2. Cancellation of Debt Income
In connection with the implementation of the Plan, the Plan Administrator will wind down and liquidate the Debtors assets and distribute all of the liquidation proceeds to holders of Claims at which time any remaining Claims (or the unsatisfied portions thereof) will be viewed as cancelled for U.S. federal income tax purposes. As a result, the Debtors may incur cancellation of debt (COD) income in the amount of such cancelled Claims (or portions thereof). As described above, because the Debtors are pass-through entities for U.S. federal income tax purposes, any such COD income will be allocated to the Azure unitholders. Certain statutory or judicial exceptions potentially can apply to limit the amount of COD income required to be included in income by the Azure unitholders, depending on such unitholders particular circumstances. In particular, exceptions are available that would allow COD income to be excluded from gross income if the COD income is taken into account by a taxpayer that is insolvent (but only to the extent of insolvency) or in bankruptcy. These exceptions apply at the partner level and thus depend on whether the partner, i.e., the Azure unitholder to whom the COD income was allocated, is itself insolvent or in bankruptcy. The fact that the Debtors are insolvent and in bankruptcy is not relevant for that purpose. For purposes of determining a unitholders insolvency (measured immediately prior to the Effective Date), the holder would be treated as if it were individually liable for an amount of partnership debt equal to the allocated amount of the COD income. To the extent any amount of COD income is excludable by an Azure unitholder by reason of the insolvency or bankruptcy exception, the holder generally would be required to reduce certain tax attributes (such as net operating losses, tax credits, possibly tax basis in assets and passive losses) after the determination of its tax liability for the taxable year. An Azure unitholders adjusted tax basis in its units will be increased to the extent of any COD income allocated to such unitholder.
For U.S. federal income tax purposes the cancellation of Azures indebtedness pursuant to the Plan will result in a deemed cash distribution to each Azure unitholder based on the amount of the indebtedness allocable to such Azure unitholders common units. To the extent that any such deemed cash distribution exceeds the Azure unitholders adjusted tax basis in its common units (after adjustment for COD income and net gain or loss allocable to the Azure unitholder as described above), such unitholder will recognize capital gain. Any such capital gain generally should be long-term if the Azure unitholders holding period in its common units is more than one year and otherwise should be short-term. An Azure unitholders adjusted tax basis in its common units will be decreased (but not below zero) to the extent of any such deemed cash distribution. Significantly, although Azure unitholders will be deemed for U.S. federal income tax purposes to receive a cash distribution as a result of the discharge of Azures indebtedness, a cash distribution may not actually be made to the Azure unitholders.
To the extent an Azure unitholder was allocated losses in taxable years ending prior to the date the common units are viewed as cancelled for U.S. federal income tax purposes (i.e., when all distributions have been made), such losses may have been suspended by reason of certain provisions of the Tax Code (in particular, those relating to so-called passive losses or the at risk rules). As a result of the deemed cancellation and the recognition of COD Income, all or part of such losses may become deductible. Additionally, to the extent an Azure unitholder has any remaining tax basis in its common units (after adjustment for COD income and net gain or loss allocable to the Azure unitholder as described above and the deemed cash distribution to the Azure unitholder as described above), the Azure unitholder generally should be entitled to recognize a capital loss.
Accordingly, all Azure unitholders are urged to consult their tax advisors regarding the U.S. federal income tax consequences to them.