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A Liquidating Trustee's Principal Tools for Resolving Tax Issues in Bankruptcies

By Patrick M. Cox and Robert J. Stark

As part of making distributions to allowed claimants of a bankrupt entity, a liquidating trustee must decide the best way to handle potential outstanding tax liabilities. Generally, this decision requires the trustee to decide between two available options; namely:

  1. Make one or more “final” distributions to allowed claimants to wind-down the estate and leave the estate (and the trustee) open to tax liability should the Internal Revenue Service (“IRS”) successfully challenge any of the tax positions taken by the estate and/or the trustee during the time period of the applicable statute of limitations, which could be three years, six years or, in the case of fraud, never (the “Statute of Limitations”); or
  2. Explain to allowed claimholders that distributions will be net of all potential tax liabilities for the duration of the Statute of Limitations.

No prudent trustee would assume any risk relating to alternative (a) above, as once the estate's assets are irretrievably disbursed, the IRS could hold the trustee personally liable. Fortunately, the Bankruptcy Code, in the form of ' 505, equips trustees with effective tools to resolve tax issues and avoid this dilemma.

It is also important to note that ' 505 is available to reorganized debtors, however the stakes are not as high for reorganized debtors as there is generally no trustee left “holding the bag,” but rather the ongoing business would satisfy any final determination of tax owed and concomitantly the returns to the allowed claimholders would rise and fall with the value of the reorganized equity interest. The exception may be the reorganized debtor that liquidates within a few years after the effective date of the bankruptcy. In this generally rare exception, the application of the rules herein apply with similar importance.

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