Many oil and gas companies have sought debt reduction through bankruptcy protection or debt restructuring in response to financial difficulty brought on by the COVID-19 pandemic. When considering options to reduce debt, companies should understand the tax consequences that these actions can bring. This is particularly true for partnerships, which have special rules that affect certain allocations related to canceled or restructured debt.
Tax Impacts of Debt Discharges
Debt discharges can have significant tax consequences that oil and gas partnerships must assess when considering debt reduction options. When a debt is discharged, the difference between the outstanding debt and any amount paid as consideration for the debt is deemed cancellation of indebtedness income (CODI). While taxpayers are generally required to include CODI in their gross income, they can exclude it in certain circumstances, including bankruptcies and insolvency. Specifically, IRC Section 108 allows taxpayers to exclude CODI from gross income in Title 11 cases, which include Chapter 7 liquidations, Chapter 11 reorganizations and Chapter 13 bankruptcies for individuals. Insolvent taxpayers can also exclude CODI from gross income to the extent of their insolvency.
A discharge of debt from a bankruptcy or a reduction of debt from debt restructuring requires taxpayers to reduce their tax attributes by the amount of CODI excluded from gross income. Section 108(b) requires this reduction in the following order: net operating losses (NOLs), general business credits, minimum tax credits, capital loss carryovers, basis reduction, passive activity loss and credit carryovers and foreign tax credit carryovers. In an exception to the ordering rules, taxpayers can choose under Section 108(b)(5) to reduce basis in depreciable property first.
Partnership Allocations
In determining whether to seek debt reduction, oil and gas partnerships must understand the treatment of CODI under the special partnership allocation rules. Under Section 108(d)(6), CODI is recognized at the partnership level without any exclusions from gross income, but it is allocated to the partners under the rules of IRC Section 702 and IRC Section 704.
Under these rules, the exclusions of CODI from gross income for bankruptcy and insolvency are determined at the partner level. While the partnership may be insolvent, the individual partners may be solvent and required to recognize the CODI income as gross income. The process can also produce significant differences between partners, as insolvent partners may exclude their share of CODI from gross income while solvent partners are taxed on their share. Failure to consider this can result in unanticipated tax liabilities for individual partners.
Given these possible differences in the tax impact of debt reduction, how a partnership allocates CODI to its partners is a significant issue in partnership bankruptcies and debt restructurings, as allocation can depend on how the CODI arose as well as on the terms of the partnership agreement. For example, Section 704 provides that the partnership agreement determines the allocation of tax items. However, if the partnership agreement does not address tax allocations or the agreement’s tax allocations do not have substantial economic effect, then the tax allocations are made in accordance with the partner’s interests in the partnership.
Debt Restructuring Options
Under these partnership allocation rules, oil and gas partnerships must also take into account the tax consequences for individual partners when considering debt restructuring options such as debt for equity exchanges, debt work-out plans, asset sales under Section 363 of the U.S. Bankruptcy Code and purchase-money debt reductions.
Debt-for-equity exchanges: Debt-for-equity exchanges can provide oil and gas partnerships debt relief in exchange for partnership capital or an interest in profits. In these transactions, a partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its debt. The excess of the debt over the fair market value of the partnership capital or profit interest results in CODI. The regulations provide a safe harbor for partnerships under which the fair market value of the partnership interest is deemed equal to the liquidation value that the creditor would receive, allowing the debt-for-equity exchange to reduce or eliminate CODI. Section 108(e)(8) requires CODI that results from these transactions to be allocated to those partners that were partners immediately before the exchange, and the exclusion for bankruptcy or insolvency is made at the individual partner level.
- Debt work-out plans: A debt work-out plan or debt restructuring involves modifications to the original debt instrument that produce debt relief. Typical restructuring includes changes in yield, timing of payments, obligor or security, or changes in the nature of the debt instrument. Under Treas. Reg. §1.1001-3, these types of “significant modifications” in the terms of the debt could result in CODI, as they are treated as an exchange of that debt instrument for a new debt instrument.
- Section 363 sales: With private equity firms looking for investment opportunities, selling assets to settle outstanding debt could be an option. Section 363(b) of the U.S. Bankruptcy Code allows for court-approved sales of assets during bankruptcy that allow a debtor to have more control over the terms of the sale than they would otherwise have in a Chapter 7 liquidation. Section 363 sales, however, can have significant tax consequences not only from CODI but also from possible state transfer taxes and taxes on any gain on the sale of the asset.
- Purchase-money debt reduction: Solvent taxpayers not in bankruptcy could find an exception to CODI if they negotiate a reduction of purchase-money debt from the seller. Section 108(e)(5) treats this type of reduction as a purchase price adjustment if the reduction would otherwise be treated as CODI. Given that the treatment of CODI is determined at the partner level, the IRS waived the bankruptcy and insolvency restrictions for partnerships. Under IRS guidance, the exclusions apply at the partner level, making the bankruptcy or insolvency of the partnership irrelevant for the application of Section 108(e)(5). A bankrupt or insolvent partnership can treat a reduction of an indebtedness as a purchase price adjustment if the transaction would qualify as a purchase price adjustment but for the bankruptcy or insolvency of the partnership. This allowance does not apply if any partner adopts a federal income tax reporting position for the debt discharge that is inconsistent with that of the partnership.
Conclusion
When considering discharges of debt through bankruptcy, insolvency or debt restructuring, oil and gas partnerships must assess the tax impact of CODI allocations on individual partners. This assessment includes understanding how the partnership agreement will affect CODI allocations and how this will impact the financial position of each partner. Partnerships that do not fully understand the tax implications of bankruptcies and debt restructurings could cause individual partners to incur an unexpected tax liability.
Jon R. Roberts, CPA, Partner, Tax Service, has more than a decade of public accounting experience, with a focus on serving oil and gas exploration, production and service companies. He has extensive experience in federal and state taxation of partnerships, corporations, S corporations and limited liability companies, as well as serving their individual owners. Roberts is also experienced in tax planning for business and individual clients and providing tax services for closely held family groups. A certified public accountant, he is a member of the Texas Society of Certified Public Accountants (TSCPA), American Institute of Certified Public Accountants (AICPA) and the Wednesday Tax Forum. Roberts earned a Bachelor of Business Administration in accounting from Abilene Christian University.
Jon Pezzi, CPA, Partner, Tax Service, has more than 13 years of public accounting experience which includes federal and state taxation of partnerships, corporations, S corporations and limited liability companies. His focus is on providing tax consulting for mergers and acquisitions, including tax structuring and tax due diligence. Pezzi also has experience handling multi-state taxation issues and public company taxation issues, including ASC 740 issues. He is a certified public accountant in Texas and Virginia. Pezzi earned a Master of Science in accounting with a concentration in tax consulting from the University of Virginia, as well as a Bachelor of Science in accounting from Ohio State University.
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