Bankruptcy Trust Given More Time to Liquidate Due to Litigation

Litigation Delays Won't Kill Tax Status of Bankruptcy Trust

A bankruptcy liquidating trust can extend its lifespan beyond the standard period if ongoing litigation prevents asset liquidation. In a new private letter ruling (PLR), the IRS ruled that a trust will retain its status as a liquidating trust, and thus be treated as a grantor trust, despite requesting another term extension to 'Date 10'. This classification allows the trust to avoid being taxed as a corporation, with the corresponding tax liabilities passed directly to the beneficiaries.

The Never-Ending Liquidation: Facts of the Case

Debtors filed for Chapter 11 bankruptcy on Date 1. The bankruptcy court approved the debtor's plan of reorganization on Date 2, with an effective date of Date 3. As part of that plan, a trust was established on Date 3 to liquidate assets, with an initial term scheduled to end on Date 4. However, unresolved litigation prevented the trust from completing its liquidation. Consequently, the bankruptcy court approved multiple extensions, pushing the termination date to Date 5, then Date 6, Date 7, Date 8, and finally Date 9.

Because the litigation remained unresolved as Date 9 approached, the trustee planned to request another extension from the bankruptcy court, moving the termination date to Date 10. Further extensions will be sought as needed until all legal claims are resolved and subsequent distributions are completed under the plan.

The trust was created under Section 301.7701-4(d) of the Treasury Regulations for the sole purpose of liquidating assets, converting them to cash, and distributing them to beneficiaries, with no intention of conducting a trade or business. The trust agreement requires the trustee to distribute net income and proceeds from asset sales at least annually, except for amounts reasonably necessary to maintain the value of the trust's assets or to meet claims or contingent liabilities. The trust can only hold cash necessary to make distributions, satisfy liabilities, and maintain reserves as contemplated by the plan. Cash not immediately needed is held in short-term, liquid assets like certificates of deposit or Treasury bills.

The trust agreement also stipulates that the beneficiaries will be treated as grantors and deemed owners of the trust under Sections 671 through 679, which define the tax treatment of "grantor trusts." This means the beneficiaries, not the trust itself, are responsible for paying taxes on the trust's income. The agreement further specifies that all parties will consistently value assets transferred to the trust for all federal income tax purposes. The trustee represents that since its creation, the trust has operated in accordance with Revenue Procedure 94-45, which provides a safe harbor for liquidating trusts established under Chapter 11 bankruptcy plans. The trustee also affirms ongoing efforts to dispose of assets and make timely distributions, while acknowledging that pending adversary proceedings have prevented complete liquidation by Date 9.

The Rules of the Road: Liquidating Trusts vs. Businesses

The trustee in this case represents that the trust has operated in accordance with Revenue Procedure 94-45, which provides a safe harbor for liquidating trusts established under Chapter 11 bankruptcy plans. Section 301.7701-4(d) defines a liquidating trust as an organization formed primarily to liquidate and distribute transferred assets. Critically, its activities must be reasonably necessary for, and consistent with, that liquidation purpose. The regulation clarifies that a liquidating trust cannot operate as a profit-making business that would normally be conducted through a corporation or partnership. Should the liquidation be "unreasonably prolonged" or the liquidation purpose become obscured by business activities, the entity risks losing its status as a liquidating trust.

Revenue Procedure 94-45 offers a path to secure an advance ruling from the IRS, classifying certain trusts as liquidating trusts under § 301.7701-4(d). Specifically, for entities created under a Chapter 11 bankruptcy plan, the IRS will issue a ruling if certain conditions are met. Section 3.06 of Rev. Proc. 94-45 mandates that the trust instrument include a fixed or determinable termination date, generally no more than five years from the trust's creation. This termination date must be reasonable, considering all facts and circumstances. The procedure does allow for extensions, provided the bankruptcy court with jurisdiction approves, finding the extension necessary for the trust's liquidating purpose. The court's approval must be obtained within six months of the extended term's commencement.

The Verdict and Implications for Insolvency

The IRS ruled that extending the trust's term to Date 10 would not jeopardize its classification as a liquidating trust under Treasury Regulation Section 301.7701-4(d). This regulation defines a liquidating trust as an entity established primarily to liquidate and distribute assets, not to conduct an ongoing business. Consequently, the trust will continue to be treated as a grantor trust, and its beneficiaries will be considered the owners of the trust assets under Section 671. Section 671 dictates that when a grantor or another person is treated as the owner of a trust, the income, deductions, and credits are taxed directly to that person, not to the trust itself. The IRS explicitly stated that this ruling applies solely to the taxpayer who requested it and cannot be cited as precedent, as stipulated by Section 6110(k)(3).

Implications for Insolvency: This ruling offers important guidance for bankruptcy trustees and tax practitioners. The IRS acknowledges that protracted litigation can justify extending a liquidating trust's term well beyond the standard five-year period outlined in Revenue Procedure 94-45. Rev. Proc. 94-45 provides a safe harbor for trusts created pursuant to a Chapter 11 bankruptcy plan. To maintain its status, the trust must generally have a fixed termination date not exceeding five years, although extensions can be granted by the bankruptcy court. The key takeaway is that the IRS will likely approve such extensions if the trust demonstrably continues to focus on liquidating assets and avoids engaging in active business operations. This provides flexibility for trusts dealing with complex asset dispositions or legal challenges common in bankruptcy proceedings.