Page 136 - Bankruptcy Volume 1

 A significant change in the ownership of creditor claims during the bankruptcy case may prohibit
the debtor from qualifying for the favorable bankruptcy ownership change rules under Section
382(l)(5).

To avoid these potential complications, early consideration should be given to the possible adoption of
preventative measures (for example, equity or claims trading restrictions or worthless stock deduction
restrictions for shareholders owning greater than 50%).

First-Day Motions—Tax Considerations

An important part of first-day motions involves taxes. Authorization will need to be obtained from the
bankruptcy court for the debtor to pay so-called trust fund taxes (for example, sales taxes, payroll with-
holding taxes) incurred prepetition. Officers and directors have an interest in making sure such trust fund
taxes are paid because many taxing jurisdictions impose personal liability on responsible persons for any
trust fund taxes that are not withheld in a timely matter and remitted to the taxing authority.

As described, equity and claims trading restrictions may be appropriate to include in first-day motions to
preserve NOLs and other tax attributes.

Cancellation of Debt

Generally, a taxpayer realizes income from the discharge of indebtedness if the amount owed under a
debt obligation is reduced, if there is a significant modification made to such debt, or the obligation to
pay is eliminated. Such income is commonly referred to as cancellation of debt (COD) income, and
COD is generally included in the gross income of the debtor. fn 4

When the debtor transfers secured assets to a creditor, the amount of COD income depends upon wheth-
er the debt is recourse or nonrecourse. Generally, debt is recourse if the debtor is personally liable for its
repayment, even if the debt is secured by collateral; and debt is nonrecourse if the creditor is limited to
the underlying collateral for payment upon debtor default.

When the debtor transfers assets to a creditor in retirement of a recourse liability, the transaction is bi-
furcated. The debtor is treated as selling the assets for an amount realized equal to the fair market value
of the assets. The debtor generally realizes gain or loss on the sale. The debtor is also treated as satisfy-
ing the debt for an amount equal to the fair market value of the assets. fn 5 The excess of the amount of
the debt obligation over the fair market value generally is treated as COD income.

If, instead of transferring the assets to the holder of the debt, the collateral is sold to a purchaser (other
than the creditor) and the purchaser assumes the recourse liability, the debtor has an amount realized on
sale of the property that includes (a) the cash and other consideration paid to the debtor and (b) the
amount of the debt assumed. This is the case even in situations in which the debtor does not receive a

fn 4 IRC Section 61(a)(12).

fn 5 Reg. Section 1.1001-2(a)(2), (c) Ex. (8) and Gehl v. Commissioner, 1995 U.S. App. LEXIS 5482 (8th Cir. 1995).

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