Creditors' Liquidating Trusts
Alan D. Lasko1

Once the business activities of a chapter 11 bankruptcy estate have wound down, a confirmed plan can establish a creditors’ trust to facilitate the liquidation of the bankruptcy estate. The assets and liabilities of the estate are transferred to the trust for the benefit of the estate’s creditors. As previously mentioned, the trust will facilitate the liquidation of the estate’s assets and distribute the assets, net of claims and expenses, to the beneficiaries of the trust, i.e., the creditors.

If certain requirements are met, a creditors’ trust will be treated as a grantor trust for U.S. income tax purposes. A grantor trust is not taxable for federal income tax purposes, but passes its income or loss through to its beneficiaries, the grantor.

In the case of a bankruptcy creditors’ trust, who is the grantor? Although there are other possibilities, the creditors are commonly treated as the grantors. This results from two deemed transfers that create a fiction for tax purposes. The formation of the trust is treated as if the bankruptcy assets and liabilities are transferred directly to the creditors, who then are deemed to contribute the assets and liabilities to the creditors’ trust. Each of the creditors would recognize their share of each item of income, expense, gain or loss recognized by the trust during its existence or during their participation as a beneficiary.

However, there are dangers inherent in poor planning and poor drafting of a trust agreement. In Holywell Corp. v Smith, 503 US 47, 112 S.Ct. 1021, 117 L.Ed. 196 (1992), the Supreme Court determined the tax treatment of a creditors’ trust. In that case, the trust was not treated as a grantor trust, and the trust was taxed on its income. The Court noted that the trust was the ultimate assignee of the debtor’s assets. To the contrary, see, for example in In re Sonner, 53 BR 859 (Bankr. E.D. Va. 1985), in which the creditors’ trust was found to be a grantor trust.

Subsequently, in Rev. Proc. 94-45, the Internal Revenue Service (IRS) provided some certainty for the taxation of creditors’ trusts by establishing a policy for issuing rulings on such trusts. Although this procedure is only controlling with regard to taxpayers requesting a ruling, the Revenue Procedure provides insight into the proper structuring of a creditors’ trust from the IRS point of view. Trusts formed under the principles of this Revenue Procedure differ from the Hollywell trust because of the deemed transfer to the creditors, which causes the creditors to become the grantors of the trust on the deemed transfer by them to the trust.

The deemed transfer of assets from the estate to the creditors is treated as a transfer to the creditors for all federal income tax purposes, including, for example, debt forgiveness, determination of gain or loss, and original issue discount.

In Rev. Proc. 94-45, the IRS indicated, among other things, that, to be treated as a grantor trust for income tax purposes, the trust must be created by a confirmed plan of bankruptcy under chapter 11; the plan must indicate how the bankruptcy estate will treat the transfer of its assets to the trust; and the plan or separate trust agreement must indicate that the creditors will be treated as the grantors. Further, the trust must be required to distribute its income at least annually. However, the trust is allowed to retain income reasonably necessary to meet claims or contingent liabilities. The procedure also contains a checklist to assist debtors/taxpayers in structuring the trust or requesting a ruling.

In addition to Rev. Proc. 94-45 and IRS Regulation 1.671-4(a), there is a letter ruling dated March 5, 2002 (Letter Ruling 200228003), which provides that this trust will be taxed as a “grantor trust” for federal income tax purposes. Last, IRS Regulation 1.671-4(a) also reflects that the trustee of the trust must file income tax returns on an annual basis.

It is also intended by the IRS that a creditors’ trust be temporary, existing only until the assets are liquidated. The regulations indicate that the entity will lose its status as a liquidating trust if the trust unreasonably prolongs its existence or if its business activities are too extensive. Rev. Proc. 94-45 provides that the trust must have a fixed or determinable termination date that is not more than five years after the date the trust was created.

With the aid of Rev. Proc. 94-45 and the subsequent Revenue Regulation and Letter Ruling, a chapter 11 bankruptcy estate can utilize a creditors’ trust as an efficient mechanism to liquidate and distribute the net assets of a debtor to its creditors.

Companies may want to administer the trust on behalf of the trustee of the creditors’ trust. This results in a debtor post-confirmation absorbing the time and cost of determining the allocations to the beneficiaries (creditors), preparing the annual accounting for the trust along with the trust tax returns as well as acting as the disbursing agent for the trust. Companies coming out of chapter 11 and trustees of these trusts may want to consider outsourcing any one or all of these functions to firms that are familiar with the applicable rules and requirements for these types of trusts in order to save on time and costs to the post-confirmation debtor.

Alan D. Lasko & Associates, P.C.
Certified Public Accountants
29 South LaSalle Street, Suite 1240
Chicago, Illinois 60603
Email: alasko@adlassoc.com
Website: www.adlassoc.com
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