Accountants who study for CPA credentials are expected to deliver high quality counsel, particularly in regard to complex tax matters. An increasingly common area of advice in today’s economic environment entails debt modification. Businesses are relying completely upon their accountants to avoid unpleasant tax surprises from restructuring of debt.
Tax consequences of debt modifications lie within a scope of knowledge that is almost exclusive to CPAs. Several elements described in CPA review class are drawn into these situations. The first step after recognizing that a modification has occurred is determining whether it is significant. The tax rules provide six tests for making this assessment.
Debt modification is a typical example of how a regulatory pattern is utilized to establish accurate accounting. For instance, significant modification arises when general facts and circumstances indicate substantial alteration in legal rights or obligations. This means that a series of small changes can collectively amount to economic significance. The general test only applies when none of the other specific tests covered in CPA review is applicable.
Specific testing of debt modification to ascertain significance initially entails examination of change in yield. Interest rate alteration is not the only factor. A change in principal also impacts the amount of yield. Other possible substantial modifications occur from changes in the timing of payments, the obligor, the borrower’s creditworthiness, and the covenants that accompany the debt. Any one of these characteristics could be the triggering event to identifying a significant debt modification. Each of them has an equal likelihood of appearing in CPA exam questions on this issue.
If a debt modification is significant, a CPA must recognize tax consequences for the borrower. The original amount of the debt is essentially altered. This assesses a gain or loss based upon the alteration. In addition, the lender recognizes a new tax basis. Developing a thorough understanding of this subject demands some intense study. Careful investigation of the overall matter gradually brings focus to such details as how a debt holder can have a tax basis that varies from the issue price and the fact that issue price is the principal amount with adequate stated interest. Also, the rules about issue price are different for private debt compared to publicly traded debt instruments.
Many nuances exist to the simple situation of debt modification. This is a type of highly complex subject that accountants must resist the temptation to skip in courses for CPA exam study. Moreover, understanding the tax impact of debt modification is more than just a CPA exam topic. It is also an important part of work for any CPA rendering tax advice.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.