Tax Considerations in Insolvency Cases

Tax issues exist in most insolvency, bankruptcy, receivership, and debt workout cases (‘Insolvency Cases’). The failure to address and plan for tax issues can adversely affect multiple persons in an Insolvency Case and can completely undermine the success of the debtor’s debt or equity restructure plan, the debtor’s bankruptcy or non-bankruptcy plan of reorganization, or the debtor’s bankruptcy or non-bankruptcy plan of liquidation.

Tax mistakes can result in (1) increased tax liability to the debtor entity (or individual), to creditors, to owners of pass-through income tax entities discussed below (‘PTEs’) and other persons in an Insolvency Case, (2) imposition of tax penalties and interest, (3) loss of tax refunds, (4) loss or recapture of tax credits, (5) loss or reduction of valuable current or future tax benefits, and/or (6) reduced recoveries for creditors. In certain cases, a responsible person including but not limited to a fiduciary such as a trustee, receiver, assignee, or a disbursing agent, can be personally liable for the failure to pay current or delinquent taxes in an Insolvency Case.

“Even a well‑crafted restructuring can fail if the tax implications aren’t fully mapped,” notes Robert Richards of Dentons.

Although this article will primarily discuss certain federal income tax issues, debtors, creditors, fiduciaries and other parties in an Insolvency Case should also address the potential application of other federal, state, local, and foreign tax issues, including but not limited to employment/payroll taxes, sales and use taxes, property taxes, excise taxes, withholding taxes, transfer taxes, gross receipt taxes and fees, value added taxes, and tariffs.

What Is a Pass‑Through Entity?

Pass‑through entities (PTEs) are structures where business profits and losses are taken into account on the owners’ personal tax returns rather than at the entity level. This includes partnerships, most limited liability companies (LLCs), and S‑corporations. The approach provides flexibility and avoids double taxation but creates complex implications when the business becomes insolvent. For instance, an S‑corporation’s election or an LLC’s partnership status might seem like paperwork at startup, but can determine who ultimately bears the tax burden when debts are canceled or assets are sold.

Partnerships vs. S‑Corporations

While partnerships and S‑corporations share the pass‑through concept, their tax treatment in distress differs:

• A partnership can dissolve automatically if it drops to a single owner, creating a disregarded entity and new tax implications. Equity contributions are generally tax‑free under Section 721, but the liquidation or reclassification of a partnership interest can trigger gain recognition.
• S‑corporations, on the other hand, can have a single owner without losing their pass‑through status, but they face strict eligibility rules. If an ineligible shareholder, like a non‑resident alien or another corporation, acquires stock, the entity immediately becomes a C‑corporation. That reclassification can create double taxation just when liquidity is tight.

Entity‑Level Transactions

Transactions that occur at the entity level, like asset sales, recapitalizations, or debt modifications, ripple through to individual owners. Because each owner has a different tax profile, these effects can be uneven. Some may recognize gains, while others generate losses or lose the ability to use existing deductions.

“A restructuring lawyer must understand owner-level tax implications when planning entity‑level moves,” advises John Harrington of Dentons.

Even small adjustments, such as converting debt to equity or changing capital structure, can change owner basis and alter future tax liability. Net operating loss limitations, capital loss carryovers, and passive‑activity rules all influence how much tax relief each owner can claim. Before any restructuring is finalized, advisors should model the impact at both the entity and owner levels.

Cancellation‑of‑Indebtedness Income

Perhaps the single most under-appreciated concept in restructuring is cancellation‑of‑indebtedness income, or CODI. When a lender forgives, reduces, or modifies a borrower’s debt, the forgiven amount can be treated as taxable income. For example, if a business owes $1 million and a creditor agrees to accept $600,000 in full payment, the remaining $400,000 may create CODI.

“The impact of CODI can catch business owners off guard, creating unexpected and potentially significant tax liabilities,” warns Stephanie Drew of RubinBrown.

The Internal Revenue Code provides several exceptions under Section 108, including the bankruptcy and insolvency exclusions. In a bankruptcy case, debt discharge may be excluded from income. If the taxpayer is insolvent but not in bankruptcy, CODI can also be excluded up to the amount of insolvency. However, these rules apply differently for corporations and pass‑through entities. For partnerships and LLCs taxed as partnerships, the determination of insolvency happens at the partner level; for S‑corporations, it occurs at the entity level.

This phantom income problem underscores the need to evaluate CODI early in the process, ideally before any settlement or debt modification is finalized. Even when CODI is excluded, the taxpayer must often reduce tax attributes, such as net operating losses, credits, or asset basis, under Section 1017. That means today’s relief can limit tomorrow’s deductions.

A Word of Caution for Receivers, Trustees, and Officers

When a receiver, trustee, or assignee takes control of a business, they inherit not only its assets but also its tax responsibilities. Failing to file required returns or remit trust‑fund taxes, such as payroll withholdings or collected sales tax, can lead to personal liability. Courts have held fiduciaries liable for negligence or willful disregard in handling tax matters.

“Even well‑intentioned receivers can find themselves in the IRS’s crosshairs if filings fall through the cracks,” notes Richards.

Managing Tax Risk in Restructuring

The most effective restructuring plans are the ones that balance tax preservation with legal strategy. Doing so ensures not only compliance but also the preservation of value for owners and creditors alike.

When faced with a complicated case like those mentioned here, remember to:

1. Engage tax counsel early: Model the tax consequences of any debt workout or restructuring before documents are signed.
2. Model CODI exposure: Determine who bears the tax cost, i.e., the entity or the owners. Evaluate eligibility for bankruptcy or insolvency exclusions.
3. Confirm entity classification: Ensure elections are current and that ownership changes haven’t terminated S‑status or partnership treatment.
4. Document insolvency: Keep a contemporaneous record of assets and liabilities to support the insolvency exclusion under Section 108.
5. Review basis and at‑risk rules: Owner basis affects loss deductibility; liability reductions may lower basis and create unexpected income.
6. Coordinate with state tax rules: Many states have distinct treatment for CODI and pass‑through taxation, including special PTE taxes.
7. Avoid timing mismatches: Ensure that income and deductions align across tax years and owners.
8. Communicate with stakeholders: Lenders, accountants, and counsel should share models and assumptions to prevent conflicting tax outcomes and minimize tax leakage.

To learn more about this topic, view Pass through Entities and Individuals. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about business distress.

This article was originally published on December 1, 2025.

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