liquidating trust taxation

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Liquidating trust taxation

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Additionally, exculpation and release provisions provide further liability protection to the liquidating trustee. Liquidating trusts created under bankruptcy plans often vest their trustees with authority to prosecute avoidance and related actions against the creditors and third parties. Trustees may initiate these actions against parties with little to no connection to the United States raising unsettled questions over jurisdiction.

See, e. As the volume of crossborder Chapter 11 cases continues to increase, liquidating trustees prosecuting estate causes of action may face more personal jurisdiction challenges. It also represents parties in other insolvency proceedings, including receiverships, assignments for the benefit of creditors, dissolution proceedings under state law and rehabilitations and liquidations of insurance companies.

The Bankruptcy Group works regularly with clients through all phases of the reorganization or liquidation of troubled businesses, including out-of-court workouts and distressed asset acquisitions. For questions concerning insolvency law, including US bankruptcy law and insurance company insolvency law, please contact Ashley Stitzer at or AStitzer bayardlaw. A liquidating trust can also be a useful tool outside of bankruptcy. Business organizations that are dissolving may wish to use a liquidating trust in order to delegate the administration of the winding up process.

While the managers of a business may be well-suited for the tasks of running a going concern, their talents may not be optimal for the winding down process, which consists of marshaling and selling assets, making distributions to and communicating with creditors and estimating reserves. These tasks may not justify the salaries being paid to the management team, which may wish to move on to new challenges.

These considerations may tip the scales in favor of setting up a liquidation vehicle and bringing in an administrator experienced with winding down operations. The dissolution procedures for a business organization vary, depending on the type of entity and the jurisdiction in which it is formed. For an entity with a complicated asset portfolio, it may make sense to transfer all assets, rights, and causes in action to a liquidating trust that can liquidate assets and investments over time, avoiding market dips and other timing concerns.

Moreover, to the extent that entities like partnerships and limited liability companies are not permitted to engage in business once they are dissolved, the liquidating trust may be authorized to operate or hold certain assets to take advantage of economic factors but subject to tax considerations. Other timing considerations may be presented by contingent, unliquidated or unmatured claims. As reflected on the below chart, Delaware corporations, partnerships and limited liability companies must make reasonable reserve for all pending litigation, and for claims and obligations that have not yet accrued but, based upon facts known to management, are likely to accrue within ten years following the dissolution.

The terms of a liquidating trust may permit the trustee s to invest the proceeds of liquidation of assets typically in short-term assets and await the outcome of litigation or the occurrence or lapse of conditions affecting the magnitude or likelihood of claims, subject to the requirement of Treas. Moreover, by entrusting the liquidation process to a liquidating trust charged with establishing appropriate reserves, management can take comfort that they have discharged their duties. Arguably, by using a Delaware statutory trust or an equivalent vehicle for a liquidating trust, the exculpation and indemnification provisions applicable to the trustees can be used to protect them from liability.

The DST Act does not require that a DST be organized for profit, and contains a variety of features that are advantageous in dealing with the many competing considerations in a liquidating trust. To the extent that the persons winding up the debtor or other liquidating entity may have claims to pursue or defend, a DST is a separate legal entity.

The DST Act permits a trustee to take direction from other parties, whether beneficiaries, advisors, a grantor or other interested or independent parties. The DST Act also empowers a trustee to delegate some or nearly all of its powers without rendering the delegee liable as a trustee. Of critical importance are the provisions of the DST Act permitting drafters of a trust governing instrument to restrict, modify or eliminate fiduciary duties of trustees and other persons managing a DST, subject to the implied contractual covenant of good faith and fair dealing.

The annual maintenance costs for a DST are fairly nominal — the trust pays no annual maintenance fee to the Delaware Secretary of State. In addition to the fees payable to the liquidating agent, or liquidating trustee, if the liquidating trustee is not an individual Delaware resident, or a Delaware banking institution or trust company or federally chartered bank or trust company with its principal place of business in Delaware, the trust will need to engage a trustee meeting that description.

Fortunately, there are individuals and institutions in Delaware that make a business of providing Delaware statutory trustee services for a fairly nominal fee a few thousand dollars a year who will undertake the limited role of qualifying the trust as a DST. Of course, many local banking institutions will also provide the more substantive services, for a higher fee. Additional factors to consider include tax and securities implications.

As noted above, most liquidation trusts are structured as grantor trusts for tax purposes, and the IRS has established standards pursuant to Treas. If the trust term will be longer than a few years, it may be prudent to seek an IRS determination letter that the trust will qualify for grantor trust tax treatment. For these and other reasons, it is important to secure experienced professionals to assist with the formation of a liquidation trust.

Each of these entity types presents different considerations as to establishment, operation, management, liability, scope of authority and dissolution. For questions regarding Delaware entity law, please contact Marla Norton at or MNorton bayardlaw. For your convenience we are providing an excerpt of a chart we have prepared which provides an overview the different features of each entity type, highlighting the default rules relating to liquidation and winding up of each.

In other words, the money or property invested in the trust is the contributed capital, so any distributions from contributed capital are simply distributions of the original investment, and, therefore, not taxable. Generally, taxes on taxable income must be paid either by the trust or by the beneficiaries, but not both.

If the trust retains income beyond year-end, then the trust must pay taxes on it. However, if the income is distributed, then the beneficiaries pay taxes on it and the trust is permitted to deduct it. If the trust accounting income consists of both tax-free and taxable income, then the tax-free and taxable portions of the income distributed must be allocated to each beneficiary.

The trust can deduct the taxable portion of the distributions but not the tax-free portion nor any expenses that must be allocated to the tax-free portion of income. To calculate this allocation, an intermediate result must first be calculated, called the distributable net income.

The distributable net income DNI sets a ceiling both on the trust distribution deduction and on the amount taxable to the trust beneficiaries. The DNI is used to calculate the trust taxable income, calculate the beneficiaries taxable income, and to characterize distributions to beneficiaries, such as between taxable and tax-free distributions.

The personal exemption is added back to taxable income because, while it is a deduction, it is not an actual expense, and thus, it is available for distribution. Tax-exempt interest is added because it is not includible in taxable income, but it is available for distribution to the beneficiaries.

Since the tax-exempt interest is distributed, the expenses allocable to the interest are also subtracted. Capital gains that are allocated to trust principal are subtracted from taxable income because the gains are not distributed to the beneficiaries. For the same reason, capital losses allocated to trust principal are added back, because the losses decrease taxable income, but do not decrease the income available for distribution to the beneficiaries.

Income Tax Return for Estates and Trusts to each beneficiary, listing the beneficiary's share of income and deductions. Only taxable income is listed; tax-exempt income is omitted. The purpose of DNI is to determine what part of a distribution to beneficiaries is taxable to the beneficiary and deductible by the trust. This is achieved by multiplying each type of income, such as rent or dividends, by the total amount distributed divided by the DNI. Capital gains or losses are generally allocated to corpus unless they are distributed to the beneficiaries.

Capital gains and losses are netted out at the trust level. However, beneficiaries cannot deduct any net losses on their return except when the trust is terminated, in which case any unused capital loss carryovers can be used to offset income to the beneficiaries. The distribution deduction cannot exceed the taxable distribution, since taxes must be paid on taxable income either by the trust or by the beneficiaries.

For a complex trust, the distribution deduction can be determined by the following formula:. Example: the WCS Trust is required to distribute all income to its sole beneficiary. All capital gains and losses and expenses are allocable to the trust corpus. Income and expenses for the year are listed in the Totals column in the table below.

Trust accounting income, trust taxable income, DNI, and the distribution deduction are also calculated in the table below, based on the income and expenses in the Totals column:. Note that in calculating DNI, the personal exemption is added back because it is a statutory deduction, which is not a real expense, so it is available for distribution. Trusts and estates are subject to most of the same tax rules that apply to individuals. They even have the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels.

On the other hand, it makes sense to distribute income to the beneficiaries, since their tax brackets will be at much higher income levels, resulting in lower taxes. Trusts may also be subject to the alternative minimum tax , but this is usually easy to avoid. Tax changes enacted in included a top tax bracket for trusts of Hence, the total tax on undistributed capital gains in the top bracket will be However, the following types of trusts are not subject to the NIIT:.

The trust is only permitted to deduct distributions that are taxable to the beneficiaries. Therefore, the total amount taxable to all trust beneficiaries cannot be less than the distribution deduction claimed by the trust. Total distributions to beneficiaries will exceed the distribution deduction if a portion of the distribution consists of tax-exempt income, income on which the trust has already paid tax on, principal, which is not subject to taxation, or if there were deductible expenses that were allocated to corpus, and deducted to arrive at the tentative taxable income before the deduction of the distribution deduction.

Multiple beneficiaries are taxed proportionately on their share of taxable amounts distributed. Naturally, the taxation of complex trusts is more complex. The distributions are divided into what are called first-tier distributions and second-tier distributions. First-tier distributions are required distributions from trust income, which is stipulated in the trust document; the remaining distributions are second-tier distributions. If all distributions are within either the first- or second-tier, then the taxation of beneficiaries is calculated as it is for simple trusts.

However, if there is more than one level of distributions, then the taxability of beneficiary income depends on the following rules:. If portions of taxable income differ in character, such as some being capital gains and some being ordinary income, then the character is assigned proportionately to the taxable distribution amounts using the same order as for first-tier and second-tier distributions. A separate share rule may also apply if the trust is administered as separate shares according to the trust document.

In this case, DNI is determined as if the shares are treated as separate estates or trusts in computing DNI allocable to the beneficiaries. The separate share rule generally applies to 1 trust; it does not apply to multiple trusts created by a single trust instrument. However, the separate share rule does not increase the number of deductions available to the trust nor does it increase the number of personal exemptions nor can the income be split so that it is taxed at lower rates.

Trust property distributions are based on the adjusted tax basis of the property rather than its fair market value FMV when it is distributed. However, the trustee can elect to recognize gains or losses on the distribution of appreciated property if the trust has other losses or gains that can be offset by the election.

If so, then the contribution to the distribution deduction will be equal to the property's FMV on the distribution date and the beneficiary's tax basis will be equal to the FMV and the beneficiary's holding period will begin on the distribution date.

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Are Trust Distributions Taxable?

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