Why the payment ordering rules are best interpreted as inapplicable to a distressed debt satisfaction
Although distressed debt satisfactions occur frequently, there remains uncertainty about whether payment in a distressed debt satisfaction is treated first as a payment of principal or interest for federal income tax purposes. When the debtor and creditor are both U.S. accrual basis taxpayers, it may make little difference whether the payment is treated as a payment of principal or of interest that has already been deducted by the debtor and included in income by the creditor. However, for withholding tax purposes, the distinction between a payment of principal versus interest can be significant. Further, even in the context of accrual method taxpayers, not all interest expense may have been taken into account by the debtor and creditor at the time of a distressed debt satisfaction, meaning that the allocation between interest and principal can have significant consequences to the debtor and creditor.
Read an August 2024 report* prepared by a KPMG LLP tax professional that examines the history of payment allocation in the context of distressed debt and explains why the payment ordering rules are best interpreted as inapplicable to a distressed debt satisfaction.
*This article originally appeared in Tax Notes Federal (August 12, 2024) and is provided with permission.