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What Is a Liquidating Trust?

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When "Liquidating Trust" is mentioned, most people associate this with bankruptcy. In a bankruptcy, a liquidating trust may be formed whereby certain assets are placed in a trust for the benefit of creditors who may have certain claims against those assets.

A liquidating trust may also be an effective method for a fund manager to wind down a fund without having a significant role in the liquidation. At the end of the fund's life cycle or term, the fund manager may have certain assets that are not easily liquidated and convertible into cash for distribution to the owners of the fund. It may take several years for such assets to be converted into cash. Such assets may consist of securities that are illiquid or have certain restrictions or monies held in escrow where it will take several years for the conditions to be met for release of such funds. The objective of a liquidating trust is to help expedite the liquidation of the entity, and allow the owners to recognize gain or loss and to receive proceeds in an orderly manner.

In addition, it may be prudent for the fund manager to set aside certain cash reserves before making final distributions to the fund owners. This reserve could be held in the trust for any contingent liabilities as they become due.

A liquidating trust is a new legal entity that becomes successor to the liquidating fund. The remaining assets and liabilities are transferred into the newly formed trust and the former owners of the liquidating fund become unit holders or beneficiaries of the trust. The newly formed trust is governed by a trust agreement executed between the former fund and the trustees before liquidation of the fund. Such agreement provides for trustee duties, compensation of trustees, and governance as well as distributions and other administrative matters.

The liquidating trust normally has a lower cost structure than the existing fund and is managed on an "as needed" basis by the trustee as opposed to a full-time basis for the fund. The trustee takes control of the newly formed liquidating trust.

The role of the trustee of the liquidating trust is to administer and manage the liquidating trust, sell assets, pay creditors, resolve any claims and distribute any available funds to the beneficiaries of the trust. Over the last decade, a number of firms have been established to provide trustee services in addition to trust departments of banks.

Tax implications of a liquidating trust

A liquidating trust is generally considered a grantor trust for tax purposes. The trust will be considered a liquidating trust with the primary purpose of liquidating its assets. Should the purpose of the entity change, such as to carry on a for-profit business, then the entity will no longer be considered a liquidating trust. Also, if the time period is unreasonably prolonged, the status of the entity may change from a liquidating trust.

If a trust is created outside of Chapter 11 of the Bankruptcy Code, a private letter ruling may be requested if conditions of Revenue Procedure 82-58 are met.

Under Revenue Procedure 82-58, the IRS will issue a private letter ruling if 8 conditions are met. Such conditions include, among other things, that the primary purpose of the trust is liquidation of the assets with no objective of carrying on a trade or business and the trust agreement should contain a fixed or determinable termination date. That term generally should not exceed 3 years.

A "business trust" should be considered instead of a liquidating trust if the purpose of the trust is to carry on a trade or business. A business trust is either treated as a corporation or partnership for federal income tax purposes.

Tax treatment of a liquidating distribution from a corporation

Since the business assets are deemed to have been distributed to the owners and then transferred to the liquidating trust, there will be an immediate recognition of a gain or loss from liquidation of the former business by the owners. Each owner must recognize a gain or loss on the deemed distribution received in liquidation. Such gain or loss is measured by the difference between the fair value of the liquidating distribution and the owner's adjusted basis in the corporation. The fair value of the contribution to the liquidating trust would represent the new owner's basis in the liquidating trust.

Tax treatment of a liquidating distribution from a partnership

Similarly, in the case of a liquidating distribution from a partnership, the business assets are deemed to have been distributed to the partners and transferred to the liquidating trust. Generally, a partner recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. A partner does not recognize loss on a partnership distribution unless (1) the adjusted basis of the partner's interest in the partnership exceeds the distribution, (2) the partner's entire interest in the partnership is liquidated and (3) the distribution is in money, unrealized receivables or inventory items. However, a partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property during the 7-year period before the distribution. A partnership generally does not recognize gain or loss because of distributions it makes to partners.

The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership, reduced by any money distributed in the same transaction. Thus, the partner's basis in the property can never be greater than the partner's basis in the partnership.

Upon the deemed contribution of the assets to the liquidating trust, the trust will have the same adjusted bases in its assets as the partners had in those assets immediately prior to the transfer to the trust.

Conclusion

As noted, the use of a liquidating trust may be a cost efficient method to liquidate certain assets. However, as with new legal entities, fund managers should consult with tax advisors before embarking on a liquidating trust to make sure that this type of entity makes sense for the situation.


Asset Management Intelligence - Q1 2016

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Garth Puchert, Audit Partner of EisnerAmper's Financial Services Group, is primarily devoted to private equity funds, registered investment companies, investment advisors, mutual funds, hedge funds and broker-dealers in securities.

Richard Shapiro, Tax Director and member of EisnerAmper’s Financial Services and Corporate Tax Groups, has more than 40 years’ experience in federal income taxation, including the taxation of financial instruments and transactions, both domestic and international, corporate taxation and mergers and acquisitions.