Examining the Income Tax Treatment of Restructuring Costs

This note briefly discusses the book-tax difference in the treatment of restructuring costs.  As a general rule, these costs must be expensed for book purposes, often times appearing in separate line items in income statements of entities reporting under ASC Topic 852.  However, for U.S. federal income tax purposes, many of these costs are not currently tax deductible but must be capitalized and recoverable only in the case of future events, or, alternatively, never tax deductible.  The tax rules governing these costs are summarized as follows:

  1. Legal, financial advisor and other related (banking, valuation, etc.) costs are generally viewed on a “with/without” basis. Thus, one must look to whether the costs would have been incurred outside of the restructuring, and if so, would they be deductible under the circumstances.
    • Normal business operating costs, if deductible outside of a restructuring environment, are unchanged by the fact that restructuring efforts (whether court-supervised or not) are underway.
  2. Costs incurred for filing and administrating a bankruptcy petition under Chapter 11 of Title 11, USC, are not deductible.
    • However, a major exception set out in the regulations involves fees and costs incurred to resolve tort liabilities associated with the restructuring are allowable. So, if there is an ongoing dispute over, say, a personal injury claim on a production platform, one could see those costs being allowable as current deductions for income tax purposes if otherwise deductible.
  3. Pre-filing costs fall into a similar analysis of whether the costs led to a “reorganization” of the taxpayer entity, under the traditional M&A acquisition/disposition of entities or properties, capital raising, and debt renegotiation.
See Treas. Reg. Section 1.263(a)-5 for additional guidance. For financial reporting purposes (in a tax provision calculation), these costs typically are added back to pre-tax income as a current period (discrete) permanent differences. However, to the extent these costs can be capitalized into the tax basis of a wasting asset (recoverable through future cost recovery deductions), they would appear as an unfavorable temporary difference for the period incurred, similar to transaction costs incurred to acquire assets in a taxable exchange treated as a purchase of a business for book purposes.

While the effect of this unfavorable permanent difference may not be readily apparent to external readers of financial statements for entities with a current Valuation Allowance (since no net income tax benefit is recorded), if not accurately measured, this issue has the effect of overstating the net operating loss (NOL) generated during the period. Consequently, there will be an inaccurate determination of that deferred tax attribute (NOL carryover) which could lead to miss-stated post-restructuring tax attributes surviving the execution of the Plan of Reorganization.

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