Follow these rules to reduce your debt, but proceed with caution.
The economic difficulties that contractors have faced in the past two years have forced many to seek debt relief.
But even when times are prosperous, low profit margins lead contractors to seek some form of debt forgiveness. Due to heavy losses in the surety industry beginning in the late '90s, bonding agencies started tightening financial requirements well before the recession.
To improve their balance sheets for sureties, banks and other financiers, contractors must negotiate with lenders to either reduce or capitalize the principal amount due.
Obtaining debt forgiveness or restructuring debt can actually lead to taxable income. A provision in the American Recovery and Reinvestment Act (ARRA) of 2009 addresses how cancellation-of-debt (COD) income is recognized (COD income refers to the tax consequences when debt is cancelled).
To better understand how to restructure your debt to a more manageable level, use these rules that apply to a debt-for-debt exchange (exchanging a debt obligation for a newer, smaller obligation).
The Rules
According to IRS Publication 4681, Section 1: "if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. A debt includes any indebtedness for which you are liable or subject to which you hold property."
According to ARRA, in tax years ending after Dec. 31, 2008, a taxpayer can choose to have COD income from a debt reacquisition (that occurred after Dec. 31, 2008, and before Jan. 1, 2011) included in gross income over five tax years beginning in 2014. While all of the deferred COD income will eventually be recognized, the taxpayer benefits from the tax deferral to later years.
Here's an example: In 2010, a contractor repurchased $6 million and had originally issued $10 million. Although the contractor realizes $4 million of COD income, he or she does not need to recognize that income for 2010. Instead, the contractor can recognize $800,000 of the COD income each year over a five-year period ($4 million divided by five years) from 2014 to 2018.
Forms to Use
When a debt is canceled or forgiven, the lender issues a Form 1099-C to both the IRS and debtor. This form is used to calculate the amount of income generated by debt forgiveness. The form examines if the contractor is personally liable for repaying the debt and if the debt was canceled in a bankruptcy proceeding. It specifies the fair market value of any property that may be foreclosed in connection with the debt cancellation.
Lenders may also issue a 1099-A, which is the form the IRS requires for abandonment. But if the debt is canceled, the lender can include information about the abandonment in Form 1099-C instead of 1099-A. Copy B of the form must be sent to the borrower by Jan. 31, or by March 31 if filing electronically. Contractors who receive this form must meet certain reporting requirements in their tax return.
Bankruptcy Debtors
Bankruptcy debtors are either debtors of qualified farm indebtedness or non-corporate debtors whose debt is qualified as real property indebtedness, and they cannot recognize COD income. Instead, they must reduce their loss or tax credit carryovers. Or, if they do not adjust their tax attributes, they can reduce the basis in their assets. (Basis is generally the amount of your investment in a property for tax purposes.) These debt cancellation rules are applied at the partner level for partnerships and the corporate level for S corporations.
CPA Advice
When feasible, seeking COD may be the best choice for healthy construction companies that have a higher-than-normal debt level. If mishandled, however, companies might have to pay more in income taxes—and possibly penalties.
Before seeking COD, contractors should get advice from a construction-specific CPA to determine if annual taxes will be affected and whether exclusions apply.
Construction Business Owner, September 2011
