Liabilities and Contractual Obligations: Consistent with the accounting for business combinations, the liabilities to be assumed by the new entity also need to be valued as part of the fresh-start process. Any liabilities not settled as part of the bankruptcy process must be recorded at fair value in the application of fresh-start accounting. Certain contractual obligations of the new entity may arise from negotiations between debtors and creditors during the bankruptcy process. In these instances, negotiated terms may not necessarily reflect market conditions and therefore should be adjusted to reflect fair value.
Tax Matters: It is common for companies emerging from bankruptcy to have net operating losses (NOLs). Section 382 of the U.S. Tax Code imposes an annual limitation on a company’s use of NOLs if there has been more than a 50 percent change in ownership. Generally, the Section 382 limitations for a company emerging from bankruptcy are calculated using the equity value of the company after reduction of creditors’ claims in the reorganization. Under certain circumstances, the annual limitation of Section 382 can be modified for a corporation emerging from bankruptcy.
Companies emerging from bankruptcy also frequently encounter issues related to cancellation of indebtedness (COD). For tax purposes, a company generally realizes income from COD when the indebtedness is satisfied for less than the face amount of the debt. COD income is excluded from gross income if the cancellation is granted in a bankruptcy. (COD income is also excluded from gross income if a company is insolvent but not in bankruptcy.) The exclusion is limited to the amount of the insolvency. Any COD income excluded from gross income under these exceptions is generally applied to reduce certain tax attributes (NOLs, general business credits, capital loss carry-overs, minimum tax credits, basis in property, etc.).
Emergence from bankruptcy provides management a unique opportunity for a “fresh start” with regard to how to operate and manage its business. However, the complexities of the fresh-start accounting process can result in challenges for management, particularly after going through the stresses of a potentially prolonged and contentious bankruptcy process. These factors, along with staff resource constraints and diminished employee morale can present difficult challenges to overcome in emerging from bankruptcy. Proactive planning and close coordination among management, valuation professionals, independent auditors and tax professionals can help contribute to an efficient process, resulting in supportable and defendable conclusions.
Richard Law is managing director of Alvarez and Marsal, a professional services firm specializing in turnaround and interim management, performance improvement and business advisory services.