lender agree to reduce the annual interest rate on the note from 10% to 9% (adequate stated interest) resulting in a significant modification of the debt.

But the principal amounts of the existing and modified debt are both $1,000—there was no reduction in the principal amount of the debt. The partnership has no COD income even though a significant modification was made to the debt.

If, however, the lender agrees to reduce the principal amount of the debt, then the partnership has COD income equal to the principal amount of the existing debt less the principal amount of the modified debt.

Any COD income of a partnership flows through to the partners of the partnership, who are subject to tax on such income. If a partner is bankrupt or insolvent, such partner’s share of the partnership’s COD income isn’t subject to tax. But a corresponding reduction is made to the partner’s tax attributes, such as net operating losses.

In determining the amount of a partnership’s COD income, the calculation generally is the excess (if any) of the principal amount of the existing debt over the principal amount of the modified debt. If a partnership has accrued but unpaid interest on its debt, such amount may be included in COD income if the lender agrees to cancel and forgive payment of such interest.

If the partnership deducted the accrued but unpaid interest, then such amount will be included in calculating any COD income of the partnership. But if the partnership didn’t deduct the accrued but unpaid interest and payment of such interest would give rise to a deduction, then such amount isn’t included in calculating the partnership’s COD income.

Partnerships and lenders may not realize that modifications to partnership debt, even modest alterations that are sensible in the current economic conditions, may trigger federal income tax consequences, such as COD income for the partnership and gain or a deduction to the lender. With proper planning, however, any adverse tax consequences may be avoided while still achieving the goals of the debt restructuring.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Laura Theiss is partner at Moss Adams in the firm’s real estate practice with focus on compliance and tax services.

Christopher Hanna is director at Moss Adams specializing in M&A tax services.

Jackie Noland is director at Moss Adams, providing both public and private companies with a wide range of tax compliance and consulting services.

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