Bad Times
Of course, you’ve noticed that we’re in the midst of an economic mess. The nearly complete shutdown of large segments of the U.S. economy beginning in March, in response to the COVID-19 crisis, both accelerated and greatly aggravated the recession toward which we were already heading after almost ten years of steady growth.
The sudden elimination of so much economic activity, for what has turned out to be a relatively prolonged period,[i] has left us with many struggling businesses, other businesses that will never reopen, staggering unemployment numbers, a record reduction in consumer spending, the prospect of increased taxes,[ii] a bipolar stock market, and a general sense of unease and uncertainty.[iii]
Sounds awful, right? However, these conditions have created an environment that may be ideal for attorneys who practice in the area euphemistically known as “creditors’ rights,” which encompasses matters of insolvency, bankruptcy and debt collection, among other things.
One of the tools that is often utilized by a creditors’ rights attorney to facilitate the orderly disposition of a debtor’s assets and the satisfaction of its liabilities – especially for the benefit of general, unsecured creditors – is the liquidating trust.[iv]
In order to qualify as a liquidating trust,[v] a trust must be organized for the primary purpose of liquidating and distributing the assets transferred to it, and its activities must be reasonably necessary to, and consistent with, the accomplishment of that limited purpose.[vi]
Assuming a liquidating trust is respected as such, it is important to understand how and to whom the income and gains of the trust will be taxed, as one taxpayer-debtor recently learned to their detriment when they unilaterally established a trust in order to obtain a tax benefit.[vii]
The “Not-So-Great” Recession
Just before the Great Recession,[viii] Taxpayer owned Corp, an S corporation[ix] in the business of buying land and developing it into finished lots, which it then sold in the ordinary course of its business.[x]
Corp. owned three parcels of real property: Prop A, Prop B, and Prop C (the “Properties”). It borrowed significant amounts from the Banks. These loans were secured by the Properties.
Taxpayer’s real estate business was hit hard by the Great Recession. Taxpayer took a variety of actions to stay afloat, including cutting staff and overhead, renegotiating prices with subcontractors, slowing down construction and, in some cases, contributing more of their own money back into the business.[xi]
Taxpayer also negotiated with, and sought accommodations from, their lenders. Taxpayer entered into two forbearance agreements[xii] with the Banks, and had discussions with them about Taxpayer’s attempts to keep the business afloat.
The Liquidating Trust Transactions
When the Properties became worth significantly less than the liabilities they secured, Taxpayer decided to pursue a “liquidating trust strategy” for these parcels, but without consulting the Banks.
Corp organized three “Project LLCs” – one for each Property – each of which was disregarded for Federal tax purposes, with Corp as their sole member,[xiii] and transferred each of the Properties to the corresponding Project LLC for a stated consideration of zero.
On the same day, Taxpayer established three trusts (together, the “Trusts”) – one for each newly created and funded Project LLC – with a related company as the sole trustee. Corp transferred its membership interest in each of Project LLCs to the corresponding Trust. Corp did not receive any consideration for these transfers.
The trust agreements specified that the Trusts were intended to qualify as liquidating trusts for tax purposes, identified the Banks as the beneficiaries of the Trusts – though the Banks were not parties to the trust agreements and were not yet aware of their existence[xiv] – provided that the Trusts had been established for the sole purpose of liquidating the Properties for the benefit of the Banks, and stated that the Trusts had no objective or authority to pursue any trade or business activity beyond what was necessary to accomplish that purpose.
The trust instruments further specified that, for Federal tax purposes, the parties would treat the foregoing transfers as a transfer by Corp of the Project LLC membership interests to the Banks, immediately followed by a transfer of such interests by the Banks to the Trusts in exchange for the beneficial interests in the Trusts.
The end result of these transactions was that the Properties were held by the Trusts.
Consistent with these transactions, Corp. did not retain the Properties as assets on its books. However, Corp remained liable to the Banks and reported the remaining unsatisfied loan balances as liabilities on its financial reports. What’s more, Taxpayer continued to manage and market the Properties, and when the Properties were eventually sold,[xv] the net proceeds were distributed to the Banks, which in turn credited the distributed amounts against Corp’s outstanding indebtedness.[xvi]
Tax Returns and IRS Examination
On its tax return,[xvii] Corp reported ordinary business losses, stemming from its transfers of the Properties to the Trusts, in amounts equal to the difference between Corp’s adjusted tax basis in each property and its estimate of the fair market value of such property as of the transfer date. These losses were also reported on the Schedule K-1 that Corp issued to Taxpayer, and were included by Taxpayer on their individual income tax return.[xviii]
Taxpayer claimed a non-passive loss on their tax return, part of which was attributable to Corp’s “sale” of the Properties. These losses, in turn, gave rise to a net operating loss (“NOL”), which Taxpayer carried back to prior years, as well as forward to future years.[xix] The NOLs resulted in significant refunds, which Taxpayer used to pay off debts on various loans owed by his companies.
The IRS examined the tax returns filed by Taxpayer and Corp, and determined that the losses reported by Corp (and claimed by Taxpayer as the S corporation’s shareholder) with respect to the trust transactions should be disallowed.[xx] This disallowance significantly reduced the amount of Taxpayer’s allowable NOL.
The IRS issued notices of deficiency, and Taxpayer filed a timely petition in the U.S. Tax Court seeking a redetermination of the asserted deficiencies.
Net Operating Losses
The Code[xxi] permits a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Such a loss “must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year”[xxii] in which it is claimed.
In most cases, a “closed and completed transaction” will occur upon a sale or other disposition of property.[xxiii]
Where the deductions allowed to a taxpayer for a given year exceed their gross income for that year, the taxpayer has an NOL.[xxiv] For the years at issue, the Code provided an NOL deduction for a given year equal to the aggregate of a taxpayer’s NOL carryovers and their NOL carrybacks to such year.[xxv]
Taxpayer asserted that Corp was entitled to a deduction because the transfers of the Properties to the Trusts for the benefit of the Banks were bona fide dispositions of property that generated actual losses.[xxvi]
Taxpayer’s argument hinged on the nature of the relationship between Corp and the respective liquidating trust, which implicated the Code’s “grantor trust” rules.[xxvii]
Characterization of the Trusts
In general, the Code provides that, where a grantor of a trust is treated as the owner of any portion of the trust, the grantor will include the trust’s items of income, gain, deduction, loss and credit in determining the grantor’s own income tax liability.[xxviii]
The grantor of a trust is treated as the owner of that trust[xxix] if certain conditions specified in the Code are met,[xxx] regardless of the existence of a bona fide nontax reason for creating the trust.[xxxi] These “grantor trust” provisions enunciate rules to be applied where, in described circumstances, a grantor has transferred property to a trust but has not parted with complete “dominion and control” over the property or over the income which it produces.[xxxii]
In the case of a liquidating trust, the most relevant of the grantor trust rules will consider a grantor the owner of any portion of the trust “whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party,[xxxiii] or both, may be” distributed to the grantor.[xxxiv] According to the applicable regulation, this generally encompasses the portion of the trust “whose income is, or . . . , may be applied in discharge of a legal obligation of the grantor.”[xxxv]
Court’s Analysis
According to the Court, because ownership under the grantor trust regime results in the attribution of income directly to the deemed owner (i.e., the grantor), “the Code, in effect, disregards the trust entity.” Consequently, if a grantor is deemed an owner, the trust “is not treated as a separate taxable entity for Federal income tax purposes to the extent of the grantor’s retained interest.” Stated differently, when the grantor trust provisions apply, they function to “look through” the trust form, and ignore the “owned” portion of the trust for tax purposes as existing separately from the grantor.
Under the specific facts of this case, the Court continued, the grantor trust rules compelled the conclusions that Corp was the owner of the Properties during the years at issue, and that the Trusts were not separate taxable entities from Corp during those years. These conclusions, the Court stated, precluded the tax treatment sought by Taxpayer as Corp’s shareholder.
Corp as Grantor
As an initial matter, the Court stated that Corp was the grantor of the Trusts by virtue of its direct gratuitous transfer of ownership of the Project LLCs (which in turn held the Properties) to the Trusts.[xxxvi] As explained above, the grantor of a trust is treated as an owner where trust income is “applied in discharge of a legal obligation of the grantor.” Income, in this regard, includes the trust corpus.[xxxvii]
As the Court observed, the parties agreed that Corp remained liable to the Banks for the loans secured by the Properties after the ownership of the Properties had passed to the Trusts. When the Properties were sold, the proceeds were distributed to the Banks, which credited the amounts against Corp’s outstanding loans secured by the Properties.
Because the corpus of each trust was used to satisfy Corp’s – i.e., the grantor’s – legal obligations, the Court concluded that Corp was the owner of the Trusts; therefore, the Trusts were not separate taxable entities as to Corp.[xxxviii]
Accordingly, the transfers from Corp to the Trusts did not accomplish bona fide dispositions of the Properties evidenced by closed and completed transactions as necessary to support the losses reported by Corp and passed on to Taxpayer.
Indeed, the transfer from Corp to the trust, of which Corp was treated as the owner under the grantor trust rules, was disregarded for income tax purposes.[xxxix]
The Banks as Grantors?
The Court rejected Taxpayer’s position that the application of the grantor trust rules in this case required that the Banks be considered the owners of the Trusts. Taxpayer argued that this result was required by the nature of a liquidating trust. Taxpayer also contended that the Banks were the owners of the Trusts by virtue of their status as trust beneficiaries.
Taxpayer argued that the Banks had no legal obligation to apply any income realized from the Properties to satisfy Corp’s debt. This point was “of no moment,” the Court replied, given that the trust corpus was, in fact, used to pay these obligations. Even assuming arguendo that the Banks had such discretion, the Court explained that the Trusts nonetheless would constitute grantor trusts because they were trusts “whose income . . . , in the discretion of . . . a nonadverse party . . . may be applied in discharge of a legal obligation of the grantor.”[xl] The trust documents required the distribution of all net trust income and all net proceeds from the sale of trust assets to the Banks. Although trust beneficiaries are ordinarily considered adverse parties, the Court added that a party “can hardly be considered adverse regarding distributions for . . . [its] benefit”.[xli]
Implied Transfers?
Taxpayer asserted that the creation of the liquidating trusts here implicitly involved two steps: (1) the transfer of property from Corp to the Banks, and (2) the transfer of property from the Banks to the Trusts, of which the Banks were the beneficiaries.
According to Taxpayer, the first step – an in-kind transfer of property by a debtor to their creditor – was tantamount to a sale and, so, Corp should be able to recognize a loss in an amount equal to the difference between Corp’s aggregate adjusted bases in the Properties and their fair market values.[xlii]
Taxpayer argued that, “[g]enerally, liquidating trusts are taxed as grantor trusts with the creditors treated as the grantors and deemed owners” under the theory that “the debtor transferred its assets to the creditors in exchange for relief from its indebtedness to them, and that the creditors then transferred those assets to the trust for purposes of liquidation.”
Indeed, although not discussed by Taxpayer or the Court, the IRS has indicated, as a condition to its issuance of an advance ruling classifying a trust as a liquidating trust, that a transfer by a debtor to the trust for the benefit of creditors must be treated for all purposes of the Code as a transfer to creditors to the extent that the creditors are beneficiaries of the trust.[xliii]
This transfer, the IRS has stated, will be treated as a deemed transfer by the debtor to the beneficiary-creditors, followed by a deemed transfer by the beneficiary-creditors (as grantors) to the trust. In addition, the trust agreement must provide that the beneficiaries of the trust will be treated as the grantors and deemed owners of the trust, and that the trustee must file returns for the trust as a grantor trust.[xliv]
The foregoing would seem to support Taxpayer’s claim in the present case.
However, the Banks were not aware of Corp’s creation of the liquidating trusts; they did not agree to relieve Corp from its indebtedness in exchange for the Properties that were transferred to the liquidating trusts; and they did not view the liquidating trust transactions as having any practical effect.
The Court explained that Taxpayer’s unilateral transactions in which they placed the Properties in the Trusts without any involvement from the beneficiary-Banks did not support the implicit two-step structure proposed by Taxpayer. Moreover, the Court found that neither the Code nor the regulations supported such an implicit two-step structure under the facts presented.[xlv]
According to the Court, the grantor trust rules dictated that Corp be treated as the owner of the Trusts. Corp’s transfers of the Properties to the Trusts, therefore, did not produce the losses claimed by Taxpayer. With that, the Court sustained the asserted deficiencies.
Know Your Trust
The liquidating trust and grantor trust rules can be difficult to navigate, even for a tax professional if they don’t delve into them regularly.
That being said, it will behoove the creditor’s rights attorney, as well as any other professional who expects to be involved in debt-collection or similar matters arising from the current economic crisis, to familiarize themselves with the basic guidance provided by the IRS regarding the structure and operation of a liquidating trust.
The most important item to remember is that, in order for a liquidating trust to be respected as a trust for purposes of the Code, it must be formed with the objective of liquidating particular assets; its activities must be reasonably necessary to, and consistent with, the accomplishment of that purpose; in general, it cannot have as its purpose the carrying on of a profit-making business[xlvi] which normally would be conducted through a business entity classified as a corporation or partnership; the liquidation of the trust should not be unreasonably prolonged; the trust should not be permitted to receive or retain cash or cash equivalents in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims); the investment powers of the trustee, other than those reasonably necessary to maintain the value of the assets and to further the liquidating purpose of the trust, should be limited to the power to invest in liquid investments; the trust must be required to distribute at least annually to the beneficiaries (the creditors) its net income plus all net proceeds from the sale of assets, except that the trust may retain an amount reasonably necessary to meet claims and contingent liabilities (including disputed claims).
Of course, creditor’s rights attorneys should always remember to call their friendly neighborhood tax-adviser.[xlvii]
[i] It doesn’t help that many parts of the country are experiencing a resurgence of COVID-19 cases just as social-distancing measures are being relaxed, and businesses are starting to re-open.
[ii] Even without the very real possibility of the Democrats taking the White House and both houses of Congress in November, we’d be looking at increased Federal taxes – how else will we be able to pay for the CARES Act, which includes the Paycheck Protection Program, and other measures implemented by the government to combat the coronavirus and the economic consequences arising from our efforts to contain it? We’re talking about almost $6 trillion of Federal spending over just a few months – spending that no one could have expected to be necessary. Then there are the States that have lost billions of dollars in tax revenues that will need to be recovered in some manner; increased rates, new taxes, and more aggressive enforcement are already on the table in many jurisdictions.
[iii] “The threat is nearly invisible in ordinary ways. It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” President Carter, July 1979.
[iv] Liquidating trusts are not limited to situations involving debtors. For example, they have been used where it may be difficult to complete the liquidation of a corporate subsidiary into its corporate parent within the statutorily-prescribed three-year period for a tax-free liquidation – for instance, because the subsidiary owns a difficult to sell asset, or has a litigation claim that cannot be resolved within that time frame.
[v] Reg. Sec. 301.7701-4(d). Liquidating trusts are recognized as “trusts” for Federal tax purposes.
Rev. Proc. 94-45 provides the conditions under which the IRS will consider issuing advance rulings classifying certain trusts as liquidating trusts under Reg. Sec. 301.7701- 4(d).
[vi] It cannot have as its purpose the carrying on of a profit-making business. If the liquidation is unreasonably prolonged, or if the liquidation purpose becomes so obscured by business activities, that the declared purpose of liquidation can be said to have been lost or abandoned, the status of the “entity” will no longer be that of a liquidating trust.
[vii] SAGE v. Comm’r, 154 T.C. No. 12 (June 2020).
[viii] Figure, the 2007-2009 period.
[ix] IRC Sec. 1361.
[x] IRC Sec. 1221(a)(1); Sec. 1231(b)(1)(B). Thus, any gain realized on a sale represented ordinary income.
[xi] Basically, what we are seeing many businesses do today – though PPP loans may have deferred the day of reckoning for some organizations – and what we have seen businesses do in the past during difficult times.
[xii] Basically, an agreement between a lender and a delinquent borrower by which the lender agrees not to exercise its right to foreclose and the borrower agrees to a new payment plan.
[xiii] Reg. Sec. 301.7701-3.
[xiv] Taxpayer subsequently informed the Banks that the Trusts had been established for the benefit of the Banks.
[xv] With respect to Prop C, one of the Banks eventually issued a demand letter, which led to negotiations with Taxpayer. These culminated in an agreement under which Taxpayer caused the transfer of Prop C to this Bank by deed in lieu of foreclosure in exchange for settlement of the debt.
[xvi] In other words, the transfer of the Properties to the Trusts did not satisfy Corp’s indebtedness to the Banks.
[xvii] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
[xviii] IRS Form 1040, U.S. Individual Income Tax Return, Sch. E, Part II. Pursuant to Section 1366 of the Code, Corp’s ordinary loss flowed through to Taxpayer, subject to the basis limitation rule of IRC Sec. 1366(d).
[xix] Immediately prior to the Tax Cuts and Jobs Act (P.L. 115-97), IRC Sec. 172(b)(1)(A) permitted a taxpayer to apply an NOL to other taxable years by first carrying back the NOL to the two taxable years preceding the year in which the NOL was generated and then by carrying over any unused portion of the NOL to the 20 years that follow.
In response to the events that triggered the Great Recession, for taxable years ending after December 31, 2007, and beginning before January 1, 2010, The Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92, amended IRC Sec. 172(b)(1)(H)(i) to permit a taxpayer to elect to carry back a net operating loss for the 2009 tax year to three, four, or five years instead of the usual two years. IRC Sec. 172(b)(1)(H).
Of course, the TCJA eliminated the carryback of NOLs and allowed their “indefinite” carryforward, though limited the amount of loss that be claimed in a taxable year.
Earlier this year, the CARES Act (P.L. 116-136) responded to the current economic crisis by temporarily reinstating and expanding the NOL carryback that had been eliminated by the TCJA. Specifically, the Act allows a business that realizes an NOL during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry its NOL back to each of the five taxable years preceding the year of the loss.
[xx] The IRS originally disallowed the losses because they were “attributable solely to nonbusiness expenses” of Corp. At trial and in its briefs, however, the IRS asserted a new theory for the disallowance of Corp’s loss: namely, that the trust transactions were not “closed and completed transactions” capable of producing realizable losses for that year. Because this basis for disallowance was not raised in the notices of deficiency, and represented a “new matter,” the IRS had the burden of proof with respect to the deficiencies. Tax Court Rule 142.
[xxi][xxi] IRC Sec. 165(a).
[xxii] Reg. Sec. 1.165-1(b). “Only a bona fide loss is allowable.” In determining the deductibility of a loss, “[s]ubstance and not mere form shall govern.” These requirements call for a practical test, rather than a legal one, and turn on the particular facts of each case.
[xxiii] The year for which a taxpayer can claim a loss deduction evidenced by a closed and completed transaction is a question of fact.
[xxiv] As defined by IRC Sec. 172(c).
[xxv] IRC Sec. 172(a).
[xxvi] Reg. Sec. 1.1001-2.
[xxvii] IRC Sec. 671 through 679.
[xxviii] “. . . there shall then be included in computing [the grantor’s] . . . taxable income and credits . . . those items of income, deductions, and credits . . . of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account . . . in computing taxable income or credits . . . of an individual.”
[xxix] Of its assets and income.
[xxx] IRC Sec. 673 through 679.
[xxxi] The term “grantor” includes any party that creates a trust or directly (or indirectly) makes a gratuitous transfer – that is, a transfer other than for fair market value – of property to the trust. Reg. Sec. 1.671-2(e)(1) and (2)(i). A partnership or a corporation making a gratuitous transfer to a trust for a business purpose of that partnership or corporation will also be a grantor of the trust. Reg. Sec. 1.671-2(e)(4).
[xxxii] Although several of the grantor trust rules are framed in terms of trust “income”, the regulations issued thereunder clarify that “it is ordinarily immaterial whether the income involved constitutes income or corpus for trust accounting purposes” in light of the general objectives of the grantor trust rules. Reg. Sec. 1.671-2(b).
[xxxiii] An “adverse party” is any person who has “a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.” IRC Sec. 672(a). The term “nonadverse party” refers to any person that is not an “adverse party”. IRC Sec. 672(b). Adversity is a question of fact determined in each case by reference to the particular interest created by the trust instrument.
[xxxiv] IRC Sec. 677(a).
[xxxv] Reg. Sec. 1.677(a)-1(d).
[xxxvi] Reg. Sec. 1.671-2(e)(1).
[xxxvii] Reg. Sec. 1.671-2(b).
[xxxviii] Reg. Sec. 1.677(a)-1(d).
[xxxix] Rev. Rul. 85-13.
[xl] Reg. Sec. 1.677(a)-1(d).
[xli] Reg. Sec. 1.672(a)-1(b).
[xlii] Reg. Sec. 1.1001-2.
[xliii] Rev. Proc. 94-45, Section 3.
[xliv] Reg. Sec. 1.671-4(a).
[xlv] The Court added: “And we see nothing . . . to suggest that liquidating trusts qua liquidating trusts should be treated differently under the grantor trust rules absent the involvement of the beneficiaries.”
[xlvi] Any such activities must be reasonably necessary to, and consistent with, the liquidating purpose of the trust.
[xlvii] OK, so we’re not super heroes. We’re not even semi-heroes. We don’t wear leotards – count your blessings – or carry hammers or shields, or turn into monsters when agitated (not most of us, anyway). But “who ya gonna call” when faced with a grantor trust issue?