Navigating Taxes When Businesses Face Insolvency

When a business begins to struggle financially, owners and advisors often focus on liquidity, negotiations with lenders, and operational triage. But taxes play an equally important role, and in many cases, a ‘make‑or‑break’ one. US businesses encounter financial distress through different legal paths, with each having its own tax considerations.

As Robert Richards of Dentons explains, “Insolvency can take many forms; bankruptcy is only one of them, and different processes trigger different tax consequences.”

Insolvency scenarios companies may face include:
• Bankruptcy under federal law
• Receivership in state or federal court
• Assignments for the Benefit of Creditors
• Out‑of‑court restructurings and debt workouts

Each forum handles claims, priorities, and tax reporting differently, which means tax planning must adapt accordingly.

Understanding the Fundamentals

Bankruptcy or insolvency does not change how an entity is taxed.

“If an entity is a corporation for tax purposes, it remains a corporation, even in distress, and that means corporate‑level income tax still applies,” cautions John Harrington of Dentons.

Corporations often think first of federal income tax, but state and local obligations can be equally important, sometimes more so.

“Taxes don’t disappear just because an entity becomes insolvent. You have to consider income taxes, property taxes, franchise taxes, and especially trust‑fund taxes,” advises Stephanie Drew of RubinBrown.

Key tax categories include:
• Income, franchise, and gross receipts taxes
• Property taxes at the state and local levels
• Sales and use tax collections
• Payroll withholding, including employee tax withholdings and garnishments

Major Considerations

Net Operating Losses

Distressed companies often have significant net operating losses (NOLs), which can shelter future income from taxation. Preserving NOLs can materially increase the value of a restructured business. However, NOLs are fragile.

NOLs can be lost or limited by:
• Intercompany transfers that disallow built‑in losses
• Cancellation of debt income (CODI) attribute reductions
• Ownership changes under Internal Revenue Code §382

Section 382 prevents trafficking in NOLs by limiting their use after major ownership shifts. For distressed companies, this often arises when creditors convert debt into equity. If ownership of the corporation shifts by more than 50 percentage points during a three‑year testing period, NOL usage becomes severely restricted.

Bankruptcy provides two special rules:
• §382(l)(5): If qualified creditors and old shareholders own at least 50% of the new equity, the usual limits do not apply, but interest paid in the prior three years on converted debt may reduce NOLs.
• §382(l)(6): If §382(l)(5) does not apply, the company may receive a higher value for computing NOL limits, typically increasing how much NOL can be used annually.

Debt Relief and the Tax Trap of Cancellation of Debt Income

When a creditor forgives debt, extends maturity, accepts equity instead of repayment, or forecloses on collateral, the company may recognize cancellation of debt income. As David Agler of Agler Law explains, cancellation of debt generally produces ordinary income unless an exclusion applies, so saving cash on the balance sheet can create taxable income at the same time.

CODI may arise from:
• Debt forgiveness or negotiated reductions
• Foreclosures, deeds in lieu, or short sales
• Debt‑for‑debt exchanges
• Debt‑for‑equity conversions
• Significant debt modifications

Fortunately, several exclusions help distressed companies, including:
• Bankruptcy exclusion
• Insolvency exclusion
• Qualified real property indebtedness
• Contested liability doctrine

When an exclusion applies, the company must reduce tax attributes, such as NOLs or asset basis, in exchange for avoiding immediate income recognition.

One of the most frustrating parts of CODI is so‑called ‘phantom income,’ income for tax purposes without the cash to pay the tax.

This risk arises most acutely in:

• Debt modifications
• Debt‑for‑equity swaps where no cash enters the business

This is another reason tax planning must occur early in the restructuring process.

Debt Modifications

Many out‑of‑court restructurings involve modifying existing loan terms. But even minor adjustments can create a ‘significant modification,’ triggering a taxable exchange of old debt for new.

Common triggers include:
• Extending maturity beyond the safe harbor
• Interest‑rate changes greater than 25 basis points
• Switching from recourse to nonrecourse status
• Material changes in covenants or payment expectations

Creditors may recognize gain or loss, and debtors may incur CODI.

Tax‑Free Reorganizations

Tax‑free reorganizations allow corporations to restructure without triggering gain or loss. Common forms include statutory mergers and recapitalizations. These can preserve corporate tax attributes and avoid immediate tax costs.

But sometimes triggering gain is preferable, for example, when selling assets allows a buyer to receive a stepped‑up basis while the seller’s NOLs shield the gain. Restructurings require weighing whether avoiding tax is worth more than the value a buyer receives from a basis step‑up.

Tax Considerations for Third Parties

Creditors also face tax consequences in distress scenarios. Lenders and suppliers must determine whether their claims represent bad debt deductions, capital losses, or ordinary losses, as each will have different tax results. Significant debt modifications, debt‑for‑equity exchanges, and partial repayments may all trigger taxable events.

Receivers, trustees, and similar fiduciaries cannot ignore tax obligations. If they have control over substantially all assets, they may be required to file returns and pay taxes. Failure to do so can expose them to personal liability under:
• Federal priority rules
• Trust‑fund recovery penalties
• State tax statutes governing withholding and sales tax remittances

Key Takeaways

Corporate distress is never simple, but the tax consequences that accompany it are often the least understood and the most consequential. When a business begins to falter, the instinct is to focus on liquidity, operations, or creditor negotiations. Yet taxes quietly shape every restructuring choice: whether a debt modification triggers income, whether NOLs survive a reorganization, whether a receiver becomes personally liable, or whether creditors unintentionally create taxable events for themselves.

Tax issues cannot be an afterthought. The rules governing CODI, corporate classifications, trust-fund taxes, ownership changes, and tax-free reorganizations are deeply interconnected. A decision made for business or legal reasons, like extending a loan, converting debt to equity, selling a division, or appointing a receiver, may cascade into tax consequences that create unexpected liabilities or eliminate valuable tax attributes.

At the same time, companies in distress are not without powerful tools. Bankruptcy-specific provisions can preserve NOLs that might otherwise be lost. Certain CODI exclusions can reduce or eliminate immediate income. Structured reorganizations can shift assets or recapitalize a company without triggering gain. For lenders, trade creditors, investors, and fiduciaries, understanding these mechanisms can help them avoid avoidable pitfalls while maximizing potential recovery.

Businesses that incorporate tax planning early, long before court filings, asset sales, or debt exchanges, are far more likely to preserve value, minimize risk, and position themselves for a successful turnaround or orderly wind-down. Conversely, those that defer tax considerations until late in the process often discover they have fewer options and greater exposure than expected.

This article was originally published on December 15, 2025 here.