Chapter 10 TAXES

• Jurisdiction: United States

Chapter 10 TAXES

This chapter provides an introduction to important aspects of tax planning in the formation and administration of liquidation trusts. The important issues center on defining a grantor trust pursuant to IRS requirements, defining the trust's reporting mechanisms, and meeting its tax filing requirements.

Analyses of the tax implications of using liquidation trusts are complex and require the advice and counsel of knowledgeable attorneys, accountants and other tax professionals. The creation of a trust requires a detailed understanding of federal and state tax laws. The application of this understanding to create a particular trust agreement that satisfies the needs of its beneficiaries within the context of bankruptcy law and tax law requires careful planning and design. We briefly introduced some important tax considerations in Chapter 6 to explain how a liquidation trust is defined. This chapter provides a more in-depth discussion of these issues, focusing on liquidation trusts for the discussion. The general issues raised may also apply to litigation trusts, and in some situations to other forms of liquidation vehicles such as escrow or custodial accounts and segregated settlement funds.

A. IRS Guidelines

The Internal Revenue Code and Treasury Regulations define the classification of legal entities and arrangements for income tax purposes. Federal tax law governs whether a trust, fund, legal arrangement, organization or other legal entity is a separate taxable entity or a pass-through entity. State and local laws, contract law and even federal bankruptcy law cannot define the tax status of an entity. The federal tax consequences of a liquidation trust, settlement fund or other mechanism will depend on the IRS classification of the legal arrangement.¹⁰⁵

Generally, the federal income tax consequences will impact the debtor/transferor of the assets, the liquidation trust and its trustee, and the creditor claimants who may become equityholders. The federal consequences may involve the recognition of gains, losses or other income, tax reporting and withholding tax obligations, and the personal liability for taxes placed on third-party trustees, administrators or assignees.

The creation and allocation of tax consequences will depend on numerous factors arising from the formation, funding and operation of a liquidation trust or the assignment of assets to a disbursing agent or other assignee. Critical issues include the terms and intent of the liquidation trust, settlement fund or other assignment; the origin of the claims/liabilities to be satisfied; the type of assets to be transferred, held and liquidated; the method of formation and funding of the trust, fund or account; and the powers granted to the third-party trustee or assignee.¹⁰⁶

Internal Revenue Code (IRC) § 468B and related Treasury Regulations outline the federal income taxation of qualified settlement funds (QSFs), designated settlement funds (DSFs) and disputed ownership funds (DOFs). IRC § 468B(g)(1) ensures that all income earned under these legal arrangements is subject to federal income taxation (1) except as provided in Treasury Regulations and (2) except for certain funds created for the receipt of settlement payments directed by a government entity to satisfy claims asserting liability under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA). Thus, escrow accounts, settlement funds or similar funds are subject to federal income tax.

B. Trusts¹⁰⁷

Liquidation trusts within and outside of bankruptcy are treated as trusts for federal income tax purposes. The IRC refers to a "trust" as an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for their beneficiaries. Ordinarily the beneficiaries of such a trust merely accept the benefits of the trust and are not the voluntary planners or creators of the trust arrangement. A trust created by the beneficiaries of the trust will be recognized as a trust if it was created to protect or conserve trust property for beneiciaries who stand in the same relation to the trust as they would had the trust had been created by others for them. Generally, an arrangement will be treated as a trust if the arrangement places responsibility on a third-party trustee to protect and conserve the trust's property on behalf of beneficiaries who do not share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.¹⁰⁸

Generally, a trust that qualifies as a liquidation trust is treated as a grantor trust under IRC §§ 671-677. Treasury Regulation § 301.7702-4(d) states:

An organization or entity will be considered a liquidation trust if it is organized for the primary purpose of liquidating and distributing the assets transferred to it, and if its activities are necessary to, and consistent with, the accomplishment of that purpose. A liquidation trust is treated as a trust for federal income tax purposes if it is formed with the objective of liquidating particular assets and not as an organization having as its purpose the carrying on of a profit-making business which normally would be conducted through business organizations classiied as corporations or partnerships. If the liquidation is unreasonably prolonged or if the liquidation purpose becomes so obscured by business activities that the declared purpose of liquidation is lost or abandoned, the status of the organization or legal arrangement will fail to qualify as a liquidation trust for federal income tax purposes.¹⁰⁹

Bondholders' protective committees, voting trusts, and other agencies formed to protect the interests of security-holders during insolvency, bankruptcy or corporate reorganization proceedings are analogous to liquidation trusts so long as they are not utilized to further the control or proitable operation of a going-concern business on a permanent, continuing basis.¹¹⁰ As noted in Chapter 4, other forms of post-confirmation entities may also be employed, such as a post-confirmation plan administrator or disbursing agent. Depending on the structure adopted under these approaches, the liquidation vehicles utilized to hold and convey asset recoveries to creditor beneficiaries may also qualify as grantor trusts.

C. Use of Grantor Trusts

Federal taxation of liquidation trusts arises from the structure of the trust arrangement. A grantor trust can be a pass-through tax entity with creditors as the grantors,¹¹¹ or with the debtor as the grantor.¹¹² The liquidation trust can be a separate taxable trust entity with creditors as beneficiaries of the trust.¹¹³ Taxes may also arise if the trust is deemed to be a tax partnership with the creditors/beneficiaries as partners, a taxable corporation with creditors/beneficiaries as shareholders, or a QSF, DSF, DOF, escrow, or other fund or trust account within the meaning of IRC § 468B and the related Treasury Regulations.¹¹⁴

Liquidation trusts are normally treated as grantor trusts for the benefit of the beneficiaries of that trust. A grantor trust is a pass-through tax entity that does not pay federal income tax. Rather, the trust files informational returns with the IRS that report the trust's taxable items, such as income, deductions, and gains and losses. The grantors of the trust, rather than the beneficiaries of the trust, are required to report and pay federal income tax on the trust's tax items.¹¹⁵ For bankruptcy liquidation trusts that are not subject to IRC § 468B, the creditor-claimants are treated as the grantors of the trust for federal income tax purposes and are required to pay federal income tax on their share of the trust's income.¹¹⁶

Revenue Procedure 94-45, 1994-2 C.B. 684, provides guidelines to obtain a private-letter ruling from the IRS that a trust created pursuant to a bankruptcy plan of reorganization in a chapter 11 case will be treated as a liquidation trust. Rev. Proc. 94-45 states that a transfer to a liquidation trust for the benefit of creditors must be treated for all purposes of the IRC as a transfer to the creditors.

D. General Guidelines for Liquidation Trusts¹¹⁷

IRS guidelines from 1982 indicate at what point the IRS will generally rule that a trust can be classified as a liquidation trust.¹¹⁸ These general guidelines are not speciically designed for liquidation trusts formed in bankruptcy cases, but they do provide the basis for overall concepts. The guidelines state that a trust will be classified as a liquidation trust if it meets the following conditions (referring to the Internal Revenue Code):

1. The governing instrument provides that the trust is organized for the primary purpose of liquidating the assets with no objective to conduct a trade or business.
2. The trust contains a fixed or determinable termination date that is generally not more than three years from its creation and that is reasonable on all the facts and circumstances. However, if the trust holds installment obligations received incident to a Code § 337 liquidation, it may extend beyond three years until the maturity of the obligation.
3. The investment powers of the trustee are limited to powers to invest in demand and time deposits in banks or savings institutions, or temporary investments such as short-term certificates of deposit or Treasury bills.
4. The trust does not receive transfers of any listed stocks or securities, any readily marketable assets or any operating assets of a going-concern business. The trust does not receive or retain cash in excess of a reasonable amount to meet claims and contingent liabilities.
5. The trust does not receive transfers of any unlisted stock of a single issuer that represents 80 percent or more of the stock of such issuer and does not receive transfers of any general or limited partnership interests.
6. The trust is required to

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