Patriot, Inc (a C corporation) filed for Chapter 11 bankruptcy protection during August, 2011 and has worked out a re-organization plan that was accepted by the Bankruptcy Court and the creditors' committee. Under the plan, the note holder (which is a venture capital firm that financed the business) with a notes payable of $125,000,000 will receive new common stock; the old common stock will be cancelled. The new Patriot, Inc will emerge from bankruptcy on November 30, 2011.
Ed Harris will continue as the CEO and will own 2% of the stock resulting from a conversion of liabilities the corporation owed him. He is concerned about the tax implications of debt forgiveness. The corporation has the following tax attributes and selected tax basis as follows:
He has heard that debt forgiveness results in taxable income which is called cancellation of debt income which, while not immediately recognized for tax purposes, reduces tax attributes. He believes the new corporation will be profitable with the burden of the debt repayment removed. His preference would be to preserve the tax carryovers to offset future taxable income.
He is also concerned about Section 382 which he heard about from a colleague at his country club. He is not sure how this will impact the future NOL utilization.
He has asked for your advice as to the best way from a tax perspective to treat the cancellation of debt to preserve the NOL carryovers and to describe how Section 382 will operate to limit the use of the NOLs. He anticipates the new corporation making an acquisition within six months which will increase revenue 15% and profits by 12%. Since this acquisition is planned, he wants your memo to cover electing out of IRC Code Section 382 (l) (5), which he has heard can be beneficial to the future utilization of NOLs.
Prepare a tax memo on these issues (no more than four pages), to the tax partner on this engagement, Robert Holder. You need to read Sections 382 and 108 and the related regulations to develop your solution. You must show how you plan to reduce the tax attributes resulting from the cancellation of debt income (see the ordering rules and elections that may be made). In addition to searching the primary tax sources, you should search the web as many accounting and law firms have written articles about this topic. You should also consult IRS form 982 and the instructions. You should discuss the Code, Regulations, Court Cases, Rulings, etc., that will support your strategy to advise and assist Mr. Harris accomplish his goals, if possible.