Corporate attorneys usually think of trusts as estate planning tools: they are the vehicles through which the owner of a business may pass along to their family a beneficial interest in the business without actually giving them direct ownership in the business. The owner will transfer an equity (often non-voting) interest in the business by either gifting or selling the interest to the trust.[1] The trustee will hold the interest and, in accordance with the terms of the trust agreement – which presumably reflect the owner-grantor’s directions or preferences – the trustee may distribute the trust’s income, and perhaps its corpus, among the beneficiaries of the trust.[2]
There are many non-estate-planning situations, however, in which a trust may prove to be a useful tool in the hands of a corporate attorney; for example, where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame; in that case, the subsidiary’s final liquidating distribution may be made into a so-called “liquidating trust.”
Such a trust may also be utilized to facilitate the orderly disposition of a debtor-corporation’s assets and the satisfaction of its liabilities. It may also enable shareholders to accelerate a recognition event so as to capture some tax benefit.[3]
In order to qualify as a liquidating trust, the trust at issue must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose. A liquidating trust will be treated as a trust for 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 classified as corporations or partnerships.
However, if the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the organization will no longer be that of a liquidating trust.
Assuming a liquidating trust is respected as such, it is important to next determine how and to whom the income and gains of the trust will be taxed – this is often no easy feat. A recent IRS ruling considered the tax status of one such trust that was used to facilitate the liquidation of a corporate debtor pursuant to a bankruptcy.
Debtor filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, and submitted to the Bankruptcy Court a Plan that was confirmed by the Court.
On the Effective Date, the transactions contemplated by the Plan were consummated. Trust was formed pursuant to the Plan, and was to be governed by the Plan and the Trust Agreement.
Trust was funded with all of Debtor’s assets, other than cash to be distributed by Debtor to cover, for example, certain expenses of administration of the bankruptcy case, certain priority claims, and fees owed to certain creditors’ professionals.
Trust would not hold any operating assets of a going business, a partnership interest in a partnership that held operating assets, or 50% or more of the stock of a corporation with operating assets.
The initial term of Trust was for three years, but the Court granted a three-year extension of the term on the basis that the extension was necessary to analyze and pursue or defend various causes of action, and to investigate, prosecute and/or resolve outstanding disputed claims against Debtor.
Pursuant to the provisions of the Trust Agreement, Trust was created for the purpose of liquidating Debtor’s assets, with no objective to continue or engage in the conduct of a trade or business. The Plan provided that the beneficial interests in Trust would be distributed to certain holders of senior notes claims, subordinated notes claims, general unsecured claims, guarantees claims, and preferred equity claims. In addition, the Plan provided that, in the event such claims were fully paid, the interests in Trust would be redistributed to certain holders of other subordinated claims and, after these were paid in full, to certain holders of preferred and common equity interests.
Pursuant to the provisions of the Trust Agreement, Trust would not receive or retain cash in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims) or to maintain the value of the assets during liquidation. Cash not available for distribution, and cash pending distribution would be held in demand and time deposits, in banks, other savings institutions, or other temporary, liquid assets. Trust was required, under the terms of the Trust Agreement, to distribute to the “beneficiaries” of Trust, at least annually, its net income and all net proceeds from the sale of Trust’s assets, except that Trust could retain an amount of net proceeds or net income reasonably necessary to maintain the value of the property or to meet claims or contingent liabilities.
Trust represented that, from its establishment, it had been formed and operated consistent with the conditions published by the IRS for treatment as a liquidating trust.[4]
Trust represented that the trustee had been working in an expeditious, commercially reasonable manner to monetize the assets transferred to it, to analyze and pursue any valid causes of action, and to investigate, prosecute and/or resolve disputed claims against Debtor.
However, two principal outstanding matters were not concluded and were not expected to conclude timely. Accordingly, Trust represented that it was impossible for it to completely liquidate by its initial extension date.
Under the Trust Agreement, multiple extensions of Trust’s term could be obtained so long as Court approval was obtained prior to the expiration of each extended term, and the extension was necessary to facilitate or complete the recovery and liquidation of Trust assets.
However, if the liquidation was unreasonably prolonged or if the liquidation purpose became so obscured by business activities that the declared purpose of liquidation was lost or abandoned, the status of the organization would no longer be that of a liquidating trust.
The IRS stated that, if warranted by the facts and circumstances, and subject to the approval of the Bankruptcy Court, upon a finding that an extension is necessary to the liquidating purpose of the trust, the term of the trust may be extended for a finite term based on such particular facts and circumstances.
The Plan and Trust Agreement required all parties, including Debtor, Trust and Trust beneficiaries, to treat the transfer of assets from Debtor to Trust as (i) a transfer of Trust assets (subject to any obligations relating to those assets) directly to Trust beneficiaries and, to the extent Trust assets were allocable to disputed claims, to the reserve established to hold Trust assets allocable to, or retained on account of, such disputed claims, followed by (ii) the transfer by such beneficiaries to Trust of Trust assets (other than Trust assets allocable to the disputed claims) “in exchange” for Trust interests.[5]
Accordingly, the Plan and Trust Agreement provided that Trust beneficiaries would be treated for federal income tax purposes as the grantors[6] and owners of their respective share of Trust assets (other than such Trust assets that were allocable to the reserve for disputed claims), and would file returns for Trust treating it as a grantor trust.
Under the True Code[7], the income of a trust, over which the grantor has retained (or is deemed to have retained) substantial dominion or control (a “grantor trust”), is taxed to the grantor rather than to the trust which receives the income or to the beneficiary (if different from the grantor) to whom the income may be distributed.[8]
Thus, the grantor is treated as the owner of any portion of a trust in which the grantor has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5% of the value of such portion. Likewise, the grantor is treated as the owner of that portion of a trust whose income, without the approval or consent of any adverse party is or, in the discretion of the grantor or a non-adverse party, or both may be distributed to the grantor.
Based on the foregoing, the IRS ruled that Trust should be classified for federal income tax purposes as a liquidating trust and, as such, Trust was also a grantor trust for federal income tax purposes, of which the Trust beneficiaries were treated as the owners.
Additionally, based on the facts and circumstances of the case and on the representations made, the IRS ruled that an extension of Trust’s term would not adversely affect the determination that Trust was a liquidating trust.
Although the liquidating trust is probably the form of non-estate-planning trust most often encountered by attorneys in corporate practice, it is hardly the only one.
It is not unusual, for example, for a corporation or a partnership to make a transfer of assets to a trust for a business purpose of the corporation or partnership – as where the transfer is made to secure a legal obligation of the business entity to a third party that is unrelated to the entity.[9] In that case, the corporation or partnership will be treated as the grantor of the trust, and will be taxable on the income and gain recognized by the trust.
Thus, it would behoove the corporate attorney to have at least a passing familiarity with the situations in which trusts may be utilized, and to understand the basic rules governing the income taxation of trusts, their grantors and their beneficiaries.
[1] Attorneys who advise S corporations are generally familiar with the workings of trusts as shareholders.
[2] By keeping the ownership interest out of the hands of family members, the owner-grantor may ensure continued family ownership of the business, provide a source of income for the family, and protect the trust property from the reach of the beneficiaries’ creditors and from the beneficiaries’ own spendthrift habits.
[3] For example, the recognition of a loss by some shareholders of an S corporation in the same year as their recognition of pass-through gain from the corporation’s sale of its assets.
[4] See Rev. Proc. 94-45 for the conditions set by the IRS for issuing advance rulings classifying certain trusts as liquidating trusts.
[5] More accurately, the grantors retained interests in the assets transferred to the Trust.
[6] A “grantor” includes any person that, directly or indirectly, makes a gratuitous transfer of property to a trust. A “gratuitous” transfer is any transfer other than one for fair market value.
[7] As distinguished from the earlier-mentioned bankruptcy code.
[8] IRC Sec. 671 – 679.
[9] Most corporate attorneys have probably heard of the so-called “rabbi trust” that is often used by employers to provide a mechanism by which employers may fund their obligations for deferred compensation owing to key employees. See Rev. Proc. 92-64.
