January 2007

It comes as no surprise that small business Chapter 11 bankruptcies are difficult in many respects. Managing administrative costs related to the proceeding itself is one of those challenges. Accordingly, being prudent in course and both expedient and efficient in administration are paramount. In the case of winding down a Chapter 11 in the context of a Plan of Liquidation, our practice has generally seen two prevailing courses. One provides for the transfer of assets and interests into a Trust for the purposes of liquidating and administrating assets ultimately for the benefit and distribution to creditors. The other simply allows the existing debtor entity to serve the same purpose as the Trust otherwise would. From personal experience, it seems as if bankruptcy lawyers are increasingly resorting to the establishment of a Trust. Perhaps a brief exploration of both scenarios will offer some reasons for the transition to using Trusts, or at minimum, offer some characteristics to be aware of so as not to incur unnecessary expense to the estate.

Prior Practice: Under “prior practice,” we frequently saw the common fact pattern:

• Sale of company pursuant to §363 of the Bankruptcy Code or a Plan;
• The combination of sale proceeds and other assets (collectively, the “Assets”) provided an adequate amount for a distribution to creditors pursuant to a Plan;
• A party would ultimately marshal the Assets for creditors and be responsible for making such distribution; and
• That party may be the debtor (though heavily influenced by the debtor’s financial advisors and counsel), the debtor’s financial advisory firm, or an individual representative of the financial advisory firm newly appointed to be the “disbursing agent” or “liquidating agent” or other similar title (and being the “Agent”). In such circumstances, it appeared to make little difference as to whether the debtor company was a regular C-corporation or elected S-corporation status. Once the Plan of Liquidation was confirmed, the Agent had the duty to collect and liquidate remaining assets and account for such amounts, allocating the funds to each creditor’s interests based upon the priorities afforded under the law and the Plan, and amongst similar classes, based upon the allowed claim in pro-rata fashion. IRC §601 (b) establishes that the Agent has the duty to prepare and file tax returns and IRC §1398(c) requires the Agent to pay the tax3. Irrespective of corporate formation, the Agent would fulfill its duties to creditors ensuring that they would receive their final distribution. However, before making distributions, the Agent would consider whether a “reserve” was required in order to both pay for the administrative expense of preparing final tax returns (typically a reserve was required) and in paying any tax obligation arising from such return. Note: the tax liability became a pre-distribution deduction or reduction of assets available for distribution to creditors. The completion of the return was typically in conformance with prior tax returns, providing, of course, for bankruptcy specific events and expenses. Upon completion and after final distribution, a final tax return was filed and the Agent’s duties generally completed. This form was relatively simple in that:
• The Plan of Liquidation did not require incorporation of and reference to a Trust Agreement;
• There was no requirement to request new EINs for another entity (the Trust);
• There was no requirement for a Trustee to open new bank accounts, set-up appropriate books and records and for the Trustee to obtain counsel, which is most common;
• Only a “final” return was required to be prepared and filed for the debtor company ;
• There was no requirement to effectively calculate the debtor’s gain (loss) on sale of assets at the time of the creation of the Trust;
• There was no requirement to obtain the tax identification or social security numbers of all creditors prior to distribution and as a condition of being able to file the tax return.

However, amongst perhaps others, there were two primary set-backs:

• If the debtor corporation was likely going to incur significant tax liabilities, and provided it did not have adequate (cash) assets to pay such liabilities, it put the debtor and the Agent in a precarious situation (though options were available like conversion to Chapter 7 or dismissal, for instance); and
• If the debtor corporation was an S-corporation, parties often contested whom had the obligation to pay the expense of preparing the returns since the ultimate obligation to pay fell to the shareholder(s). And, if the corporation had net taxable income, the income is taxed at the level of the shareholder(s). This raised uncomfortable conversations for the Agent and shareholder(s) as the shareholder(s) often challenged why they should pay a tax after they [often] have lost their business and all control of it. Conversely, if the corporation had losses which passed to the shareholders, and consequently, the shareholder(s) were entitled to refunds, the Agent, creditors and shareholder(s) often bantered over whom was entitled to the refund dollars. No course of action is without its consequences, and generally, each of the above could be worked through either based on the economics or through negotiation

• The use of the Liquidation Trust, which is more common in practice today, is done with similar fact patterns and both with S-Corporation and regular corporation debtors. And, while the necessity for reserving assets for preparing the Trust return remains, it is no longer necessary to holdback monies for payment of tax liabilities. Note: the tax liability becomes an obligation of the creditor recipient of the distribution. A Liquidating Trust under a Plan of Liquidation at a minimum requires the following:
• Reference and incorporation of the Trust and Trust Agreement in the Plan of Liquidation;
• Assurance that the Trust Agreement is drafted so as to ensure that it is not challenged by the IRS with respect to its purpose which might cause the Trust (or recipients) to incur significantly higher taxes than it (they) otherwise would6,7;
• The designation of a Trustee;
• That the Trustee obtain a new tax identification number specifically for the trust;
• That the Trustee set-up a new set of accounting records to account for the financial transactions of the Trust;
• Frequently, the engagement of counsel for the Trustee;
• The filing of a final return for the corporate debtor in which such return includes the deemed sale of assets to the Trust;
• The preparation of a new Trust return where the opening assets are the assets from the debtor’s last return;
• Assurance that the new Trust return is filed timely based on new filing deadlines associated with trust returns;
• Obtaining all creditor recipient tax identification numbers which shall be included with the Trust tax return in the Form K-1; and
• Regular distributions from the Trust.

Some of the noted consequences of selecting the Trust as the means to effectuate the marshalling and distribution of assets to creditors are:

• The tax identification numbers of the creditors can frequently be very numerous and difficult to obtain;
• To qualify as a Liquidating Trust, the Trust must make distributions at least annually, which is often difficult or administratively expensive, burdensome and impractical given the status of the case (and inability to get recipient EINs), assets in the Trust, uncertainty about future assets to be collected for the Trust and associated expenses in administering the Trust; and
• The Trustee may have a learning curve in acquiring knowledge about the assets and status of claims that the Trust may have against other parties which the debtor and its professionals already obtained throughout the case. So, what is the best course of action you might ask? As with all situations, it depends on the facts of the matter at hand. However, there are a few elements which may cause you to consider one direction over the other.

If the following hold true and unless there are prohibitive reasons, you may want to first consider the older way, not establishing a Trust:

• A significant number of creditor distribution recipients;
• There exists significant uncertainty about the ultimate amount of cash which will be available to creditors and the timing for its distribution to creditors;
• Prior tax returns have been filed and the debtor’s records are adequate to allow for the preparation of subsequent returns;
• The debtor (and its management) are trustworthy and competent so as to allow the debtor, with oversight from the unsecured creditors’ committee, to serve as the Agent and to fulfill the remaining obligations and requirements;
• It is unlikely that there will be consequences to the shareholders in a pass through entity (Scorporation) which cannot be readily resolved; or
• There are many complex issues which would require a newly appointed Trustee to become familiar with in order to fulfill his or her responsibilities and in which doing so would cause the estate significant financial hardship.
  

And, if these elements apply, you may want to consider a Trust:

• A reasonably manageable number of creditors from whom EINs must be obtained;
• Distrust of management in properly handling the remainder of the estate’s responsibilities and its assets;
• Potential causes of action against former management or owners;
• Lack of remaining management whom has the authority to act for the benefit of the debtor (perhaps all become employed by the acquiring company);
• Shareholder issues arising as the result of the corporate entity being a pass through entity;
• Certainty of the timing and ability of future distributions;
• The appointed Trustee has a good understanding of the facts of the case because they were involved or representing parties of interest earlier in the proceeding; or
• Uncertainty about whether the estate will have the ability to actually fund the tax liability if one is anticipated.

As in most cases, a good dose of common sense and prior experience will lead you far down the right path. Avoid the temptation to simply follow what was done in other circumstances because you have familiarity with that experience. And, in all cases, encourage dialogue with the crafter of the Plan of Liquidation to ensure an understanding of the facts and anticipate outcomes, seeking competent legal and tax consultation where it is warranted. Your thoughtful analysis and decision may not always result in a right or wrong action because you may have either option at your disposal, but your election should always avoid unnecessary administrative expense to the estate.

- Kevin Hamernik

317-684-1550

kjhamernik@hamernik.com