Tax Issues Associated With Restructuring Credit Lines

Overview

Last week the U.S. Tax Court held that MoneyGram is not a bank, which meant that it could not claim ordinary loss deductions associated with the write-off of a substantial amount of partially or wholly worthless asset-backed securities.  MoneyGram International, Inc. v. Comr., 153 T.C. No. 9 (2019).  Buried in the court’s opinion is a discussion of the “original issue discount” (OID) rules.  That discussion triggered a thought about farmers and their lines of credit. 

As 2019 comes to a close, some farmers and ranchers will have unpaid lines of credit remaining and may be asked or required by a lender to roll the existing credit line balance into the 2020 line of credit.  They may also be asked to pay some of the interest charge down.  If either of those events happens, what are the tax consequences?  It’s an important question that is often overlooked when making a determination of what to do with an existing line of credit.

The tax consequences of restructuring credit lines – that’s the topic of today’s blog post.

In General

For a loan that has fixed interest payable in one year or less, the interest is not deductible when there is a rollover of a remaining line of credit at year-end into the next year.  I.R.C. §1273(a)(2); Battelstein v. Internal Revenue Service , 631 F.2d 1182 (5th Cir. 1980), cert. den., 451 U.S. 938 (1981); Wilkerson v. Comr., 655 F.2d 980 (9th Cir. 1981), rev’g., 70 T.C. 240 (1978; IRS News Release 83-93 (Jul. 6, 1983). The result is the same if the taxpayer borrows funds from the same lender for the purpose of satisfying the interest obligation to that lender.  For a cash basis taxpayer to deduct interest, the payment must be in cash or a cash equivalent.  I.R.C. §163. The delivery of a promissory note isn't a cash equivalent but merely a promise to pay.   In Battelstein, the taxpayers were land developers embroiled in a bankruptcy proceeding. A lender agreed to loan the taxpayers more than three million dollars to cover the purchase of a tract of land. The lender also agreed to make future advances of the interest costs on the loan as the interest cost came due.  Indeed, the taxpayers never paid interest except by means of the advances. Each quarter, the lender would notify the taxpayer of the amount of interest currently due. The taxpayer would then send the lender a check in the same amount, and, on its receipt, the lender would send the taxpayer a check for the identical amount. The taxpayers deducted the interest amount as “paid” during the tax year, but the IRS and the appellate court disagreed.  There was no current payment of interest as I.R.C. §163(a) requires.   

Thus, where a lender withholds interest from the loan proceeds, the borrower generally is considered to have paid with a note.  That is not payment in cash or with a cash equivalent and does not give rise to a deduction.

So, what’s the point of this to a farmer or rancher that is dealing with credit issues?  The “take-home” lesson is that a taxpayer can’t deduct interest if funds are borrowed from the same lender that provided the original loan.  That’s true even if unrestricted control is maintained over the loan proceeds.  However, an interest deduction should be available if the taxpayer can show that the newly-borrowed funds weren't, in substance, the same funds used to pay the loan. To do that, of course, the taxpayer would have to establish that the taxpayer had sufficient other funds to pay the interest.  Likewise, a deduction is permitted when interest is paid with funds borrowed from another lender.  See, e.g., Davison v. Comr., 141 F.3d 403 (2d Cir. 1998), aff’g., 107 T.C. 35 (1996).  But, in reality, borrowing funds from another lender might be quite difficult for a financially troubled borrower. 

What’s the Issue With “Original Issue Discount”?

Original issue discount (OID) is a form of interest.  In U.S. financial markets, “commercial paper” refers to unsecured promissory notes issued by corporations with a fixed maturity of no more than 270 days.  Commercial paper is always issued at a discount to the face amount of the obligation. The discount is OID, and it represents unstated interest that the investor receives upon selling the instrument or when it is received as the face amount at maturity.  Thus, a debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity.  OID is the difference between the stated redemption price at maturity and the issue price.  All debt instruments that pay no interest before maturity are presumed to be issued at a discount.

The general rule is that OID is taxed as ordinary income.  I.R.C. §1271(a)(4).  OID accrues over the term of the debt instrument, whether or not the taxpayer receives any payments from the issuer.  But, the OID rules generally do not apply to short-term obligations (those with a fixed maturity date of one year or less from date of issue).  See IRS Publication 550.  The one-year restriction is key.  So, if a farmer rolls over a 2019 loan into the line of credit for 2020, the OID rules may be triggered if the old loan does not become payable until more than a year after the original loan was taken out.  I.R.C. §§1272(a)(1); (a)(2)(C); 1273(a)(1).  In that event, the interest amount is spread over the loan’s term resulting in a portion of the interest being deductible in the year that the loan is rolled over. 

Consider the following example:

Kay O’Pectate borrowed $200,000 from Usurious State Bank on June 1, 2019 at 6 percent simple interest.  Interest and principle were due on December 1, 2019.  However, due to poor crop and livestock markets, Kay and the bank on December 1 agreed to defer the payments on the loan for another year – until December 1, 2020.  During that timeframe, interest would continue to accrue at 6 percent.  Because no payment is due on the renegotiated loan until after June 1, 2020, the OID rules apply.  Thus, under the loan that has been rolled over, the “issue price” is $200,000, and the “stated redemption price at maturity” is the $200,000 as of December 1, 2019, plus the half-year interest to that date of $6,000, plus the interest expected to December 1, 2020 of $12,000 for a total of $218,000.  Because the total amount due on December 1, 2020, exceeds the issue price of $200,000, there is OID of $18,000.  I.R.C. §1273(a)(1).  Thus, Kay could deduct, in 2019, the $6,000 of interest as OID through December 1 of 2019, plus one month of OID for December of 2019 (1/12 of $12,000) for a total interest deduction in 2019 of $7,000.  The balance of the OID, $11,000, would be deductible in 2020. 

The rollover caused the interest deduction to be spread out over 2019 and 2020.  That may or may not be advantageous to Kay.  The answer to that question depends on numerous factors particular to Kay.  The point is, however, that Kay should understand the consequences of rolling over her loan into the next year. 

Payment Allocation

For tax purposes, the OID rules require that payment be allocated first to OID, to the extent that OID has accrued as of the date the payment is due, and then to the payment of principal.  Treas. Reg. §1.1275-2(a).  So, if a farmer (or non-farm taxpayer for the matter) pays down principal late in the year, but leaves an amount of interest to be rolled over into the next year, the OID rules still apply. 

Conclusion

When working with a lender concerning credit lines, rarely does a discussion of the tax treatment of interest occur.  Note the problem of borrowing funds from the same lender to pay interest on an existing loan, and take into consideration the OID rules on a roll-over.  Always talk with your tax practitioner about how to maximize the tax benefit of restructuring loans and deducting interest.