Bankruptcy-Related Expenses: Are They Deductible?

Contributed by Max Goodman
As everyone reading this knows, bankruptcies produce a variety of expenses.  While not the most exciting of topics, bankruptcy practitioners may wish to be familiar with the tax treatment of such expenses – particularly whether and when such expenses are deductible for U.S. federal income tax purposes – as such questions may come up in practice.  A recent private letter ruling issued by the Internal Revenue Service provides a good illustration of the tax treatment of various bankruptcy-related expenses in a “sale and liquidation”-type chapter 11 case.
In the ruling, all of the members of a consolidated U.S. federal income tax group filed voluntary petitions for relief under chapter 11.  The debtors also filed a chapter 11 plan on the petition date.  In connection with the bankruptcy filing, the bankruptcy court approved a DIP facility, and the debtors used the proceeds of such facility to retire some of their prepetition debt (presumably secured debt).  Following an auction of the debtors’ business, the bankruptcy court confirmed the plan, and the asset purchase agreement went effective.  Pursuant to the plan and the APA, an investment fund (which was a creditor of the debtors) capitalized a new parent company with cash, the new parent borrowed additional amounts under an exit facility, and the new parent purchased substantially all of the debtors’ assets in exchange for (i) the equity and debt proceeds, (ii) a portion of the new parent’s common equity, and (iii) the assumption of certain liabilities, in what was represented by the debtors as being a fully taxable transaction.  The debtors then distributed the cash and equity in the new parent to their creditors (with the investment fund electing to receive the equity and the other eligible creditors electing to receive cash) and liquidated.  The debtors’ equity holders did not receive any distributions under the plan.
Four types of expenses were incurred on behalf of the debtors during the course of their chapter 11 cases.  First, the debtors incurred expenses in connection with their daily business operations (such as compensation, utility payments, leasing costs and overhead expenses) until the effective date of the plan.  The IRS applied a prior published ruling and ruled that such ordinary and necessary business expenses were deductible by the debtors (i.e., the debtors’ bankruptcy status did not alter the deductibility of such expenses).
Second, expenses were incurred on behalf of the debtors as part of the sale of their assets.  These included expenses for negotiating, drafting, and filing the APA and other transaction documents, for services to resolve compensation matters that arose as a result of the asset sale, and for accounting and legal services related to negotiating and drafting the portions of the plan and disclosure statement related to the asset sale.  The IRS applied the governing Treasury regulations and ruled that such expenses reduce the debtors’ amount realized on the asset sale (thus reducing the amount of gain, or increasing the amount of loss, recognized by the debtors on the sale).  The same result presumably would have applied if the debtors had sold their assets in a 363 sale rather than pursuant to a plan, but how such expenses would have been treated if the sale constituted a tax-free “G” reorganization is unclear.
Third, the debtors incurred expenses to institute and administer the bankruptcy cases, such as expenses for the negotiation and drafting of the plan and other documents required by the cases, for the reconciliation of claims, and for implementation of the automatic stay.  Applying the governing Treasury regulations, the IRS ruled that such expenses were required to be capitalized, but generated a deductible loss when the debtors liquidated.  Had the debtors reorganized and not liquidated in their chapter 11 cases, these capitalized expenses presumably would not have been deductible for a long time.
Lastly, the debtors incurred expenses associated with the DIP financing (such as costs of negotiating the terms of, and preparing filings related to, the DIP facility).  The IRS applied the governing Treasury regulations, which spread the deduction of such expenses over the life of the DIP loan by treating the expenses, for the purpose of determining the amount of the expenses deductible in each year, as creating or increasing original issue discount with respect to the loan from the perspective of the debtors.  This generally results in the amortization of such expenses over the life of the loan on a constant-yield basis.  However, where a loan is repaid prior to maturity, any unamortized borrowing costs generally become immediately deductible.  Therefore, the IRS ruled that the debtors’ unamortized DIP borrowing costs became deductible upon the retirement of the DIP facility.
Note that, while an IRS private letter ruling may not be cited as precedent, it shows how the IRS applied the law and other legal authorities to a particular set of facts.  A more detailed discussion of the deductibility of bankruptcy-related expenses for tax purposes may be found in Chapter 13 of Henderson & Goldring, Tax Planning for Troubled Corporations (CCH 2012 ed.).