III. TAX CONSIDERATIONS

When drafting the liquidating trust, one of the most important factors to consider is whether it will meet Internal Revenue Service requirements for treatment as a grantor trust. The goal is to avoid double taxation at both the trust and beneficiary levels thereby enabling more money to reach the general unsecured creditors, who are the trust beneficiaries.

Certain organizations known as liquidating trusts are treated as trusts under the Internal Revenue Code if (a) the liquidating trust is organized for the primary purpose of liquidating and distributing the assets transferred to it and (b) its activities must all be reasonably necessary to, and consistent with, the accomplishment of that purpose. See Treas. Reg. § 301.7701-4(d).

A. Safe-Harbor Conditions

Revenue Procedure 94-45 provides the conditions under which the Internal Revenue Service will consider issuing advance rulings classifying entities created under bankruptcy plans as liquidating trusts under Treas. Reg. § 301.7701-4(d). These safe-harbor conditions generally help ensure the treatment of the trust as a liquidating trust for federal income purposes:

1. A liquidating trust is or will be created pursuant to a confirmed chapter 11 plan under the Bankruptcy Code for the primary purpose, as stated in its governing instrument, of liquidating assets transferred to it with no objective to continue or engage in the conduct of a trade or business, except to the extent reasonably necessary to, and consistent with, the liquidating purpose of the trust.
2. The plan and disclosure statement must explain how the bankruptcy estate will treat the transfer of its assets to the liquidating trust for federal income tax purposes. Revenue Procedure 94-45 provides that a transfer to a liquidating trust for the benefit of creditors must be treated for all purposes of the Internal Revenue Code as a transfer to the creditors to the extent that the creditors are beneficiaries of the trust. The transfer will be treated as a deemed transfer to the beneficiary-creditors followed by a deemed transfer by the beneficiary-creditors to the trust. Accordingly, the transfer of property to the liquidating trust will be treated as a deemed transfer from the debtor to the beneficiary-creditors followed by a deemed transfer by the beneficiary-creditors to the liquidating trust. The ruling request must explain whether the debtor or the bankruptcy estate will incur any tax liability from the transfer, and if so, how that liability will be paid.