Forgivable Note Accounting

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June 20, 2024

by a searcher from Indiana University, Bloomington/Indianapolis - Kelley School of Business in New York, NY, USA

For tax people and searchers/investors that have used forgivable notes --- if the performance thresholds aren't met and a seller note is forgiven, does this result in a taxable gain on debt extinguishment? How do you structure around this so you're not stuck paying a bunch of cash taxes on a seller note being forgiven?

Seems counterintuitive that the company would have to pay cash taxes to extinguish the seller debt when those performance metrics weren't met in the first place, but my understanding is that is what would actually happen. I had discussed with my M&A and tax attorneys at one point on a deal and was planning to use an earn-out that converted into a seller note, but that would not be SBA compliant and wouldn't work for a 7(a) financed deal. Any creative structuring ideas or experiences would be appreciated!

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Reply by a professional
from Harvard University in Lynbrook, NY 11563, USA
^redacted‌ is correct. There's been a lot of confusion on this point on Searchfunder. If purchase money debt is forgiven, it's generally treated as an adjustment to the purchase price under Section 108(e)(5) of the tax code. See here: https://www.law.cornell.edu/uscode/text/26/108

This means that you don't have cancellation of debt income, but you have less basis in your acquired assets (or stock) because you effectively paid less for them. In other words, you don't take a big tax hit, but may have some smaller effect due to less redacted if you want to discuss.
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Reply by a searcher
from Indiana University, Bloomington/Indianapolis in Chicago, IL, USA
I believe that there is an exception for cancelled debt that reduces purchase price. See here. https://www.irs.gov/taxtopics/tc431

#6 under exceptions.

I’ve also seen a few other posts on this platform that seem to echo the notion that the forgiven debt is not a taxable event for the company
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