Tax Considerations for Companies Facing Financial Distress
During times of economic uncertainty, companies of all sizes may find themselves facing financial hardships and dealing with issues that impact the longevity of their business. Naturally, every business must be prepared for the peaks and valleys of the economic cycle, however, during times of expansion and success, a company’s focus may shift from preparing for an economic downturn. When downward shifts begin to occur, it is important for companies to understand the business impacts and to take advantage of any opportunities. Companies should consider restructuring opportunities and understand their tax implications, value all available tax attributes, and manage any tax compliance issues while making decisions on how to navigate through trying times.
Being cognizant of the taxability of any structural changes can increase the efficiency of these planned activities and mitigate the risk of unexpected tax exposures.
A company’s capital structure represents the distribution of debt and equity used to finance the company’s current and future activities. Companies facing distress are likely to assess their capital structure and make adjustments to more adequately sustain the business through turbulent times. Every restructuring or refinancing has implications from a tax perspective. For example, companies experiencing financial hardship may receive forgiveness from creditors for outstanding debts, which can result in the taxable cancellation of debt income (CODI). Although this forgiveness represents the most common form of CODI, the Internal Revenue Service (IRS) has expanded the definition of CODI to include income occurring from foreclosure, repossession, a voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification. Uncertainty around the taxability of certain activities prior to making substantial changes to capital structure can create current cash tax liabilities. Being cognizant of the taxability of any structural changes can increase the efficiency of these planned activities and mitigate the risk of unexpected tax exposures.
Maximizing the value of tax attributes
Tax attributes can be one of a business’s most valuable assets if the company has taken the time to understand how to maximize its benefits.
Tax attributes generally refer to specific measures in the federal income tax calculation that benefit taxpayers. These tax attributes include net operating losses (NOLs); business credit carryovers; minimum tax credits; capital losses; the basis of property; passive activity loss and credit carryover; and foreign tax credits.
For a corporation, NOLs in particular can be a valuable savings tool and a powerful component of valuations for potential transactions. However, multiple legislative changes in the past three years have modified historical rules for the utilization of NOLs. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), a company’s NOLs could be carried back two years and forward twenty years to offset taxable income. With the passage of the TCJA, the carryback period was eliminated and the NOL carryforward period was extended indefinitely. Currently, companies are only able to offset up to 80% of taxable income in the carryforward periods. More recently in 2020, in order to provide relief during the COVID-19 pandemic, the Coronavirus Aid, Relief and Economic Security Act was passed. The CARES Act allows for a five-year carryback period for NOLs, and temporarily removes the 80% offset limitation for NOLs arising in 2018 through 2020.
These recent changes create new opportunities for companies to evaluate how NOLs can be utilized immediately to generate much needed cashflow. Modeling for carryback and carryforward periods, and for potential limitations on NOL usage in the event of an ownership transfer will allow a company to gain a deeper understanding of its intrinsic value and its potential resources if cashflows have become an issue during turbulent economic times.
Tax compliance considerations
A company’s financial position may be compromised long before tax related issues begin to arise. General cash flow issues, defaulting on debts, and declines in business activity will likely be some of the first indications that a company’s financial standing is faltering. As issues persist, companies may experience weakness in their tax standing, which often culminates in an inability to pay current tax liabilities and unwanted communications from taxing authorities. Examples of these issues may include:
- Improper use of tax withholdings
- Failing to make estimated tax payments
- Delay or delinquency in filing tax returns
- Sudden onset of claims or audit requests from the IRS or other taxing authorities
Understanding the company’s rights as a taxpayer and understanding the tax implications of any decisions beforehand can help alleviate stress during such communications. In negotiating with taxing authorities, it can be beneficial to enlist the help of tax professionals who are familiar with the objectives of the IRS and local taxing authorities and can provide resources from historical dealings to predict realistic outcomes.
Unpredictability is a hallmark of the economic cycle. Strategically restructuring and utilizing tax attributes can provide the resources a business may need to stay afloat. Further, being able to identify tax related issues as they arise and enlisting the assistance of tax professionals who can provide support and use experience to overcome difficulties can help reduce a company’s downtime. The process of navigating through uncertain times will look different for every business, however, considering these issues and being prepared when hard times hit will allow a company to more easily weather storms and increase longevity and future business success.