Stock Transfer to Creditors Generated Deductions

Many times, an interesting fact pattern in a court case or IRS ruling offers reminders on favorable tax planning concepts. The ruling discussed below is an example. The facts demonstrate that the use of a corporate taxpayer’s stock, which creates no taxable result in a Sec. 1032 transaction, can often be bundled to create certain tax deductions. Many tax advisers are familiar with the compensation deduction generated in a Sec. 83 transaction when stock is used to reward employees; in the right circumstances, this approach can create interest deductions as well.

In Letter Ruling (TAM) 200449001, the IRS held that a corporation could deduct as a repurchase premium the excess of the fair market value (FMV) of cash, notes and new common stock it transferred to certain creditors, pursuant to a plan of reorganization, over the amount of each creditor’s claims.

Facts

A taxpayer filed a voluntary petition to reorganize under Bankruptcy Code Chapter 11. It submitted a reorganization plan, which was agreed to by its creditors and approved by the bankruptcy court. Under the plan, certain nontrade and nonconvertible debts were allowed in full, including unpaid accrued interest. In year 1, the taxpayer distributed a combination of cash, new debt and common stock in satisfaction of its obligations. Some creditors received distributions with a total FMV in excess of their allowed claims.

Initially, the taxpayer did not deduct these excess payments on its year 1 return, which reported a net operating loss (NOL) carryforward. On an IRS examination of a subsequent year, the taxpayer asserted that it had failed to deduct the excess and made a claim to increase its NOL carryforward. The examining agent rejected the claim.

Law

Regs. Sec. 1.163-4(c)(1) states that when a debt instrument is repurchased by an issuer for a price in excess of its adjusted issue price, the excess is deductible as interest. In Clark Equipment Co., 912 F2d 113 (6th Cir. 1990), the court stated that a repurchase is not limited to an exchange for cash, but includes a reacquisition by money or its equivalent, including shares of stock in the issuing corporation.

Sec. 1032(a) provides that a corporation recognizes no gain or loss on the receipt of money or other property in exchange for its stock. However, Rev. Rul. 62-217 concluded that Sec. 1032 does not prevent a corporation from taking a deduction for an otherwise allowable expense that it pays with its own stock, even if the stock is transferred in a Sec. 1032 exchange.

Conclusion

Under the TAM’s facts, the total amount of each allowed claim, including accrued but unpaid prepetition interest, was paid in full. Accordingly, the IRS held that the excess payment could not have represented a payment of principal or prepetition interest but, rather, represented a repurchase premium and was deductible under Sec. 163.

However, the TAM also made some interesting comments on tax law concepts. First, it acknowledged that Sec. 1032 applies to an exchange of stock for a corporation’s debt, but that such a transaction should also take into account the effects of Secs. 61(a)(12) and 108 and the possibility that these debt forgiveness provisions may result in taxable income. Nevertheless, this does not prohibit thinking about ways to use stock to generate deductions. In Duncan Industries, Inc., 73 TC 266 (1979), a borrower sold stock at a discount to a lender and was allowed to amortize the discount over the loan’s life as a cost of obtaining the loan. In Rev. Rul. 75-348, a similar concept was explored in a bargain sale of stock to charity to generate a charitable deduction.

Despite the TAM’s message to consider creative uses of taxpayer stock, it reminds tax advisers that the stock’s value is of primary importance. Because this is a factual question, the TAM did not rule on the validity of the stock’s value.

From JoAnn H. Hitt, CPA, Timonium, MD