The Quiet Part

Why you should read this. Monroe Capital CEO Ted Koenig said the quiet part out loud this week at the CAIS Alternative Investment Summit in Los Angeles. Extending maturities to dodge covenants and switching from cash interest to payment-in-kind, he said, are forms of “silent default.” His preference: “I want the current payment all day long.” (PitchBook, Oct. 16.)

Whether PIK hides stress is debatable. The tax bill is not. Myron Scholes called the taxing authority “an uninvited party to all contracts.” On a PIK loan, it is the one party still paid in cash.

01 What the lender signs up for

• Income with no cash. If the loan allowed PIK from day one, the interest isn’t “qualified stated interest” and is original issue discount (Treas. Reg. §1.1273-1(c)). The lender reports OID as it accrues, paid or not (§1272(a)). A cash-pay loan later amended to PIK is tested as a modification (below). A skipped coupon is just unpaid interest, still accrued; whether doubtful amounts can be skipped is unsettled.
• BDCs pay out money they never got. A BDC must distribute 90% of its taxable income, PIK included, to keep RIC status (§852(a)). Pay out under 98% of calendar-year ordinary income (98.2% of capital gains) and a 4% excise tax hits the shortfall (§4982).
• Foreign LPs: withholding at the wrong time. If the lending is a U.S. trade or business (an unsettled fact question), the fund withholds, cash or not (§1446). If not, tax waits for a payment or sale, then reaches accrued OID, capped at the cash paid (Treas. Reg. §1.1441-2(b)(3)), unless portfolio interest (§871(h)) or a treaty applies.
• An amendment can be a sale. A “significant modification” is taxed as swapping old loan for new, with possible gain or loss and fresh OID (Treas. Reg. §1.1001-3(b)). A yield move over the greater of 25 basis points or 5% of the old yield qualifies (§1.1001-3(e)(2)). Deferrals within the lesser of five years or half the original term are safe; longer ones turn on the facts (§1.1001-3(e)(3)). Forbearing after a default isn’t a modification for up to two years (§1.1001-3(c)(4)(ii)).
• Ordinary in, capital out. Accrued OID raises the lender’s basis (§1272(d)(2)), so a haircut turns taxed interest into loss. A payoff or settlement is an exchange (§1271(a)(1)); for an investor, the loss is capital. So is worthlessness of a registered corporate loan, with no bad-debt deduction (§§165(g), 166(e)). Individuals deduct capital losses only against gains, plus $3,000 a year (§1211(b)).
• Borrowers have their own problem. A PIK loan over five years yielding AFR plus five points or more, with significant OID, is an AHYDO: part of the OID deduction is denied, the rest waits until paid (§163(e)(5), (i)).

02 The numbers

A $100 million loan written at 12% PIK from issuance, compounding annually, held through a partnership fund by a top-bracket U.S. individual (37% plus 3.8% net investment income tax: 40.8%):

• Taxable OID of $12.0M, $13.4M, and $15.1M: $40.5M over three years. Cash received: zero.
• Tax on it: $16.5M, paid from the investor’s own pocket.
• The $140.5M claim settles at 60 cents, or $84.3M. Loss: $56.2M, of which $40.5M is interest already taxed.
• The loss is capital. Against long-term gains at 23.8% it saves $13.4M; with no gains, it waits.
• Best case, the $40.5M cost 40.8 cents a dollar going in and earns back 23.8 cents coming out: $6.9M lost to character alone.

Three years of income. Zero cash.

03 What to do now

1. Take a PIK census. List every loan that toggled or was amended in 2026, with its accrued OID.
2. Size the year-end payout. BDC managers: model the 98% test now, while there is time to fund it.
3. Test amendments before signing. Yield test and deferral safe harbor, every time.
4. Check foreign-LP withholding. Business or portfolio? Who funds the tax?
5. Plan the exit. Sale, restructuring, and write-off differ in timing and character. Choose early.

Silence is a choice. So is the tax that comes with it.

Holding PIK paper or weighing an extension? I’m glad to review your book before year-end. Reach me at carlos@lapresallc.com or (917) 558-6393.

Important notes

Section references are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations under it, as in effect on October 16, 2026. Figures are illustrative and rounded; the example assumes PIK from issuance, annual compounding, a 40.8% rate, a 60% recovery, and gains taxed at 23.8%. Koenig quotes: PitchBook, Oct. 16, 2026, with our thanks for the reporting.

This client alert is for general information only. It is not tax, legal, investment, or accounting advice. Consult your own advisers about your particular circumstances before acting on any matter discussed here.

C . A . S .

This alert is for general information only and is not tax, legal, investment, or accounting advice. Consult your own advisers before acting. Carlos A. Schmidt, MBT, MBA, CPA · carlos@lapresallc.com · (917) 558-6393.