Navigating the Complexities: Chapter 11 Bankruptcy Filings Amid Liability Management Trends

In 2023, the landscape of Chapter 11 bankruptcy filings was reshaped by the rising prevalence of liability management transactions. These transactions, largely influenced by debtor-friendly loan agreements and bond indentures, allowed for a plethora of solutions that could be finalized outside of court. This trend contributed to a modest upswing in Chapter 11 bankruptcy filings, which, while still remaining below pre-pandemic rates, signaled a significant shift in the financial landscape.

The Tax Implications of Debt Exchanges

However, this trend brought with it an array of complexities. Chief among these was the tax implications when debt was exchanged at a discount, leading to significant cancellation of indebtedness income (CODI). While CODI is generally taxable, it presents a significant challenge for borrowers grappling with liquidity issues and the resultant tax liability. Indeed, the pressure of mounting tax liability could drive a borrower to the brink of insolvency.

Navigating CODI Outside of Bankruptcy

Outside of bankruptcy, there are mechanisms to avoid this tax. CODI can be offset against certain tax attributes, but this relief is limited to the extent of the borrower's insolvency. This requires careful valuation and can attract the scrutiny of the Internal Revenue Service (IRS). It is here that professional valuation and tax advice become crucial for borrowers to accurately determine their tax liability, make informed decisions about restructuring, and safeguard against IRS scrutiny.

Bankruptcy and CODI: A Double-Edged Sword

In bankruptcy, CODI escapes taxation, but tax attributes must still be reduced to offset it. This could potentially lead to increased future tax liabilities. State tax rules generally align with federal rules, but there are exceptions. Therefore, the decision to undergo a liability management transaction through bankruptcy involves numerous factors, including potential cash tax liabilities stemming from CODI as well as impacts on customers, employees, suppliers, costs, and publicity.

2023 saw a significant increase in Chapter 11 bankruptcy filings in the healthcare industry, reaching a five-year high. The end of pandemic protections, challenging profitability, liquidity and leverage dynamics, capital market constraints, labor and supply cost pressures, and a shift to out-of-hospital care delivery all contributed to this situation. This distress in the healthcare industry is predicted to continue into 2024, emphasizing the importance of careful liability management and strategic planning.