What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax A Solid Overview of Liquidating Trusts During the liquidation of a business, impediments may develop that extend the time it takes to liquidate a business entity. A liquidating trust can be used to accelerate the termination of the operating entity and facilitate distributions to its beneficiaries. This article describes the operating rules of a liquidating trust and identifies the conditions necessary to qualify as a liquidating trust as well as a Chapter 11 liquidating trust. When Is a Liquidating Trust Needed? Monday, September 24, 2012 by Paul Kugler, Rich Manfreda, and Norlyn Miller, Jr., Washington National Tax Paul Kugler is a director in the WNT Passthroughs group and a former IRS Associate Chief Counsel (Passthroughs and Special Industries). Rich Manfreda is a senior manager in the WNT Passthroughs group and a former IRS Deputy Associate Chief Counsel (Passthroughs and Special Industries). Norlyn Miller, Jr., is a director in the WNT Practice, Procedure, and Administration group and was a senior technical reviewer in the IRS Office of Assistant Chief Counsel (Income Tax and Accounting). A property s value may be difficult to determine or there may be a contingent liability that will delay the liquidation of a business. When this occurs, a liquidating trust may be created to hold assets of the business that may be difficult to value and additional assets to cover any contingent liabilities as they mature. This will allow the complete dissolution of the business entity, because the liquidating trust assets are deemed to have been distributed to the trust s equity owners, and then transferred to the liquidating trust. The objective of creating this liquidating trust is to expedite the liquidation of the entity, thereby allowing the equity owners to recognize any gain or loss resulting from the liquidation, and to receive the proceeds from the termination of the business in an organized fashion. Liquidating Trust Liquidating trusts are considered grantor trusts for federal income tax purposes. A trust will be considered a liquidating trust if it is organized for the primary purpose of liquidating its assets. It cannot be an organization having as its purpose the carrying on of a profit making business that normally is conducted through a corporation or a partnership. The trustee s principal purpose is to protect and preserve the trust property for the beneficiaries. 1 If the liquidation is unreasonably prolonged, or if the liquidating purpose becomes so obscured by business activities that the declared purpose of liquidation can be said to be lost or abandoned, the status of the organization will no longer be that of a liquidating trust. 1 See section (d). KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

2 A Solid Overview of Liquidating Trusts page 2 Business Trust There are other trust arrangements that are created for the purpose of carrying on a trade or business. These trusts are referred to as business trusts because they are not simply arrangements to protect and conserve the property for the beneficiaries, but are instead created to continue the business operation. Business trusts are treated as either corporations or partnerships for federal income tax purposes. 2 The governing document of a liquidating trust must include a statement that the trust is organized primarily for the purpose of liquidating the assets transferred to it, with no objective to continue or engage in the conduct of a trade or business. This functional provision distinguishes a liquidating trust from a business trust. Obtaining a Liquidating Trust Classification Private Letter Ruling In the case of a trust created outside of Chapter 11 of the Bankruptcy Code, a private letter ruling request may be filed seeking a liquidating trust classification for the trust, if the conditions of Revenue Procedure are met. 3 The criteria described in the revenue procedure are useful guidelines, whether or not a private letter ruling is actually requested. Conditions Needed to Obtain a Private Letter Ruling Generally, under Revenue Procedure 82-58, the IRS will issue a private letter ruling for a trust, created outside Chapter 11 of the Bankruptcy Code, to be classified as a liquidating trust. The revenue procedure lists eight conditions that must be met for the ruling:.01 The trust is organized for the primary purpose of liquidating the assets transferred to it with no objective to continue or engage in the conduct of a trade or business and its governing instrument so provides..02 The trust instrument contains a fixed or determinable termination date that is generally not more than three years from 2 3 See section (d), P.L.R C.B Also see Revenue Procedure 91-15, C.B. 484, which provides the checklist to be used.

3 A Solid Overview of Liquidating Trusts page 3 the date of creation of the trust and that is reasonable based on all the facts and circumstances. If the trust contains installment obligations, such as those described in section 453(h) of the Code, that are payable over a period that ends more than three years after the date of creation of the trust, the trust term, with respect to those obligations only, may extend for a period that is reasonably necessary to collect and distribute installments on the obligations In the case of a trust created incident to a corporate liquidation, (1) the trustee is selected by the shareholders of record or a court of competent jurisdiction, and (2) if the trust is to hold assets for unlocated shareholders, due notice has been given to such shareholders in accordance with local law 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..05 The trust does not receive transfers of any listed stocks or securities, any readily-marketable assets or any operating assets of a going business. The trust does not receive or retain cash in excess of a reasonable amount to meet claims and contingent liabilities..06 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. Unless otherwise indicated, references to section or sections in this article are to the Internal Revenue Code of 1986 (the Code ), as most recently amended, or to the U.S. Treasury Department regulations, as most recently adopted or amended..07 The trust is required to distribute at least annually to known shareholders any proceeds from the sale of assets or income from investments. The trust may retain a reasonable amount of proceeds or income to meet claims and contingent liabilities..08 The ruling request contains representations that the trustee will make continuing efforts to dispose of the trust assets, make timely distributions, and not unduly prolong the duration of the trust.

4 A Solid Overview of Liquidating Trusts page 4 The use of a liquidating trust is an efficient way to terminate a business when there may be difficulty in determining the value of property in the business or the business has contingent liabilities. Because the business assets are deemed to have been distributed to the equity owners and then transferred to the liquidating trust, there will be immediate recognition of a gain or loss from the liquidation of the former business entity by its owners. At the same time, the trust will retain assets (1) for the benefit of creditors to be used to satisfy business liabilities, (2) to facilitate the sale of hard to divide business assets, and (3) to enable early and proper distributions to the equity owners. Entities Created Pursuant to Bankruptcy Plans under Chapter 11 of the Bankruptcy Code When an entity (debtor) files for bankruptcy under Chapter 11 of the Bankruptcy Code, a trustee is appointed to handle the bankruptcy. The goal is to reorganize the debtor s business assets and return the debtor to normal operation in a better financial position. In certain situations, such as one in which a portion of the business operation is to be terminated or sold, a liquidating trust may be created. Generally by creating this trust, the debtor is treated as having transferred the assets to the creditors, and the creditors then as transferring the assets to the liquidating trust, with the creditors being treated as the grantors and beneficiaries of the liquidating trust. The beneficiaries must report each item of income, gain, deduction, loss, and credit of the liquidating trust. The deemed transfer of the assets to the creditors is likely treated as a satisfaction of the debtor s obligation to those creditors for the fair market value of the assets transferred. The debtor may recognize cancellation of debt income as a result, as well as gain or loss from the deemed sale or exchange of the property transferred. Under certain circumstances, the trustee of the liquidating trust may establish an escrow account or fund to hold assets that are subject to disputed claims and elect to treat this account or fund as a disputed ownership fund. See section 1.468B-9(c)(2(ii). If this election is made, the assets in the disputed ownership fund are not treated as transferred to the creditors and the trustee must prepare a separate income tax return for the fund.

5 A Solid Overview of Liquidating Trusts page 5 Obtaining a Liquidating Trust Classification Private Letter Ruling The IRS in Revenue Procedure provides the procedures for requesting a private letter ruling classifying an entity, created pursuant to bankruptcy plans under Chapter 11 of the Bankruptcy Code, as a liquidating trust, if certain conditions are met. The revenue procedure cautions that it is not to be viewed as defining as a matter of law the circumstances under which an organization will be classified as a liquidating trust. This determination is made only after an examination of all the facts in connection with the operation and activities of the trust. In certain situations, the taxpayer may be required to enter into a Closing Agreement as a condition to the issuance of the letter ruling. Conditions Needed to Obtain a Ruling Generally, the IRS will issue a private letter ruling that a trust, created pursuant to a bankruptcy plan under Chapter 11 of the Bankruptcy Code, is a liquidating trust if the following conditions, listed in Revenue Procedure 94-45, are met:.01 the trust is or will be created pursuant to a confirmed plan under Chapter 11 of the Bankruptcy Code for the primary purpose... of liquidating the assets transferred to it with no objective to continue or engage in the conduct of a trade or business The plan and disclosure statement must explain how the bankruptcy estate will treat the transfer of its assets to the trust for federal income tax purposes The plan, disclosure statement, and any separate trust instrument must provide that the beneficiaries of the trust will be treated as the grantors and deemed owners of the trust The plan, disclosure statement, and any separate trust instrument must provide for consistent valuations of the transferred property by the trustee and the creditors (or equity interest holders), and those valuations must be used for all federal income tax purposes C.B This revenue procedure contains similar requirements to those in Revenue Procedure 82-58

6 A Solid Overview of Liquidating Trusts page 6.05 Whether or not a reserve is established for disputed claims, all of the trust s income must be treated as subject to tax on a current basis, and the ruling request must explain, in accordance with the plan, how the trust s taxable income will be allocated, and who will be responsible for payment of any tax due..06 The trust instrument must contain a fixed or determinable termination date that is generally not more than 5 years from the date of creation of the trust and that is reasonable based on all the facts and circumstances If the trust is to hold any operating assets of a going business, a partnership interest in a partnership that holds operating assets, or 50% or more of the stock of a corporation with operating assets, the ruling request must explain why it is necessary to retain these assets..08 If the trust is to receive transfers of listed stocks or securities or other readily marketable assets, the ruling request must explain the necessity for doing so. The trust is not permitted to receive or retain cash or cash equivalents 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..09 The investment powers of the trustee, other than those reasonably necessary to maintain the value of the assets and to further the liquidating purpose of the trust, must be limited to powers to invest in demand and time deposits, such as short-term certificates of deposit, in banks or other savings institutions, or other temporary, liquid investments, such as Treasury bills..10 The trust must be required to distribute at least annually to the beneficiaries its net income plus all net proceeds from the sale of assets, except that the trust may retain an amount of net proceeds or net income reasonably necessary to maintain the value of its assets or to meet claims and contingent liabilities (including disputed claims)..11 The ruling request must contain representations that the trustee will make continuing efforts to dispose of the trust assets,

7 A Solid Overview of Liquidating Trusts page 7 make timely distributions, and not unduly prolong the duration of the trust..12 A trust that is a designated settlement fund under 468B(d) of the Code or a qualified settlement fund under 1.468B-1 of the regulations is governed by 468B and the regulations thereunder, rather than by this revenue procedure. 5 The revenue procedure also provides a checklist in Appendix A to be used in assisting taxpayers requesting classification of an entity as a liquidating trust. As noted above, the trust instrument is required to contain a fixed termination date that is generally not more than five years from the date of creation of the trust. However, in Private Letter Ruling , the trust was allowed to have a term of up to 11 years. According to the facts of this letter ruling, the original term of the trust was five years, the bankruptcy court subsequently extended the term of the trust by three years, and a later request was made for an additional three-year extension of the trust s term. The ruling held that an extension of the trust s term to the extended date would not adversely affect the determination that the trust is a liquidating trust under section (d). 6 It should be noted that the requirement of a fixed termination date of not more than five years from the date of creation of the trust in this revenue procedure differs from the requirement of Revenue Procedure 82-58, which requires a fixed termination date of not more than three years from the date of creation of the trust. Generally, a liquidating trust will be created in a Chapter 11 Bankruptcy proceeding when the parties have agreed that some of the business operation needs to be disposed of and the remaining portion of the operation will exit bankruptcy in a better financial position. It is not clear whether the IRS would grant an extension of the three-year term under Revenue Procedure See section 3 of Rev. Proc See also P.L.R The facts of this private letter ruling indicated that the Bankruptcy Court extended the term of the liquidating trust. The ruling held that an extension of the trust s term to the extended date will not adversely affect the determination that the trust is a liquidating trust under section (d).

8 A Solid Overview of Liquidating Trusts page 8 Conclusion As noted above, the use of a liquidating trust may be an efficient way to either terminate a business or, in the case of a Chapter 11 bankruptcy, dispose of a portion of the business or some of the business assets. In both situations, the liquidating trust is treated as a grantor trust and either the entity s owners or creditors are the beneficiaries. Additionally, the principal purpose in both situations is to protect and preserve the trust s property for the beneficiaries during the winding-up period. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.