You are or represent an investor in a first or second lien debt tranche of an upstream oil and gas E&P entity that is held through a master-feeder fund or other private equity structure, and you receive the news that your debtor filed a Chapter 11 bankruptcy petition. Congratulations. After you confer with your auditors about the required GAAP impairment (if you have not already done so), talk then turns to what is the value of consideration to be expected and, in general, its legal form. What is often not vetted until the bitter end of the restructuring is how to treat the consideration you will receive for income tax¹ purposes?  

This article is intended to give you an array of considerations that take into account your form of organization and attendant income tax sensitivities, as well as the income tax characteristics of the new instrument you receive in exchange for your indebtedness.  

Previously, the status of bona fide indebtedness of your investment solved most tax problems involving:

• The active trade or business nature of oil and gas working interests (as opposed to royalties, net profits interests or production payments)
• The location of the property in the U.S. (including the Gulf of Mexico) being treated as a U.S. Real Property Interest² for purposes of the Foreign Investment in U.S. Real Property Tax Act of 1984 (FIRPTA)
• The tax character of the return on indebtedness, as interest is, well, interest, and the sale of an asset giving rise to interest is usually not an issue either for taxpayers with specific needs of types of taxable income such as Regulated Investment Companies and tax-exempt entities.

This is about to change with the restructuring. You will likely receive a combination of cash (hopefully) anew debt instrument, voting ownership interest in either a C corporation or a tax partnership, and warrants. 

Depending on numerous non-tax factors, use of a newco may be desired. This typically results in the assets being “marked to market” for tax purposes, as prior tax losses of a C corporate debtor do not export in asset sale transactions. The debt discharge income is the debtor’s problem, so we will wish them luck and move on.  

Income tax exit structures³ usually involve the former creditors holding either: aregarded C corporation (its own taxpayer),a passthrough taxed as a partnership (which can be an LLC or a state law limited partnership), or some combination thereof, which I like to refer to as a Restructuring UP-C.⁴

Thus, assuming for all non-tax purposes that alternative exit structures are the same (i.e., liability protection, discharge, good title to assets, adequate liquidity, governance, etc.), you should look for the exchange. 

The Exchange

Even if only adjustments to terms are made and the original principal remains outstanding, in most cases, for income tax purposes, such a debt modification is treated as an exchange⁵ for income tax purposes. Most creditors prefer the exchange at effective time of the restructuring be treated as a taxable exchange of their debt instrument usually resulting in the current recognition of a long-term capital loss.⁶ However, if the debt has Original Issue Discount (OID), market discount⁷ or there is a partial payment with accrued but unpaid interest outstanding, there is mixed authority⁸ on how the proceeds are allocated between principal and interest, so be aware of a hidden trap where ordinary interest income is recognized but a long-term capital loss is increased, as the loss may not offset the portfolio interest income.⁹

Items to Consider

If the debtor is a C corporation and stock or securities in that (or successor of) the C corporation debtor are wholly or partly received in exchange for the distressed debt, the exchange can default into a tax-free reorganization¹⁰ under Subchapter C of the code. This has the effect of defers¹¹ inherent losses on the exchange except for property received on indebtedness with accrued but unpaid interest at the time of the exchange.¹²

If an interest in a limited liability company (or state law limited partnership) taxed as a passthrough entity is received, care must be taken that the creditor’s loss is not deferred and added to its basis¹³ in the new partnership interest, similar to the tax-free reorganization discussed above. Also note that these rules may cast an “ordinary” character on the interest received in that if it is sold in the future, it does not¹⁴ generate capital gain income.

If you get a debt instrument in return, check for original issue discount upon receipt as it may require accrual of taxable interest income in periods when no cash is received. This can happen with instruments with high interest rates and/or, payment-in-kind (PIK) instruments.

Ownership Interest and Future Tax Returns

Ownership Interest Treated as Stock of a C Corporation

This instrument is usually the safest and simplest form of exit, in that it effectively serves as a blocker for the entire group. Income to investors is remitted in the form of dividends (likely qualifying for a 20% maximum rate) or gain on sale of shares, which are generally treated as capital assets.

In the event an exit strategy involves a sale to a publicly traded company in exchange for shares, this can qualify as a tax-free exchange, whereas a partnership interest cannot without some pre-transaction gymnastics.

For investors subject to FIRPTA, withholding usually only occurs upon an actual receipt of cash via a dividend or stock sale.

No investor receives an annual Schedule K-1 with active oil and gas working interest income, depletion, intangible drilling costs, investment interest limitations and other things that tend to give tax-exempts and RICs’ tax indigestion.  

One potential downside is that in the event the subject assets turn the corner in value, for a subsequent buyer to own them directly would cause the C corporation to incur a cash income tax¹⁵ prior to the sale; otherwise, it would be left with selling the stock of the entity where it will seek a discount for this inherited tax liability. 

Another C corporation downside is that if it issues new high-yield debt, it could be bifurcated¹⁶ into a (deemed) preferred stock slice and a debt instrument, which could change the timing and character of yield. 

Ownership Interest Treated as a Partnership Interest

In some ways, this is the inverse of the C corporation exit in that:

• No double tax on sale at a gain at exit.
• Should additional funding for development of proved undeveloped properties be supplied, development expenses (primarily intangible drilling costs) may be shared with investors in real time for consideration in their current year tax returns (i.e., a tax shield).
• Partnership sharing arrangements are quite flexible in accomplishing pre-tax economic arrangements if properly planned.
• Partnerships are not generally subject to the AHYDO rules (for high yield debt), although there is a concern that C corporate partners might have to “look through” an issuing partnership if the structure is deemed abusive.

Downsides of this strategy include:

• Individual unitholder blockers may be required to prevent the recognition of taxable income of an unfavorable character (UBTI and/or non-qualifying RIC income).
• Tax reporting is more difficult because the receipt of annual Forms 1099-DIV, -INT, or -OID and Schedules K-1 are usually delivered at least 6-8 weeks later than Forms 1099.
• New holders of passthrough interests may now have to file numerous state income and franchise tax returns depending on the location of the debtor’s properties.
• Should there be more than 100 investors in the surviving pass-through, consideration of whether the income would be qualifying income similar to a master limited partnership/publicly traded partnership¹⁸ in order to retain pass-through status while not either losing that status or requiring trading restrictions, which most creditors find unpalatable.
• Withholding may apply in interim periods where effectively connected income (ECI) is present (whether distributed or not) and dispositions of partnership interests holding U.S. Real Property.¹⁹

Conclusion

Restructurings are not fun times, but to avoid getting “a gift that keeps on giving,” once your economic deal seems to be gaining a tailwind, discuss the strawman exit plan with your tax advisor seeking to maximize the recognized loss in the exchange, and determine how entering into this type of investment will affect future tax filings?

In parting, just say no to the response: “We’re just trying to close and will address that later.” In addition, rules and principles involving troubled debt restructurings involve complex capital markets transactional authority that are not typically drafted to provide guidance for distressed situations. Consultations with a qualified restructuring tax advisor are always encouraged.

Footnotes

1. Statutory citations herein, unless stated otherwise, are to the Internal Revenue Code of 1986, as amended (§).  Regulatory or judicial citations are made in customary form.
2. Treas. Reg. §1.897-1(b)(2).
3. There are certainly other forms such as a Disputed Asset and Designated Settlement funds (§468B), as well as royalty trusts (often treated as grantor trusts), but these forms eventually work their way back to either being a regarded, stand-alone taxpayer or a pass through entity.
4. This refers to the so-called Umbrella Partnership-C Corporation structure, the offspring of the UP-REIT.
5. Treas. Reg. §1.1001-3.
6. Most investors treat their debt instrument investments as capital assets (§1221), which give rise to capital gain or loss upon sale or exchange (unless in a tax-free exchange). The disadvantage of selling a capital asset at a loss is that a long-term capital loss may only offset long-term capital gains plus $3,000 in annual ordinary income for individuals (§1211). This is not terribly tax efficient from a timing nor a rate perspective as net long-term capital gains are currently taxed at a maximum rate of 20% (§1(h)) plus a possible net investment income tax of 3.8% (§1411). Other investors who are considered dealers under §475 have ordinary income or loss treatment. The other main area of distinction is found in §1221(a)(4), which extends non-capital asset treatment to “accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1) [inventory].” But see Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), and Federal National Mortgage Association v. Commissioner, 100 T.C. 541 (1993), for situations where the purchase of loans in secondary markets were held not to be capital assets.
7. §§1276-1278.
8. Treas. Reg. §§1.446-2(e) and 1.1275-2(a) prescribe ordering rules that affect the allocation and character of payments received on indebtedness from the issuer. However, LTR 200035008 (Sept. 1, 2000) suggested that upon the receipt of partial payments for less than all of the amounts owed, a ratable allocation between principal and interest is appropriate. 
9. Note ii above, however, unrecovered Amortizable Bond Premium should now be recoverable as an ordinary deduction, except in cases where a substituted or exchanged-basis transaction occurs. §171.
10. The most likely characterization is that of a recapitalization under §368(a)(1)(E), but other technical results can occur if, for example, a newco is involved in an asset transfer.
11. §354(a)(1).
12. §354(a)(2)(B) excludes the interest portion from gain or loss deferral.
13. See §108(e)(8)(B) and Treas. Reg. §1.721-1(d) for additional guidance, noting that these provisions do not apply to unpaid rents, royalties or interest.
14. See §108(e)(8)(b) then referring to paragraph (7) as affecting character of the instrument received.
15. This is the classic General Utilities and Mining repeal in 1986 that is codified at §336(a).
16. This is known as an Applicable High Yield Discount Obligation (AHYDO) codified by §163(i). 
17.  See Treas. Reg. §1.701-2(f), example 1.
18. §7704.
19. §1446.

W. Lynn Loden, CPA, is a managing director at Opportune LLP. Prior to joining Opportune more than 10 years ago, he reached the partner level in the Houston offices of Arthur Andersen LLP and Deloitte Tax. He holds active CPA licenses in Texas and Mississippi and currently holds FINRA Series 79 and 63 licenses. Loden would like to thank Maggie Caldwell, CPA, a manager at Opportune, for her helpful review and comments