Liquidating trusts can help bankrupt or distressed companies settle certain debts in an efficient and organized manner. But when utilizing one, it is important to consider the tax implications that arise.
The purpose of a liquidating trust is to:
- Collect and hold assets and claims of the debtor as specified in the bankruptcy plan
- Liquidate the trust assets
- Resolve disputed claims
- Make distributions to allowed claimholders in accordance with the plan.
Liquidating trusts are particularly useful when the debtor has substantial pending litigation, assets that cannot be sold in a Section 363 or other type of sale or has other special situations. Utilizing a trust rather than the debtor corporate entity or a qualified settlement fund may allow for a more organized entity structure. Each trust has its own “Trust Agreement” and “Order Confirming a Plan of Liquidation” approved by the bankruptcy court that the trustee must follow throughout the administration of the trust.
Bankrupt or distressed companies considering using a liquidating trust should take special care to ensure it is administered as required by the bankruptcy court and accomplishes its goals in the most tax-efficient manner.
Formation, fiduciary responsibility and consultants
Liquidating trusts are funded with assets held for the benefit of creditors who may have a claim against the debtor. These trusts can exist from several months to several years, depending on how long it takes to liquidate the assets and work through various claims and settlements. The initial term of the trust is determined in the trust agreement or the bankruptcy plan, but if necessary, the trust’s life can potentially be extended to allow for additional time to complete the liquidation and distribution of assets.
In order to fulfill the fiduciary responsibility for a liquidating trust, the trustee should involve the right consultants and advisors early in the process. This is a niche market where expertise is limited and it is imperative that the trustee identify consultants that fit with the team. Attorneys, accountants, tax advisors, and other third-party service providers, such as claims agents, all play key roles in administering the trust, communicating to the trust’s beneficiaries and ensuring the trust’s goals are achieved in the most tax-efficient way.
After identifying the advisor team, the valuation of the opening balance sheet is the next step where there are potential pitfalls that need to be thoughtfully handled and discussed. An important fiduciary responsibility of the trustee is to properly value the liquidating trust assets. This valuation will be used consistently by all parties for federal and state income tax purposes. If the assets are erroneously undervalued upon set-up and cash receipts subsequently exceed the original valuation, there can be unintended tax consequences to the trust or beneficiaries. Thus, it is critical to jointly consult with valuation specialists and tax advisors during this early stage.
As the trust is administered, the trustee must manage the trust in the best interest of the beneficiaries, fully understanding when there could be tax implications to the beneficiaries or the trust. As taxable income and equity items are calculated each year, it is critical to align tax and other advisors in order to ensure the beneficiary allocations are calculated in a manner consistent with the legal agreements. This is particularly important if there are allocations that affect the beneficiaries’ individual tax situation or if there is significant uncertainty, such as changes in allowed claimants, valuation of assets, or additional funding requirements.
Another step in administering the trust is to understand the bankruptcy court requirements, including timing of various reports the trustee must file with the court. Some trusts require quarterly financial reporting to the court while others require an annual report. And some may even require financial information and grantor information be made available to anyone who may request a copy at any point in time.
The trustee has a fiduciary responsibility to maintain the books and records of the trust in order to present a proper accounting to the beneficiaries of the trust, as well as to the court. These reports must be accurate and available as required. The tax implications should also be fully vetted early in the process. For example, large swings in equity after the opening balance sheet date will drive changes to taxable income, and equity true-ups – balance reconciliations – may be necessary to assist with distribution planning.
Income tax compliance of a liquidating trust
The liquidating trust is a separate legal entity and thus has its own income tax filing requirements. The trust can be filed in several different ways and on different forms with the IRS. The classification decision resides with the trustee, unless it is specified in the trust agreement. For federal income tax purposes, the trustee will often file returns for the liquidating trust as a grantor trust, pursuant to Treas. Reg. Sec. 1.671-4(a) using Form 1041. In some cases, the trust may be established and filed as a complex trust (Form 1041) or a qualified settlement fund (Form 1120SF).
The tax filing requirements of a liquidating trust are complex and are often misunderstood. The IRS does not provide in-depth guidance on liquidating trusts, but it does provide instructions on when and how to file a grantor trust return. Most liquidating trusts are intended to be classified as grantor trusts. At a high level, this means the claimants have received a deemed distribution of the debtor’s assets and contributed these assets to the trustee. The claimants are beneficiaries of the trust and are treated as grantors and owners of the trust. Because a grantor trust is disregarded for federal income tax purposes, all income, deductions, credits, etc. are treated as belonging to and reportable directly by the grantor(s).
A trustee must file a Form 1041 for a domestic trust that has any taxable income for the tax year, gross income of $600 or more (regardless of taxable income) or has a beneficiary who is a nonresident alien. It is not common for a liquidating trust to have taxable income and many do not have gross income of $600 or more. However, there are several reasons to file a Form 1041, even if the filing is not technically required, including the following:
- Filing a return starts the statute of limitations for the IRS to assess taxes. Generally, the statute expires three years from the due date of the return or the date on which it was filed, whichever is later. If no return is filed, the statute of limitations never expires on those years.
- As part of the trustee’s fiduciary responsibility, there are reporting requirements to the beneficiaries. The grantor statement attached to the return is a good summary that provides the required information to be sent to the appropriate parties, including the holder’s share of items of income, gain, loss, deduction or credit.
- Filing requires the trust accounting to be properly prepared and reviewed, at a minimum, annually. This tax filing is useful for reporting to the court and the beneficiaries.
Liquidating trusts can be particularly useful for settling certain debts of a bankrupt or distressed company, but it is important to ensure the legal requirements are adhered to proper consideration is given to the tax implications that may arise.
To learn more visit gt.com/tax
Russell A. Daniel
Russell A. Daniel is a partner in the Tax Services practice in Charlotte, and leads the Mid-South market territory’s Tax Services practice. He assists clients in identifying and evaluating tax risks and opportunities in connection with transactions, including M&A, and implementing federal tax planning strategies.
Charlotte, North Carolina
- Strategic federal tax
- Corporate Tax
Barbara Koosa Webb
Barbara is the Office Managing Partner of the Columbia practice. She is also a tax partner in the Privately Held Business (PHB) TBL and is the Carolinas Tax Practice Leader.
Columbia, South Carolina
- Transportation & distribution
- Construction & real estate
- Manufacturing, Transportation & Distribution
- Private client services
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