Two of our recent posts considered the IRS’s recent successes in applying the transferee liability rule to collect the federal income tax liability owing by the corporation from the sale of its assets from a corporation’s shareholders. In both cases, the shareholders had employed sham transactions in an attempt to avoid the corporate tax liability.
This week, we review yet another situation in which shareholders sold their shares in a C corporation with a large unpaid federal income tax liability. In furtherance of collecting the unpaid liability from the shareholders as transferees of the corporation’s property, the IRS sought to recharacterize the stock sale as a liquidating distribution in which the shareholders received cash in redemption of their shares.
The “selling” shareholders included Corp’s officers and directors. Corp sold its assets and realized substantial gain. After the sale, it did not engage in any business activity. Its only asset was the cash from the asset sale.
During Corp’s negotiations for the asset sale, it was contacted by Investor (sound familiar?), which described itself as a company interested in purchasing the stock of C corporations that have sold their assets and that, as a result, have realized a significant taxable gain. Investor represented that it would purchase the Corp shares from the shareholders and would pay them more than the shareholders would receive if they were to dissolve Corp and receive the proceeds of the sale in redemption of their shares.
Investor proposed to acquire all of Corp’s outstanding shares for a price “equal to the cash in [Corp] as of the [closing date] reduced by [a percentage] of [Corp’s] combined state and federal corporate income tax liability for its current tax year . . .” Investor also agreed “that it shall cause [Corp] to pay [its deferred tax liability] to the extent that [it] is due given [Corp’s] post-closing business activities and shall file all federal and state income tax returns on a timely basis related thereto.”
The shareholders sold their Corp shares to Investor. At closing, they caused Corp to transfer all of its cash to a trust account maintained by Investor’s lawyer. Investor then immediately provided funds to its lawyer’s trust account for the entire purchase price. Upon receipt of the cash from Corp into the trust account, Investor’s lawyer directed the purchase price to the trust account for the shareholders’ lawyer, who then distributed the “purchase price” to the shareholders.
After the receipt of the cash from Corp, Investor’s lawyer caused that amount to be transferred to another account in the name of Corp. On the next day, this amount was transferred from Corp’s account to another account at the same bank entitled “[Investor] Credit Corp. Accounts Payable.” Corp recorded the transfer on its books as a receivable due from its new shareholder (Investor). Corp’s year-end balance sheet showed the amount owing, but no promissory note was prepared.
Corp reported taxable income on its tax return for the year of the asset sale, and showed a tax due, but it made no payment with the return. It reported a loan due from Investor on its balance sheet, and no other assets or liabilities.
On its return for the immediately following year, Corp reported a bad debt deduction resulting from the “worthlessness” of its loan to Investor. The bad debt deduction produced a net operating loss that Corp carried back to, and deducted for, the year of asset sale, offsetting the gain from the sale.
The IRS and the Tax Court Agree
IRS disallowed the bad debt deduction and the loss carried back, and determined a deficiency in Corp’s federal income tax for the year of the asset sale.
After unsuccessfully attempting to collect the unpaid tax from Corp, IRS sent notices to the former Corp shareholders stating that, as transferees of Corp’s property, they were liable for its unpaid income tax for the year of the asset sale. IRS explained that it was recasting the transaction by which shareholders disposed of their shares in Corp as a liquidating distribution of all of Corp’s cash to its shareholders in redemption of its outstanding shares. The Tax Court agreed.
State Law and Transferee Status
The Court noted that the Code does not independently impose tax liability upon a transferee, but provides a procedure through which the IRS may collect unpaid taxes owed by the transferor of property from a transferee if an independent basis exists under applicable State law, or State equity principles, for holding the transferee liable for the transferor’s debts. Thus, State law determines the elements of liability, and the Code provides the remedy or procedure to be employed by the IRS to enforce that liability.
According to the Court, the IRS bears the burden of proving that the transferee is liable as a transferee of property of the taxpayer. A transferee’s liability for Federal taxes of the transferor of property, it said, includes any additions to tax, penalties, and interest that have been assessed with respect to the tax. Moreover, transferee liability is several, and the IRS is free to proceed against one or more of any number of potential transferees.
The question of whether a person or an entity is a “transferee” for purposes of the Code, the Court said, is separate from the question of whether the transfer was fraudulent for State law purposes; first, the IRS must establish that the target is a transferee within the meaning of the Code; second, it must establish the transferee’s liability under State law.
In reviewing the facts in light of the relevant State law, the Court found that Corp did not receive reasonably equivalent value on account of the transfer. It also agreed with the IRS that Corp became insolvent upon its transfer of all its cash (its only asset) to the trust account of Investor’s lawyer: “As its liabilities exceeded its assets (which were then zero) [Corp] was rendered insolvent immediately before petitioners purportedly sold their shares.”
The Court noted that Corp was not a going concern at the time of the stock transfer. It would, therefore, have been unreasonable at that time to believe that Corp could, from its business operations, satisfy its tax debt when that debt came due.
Consequently, the Court found that the transfer of Corp’s cash was fraudulent with respect to the IRS, within the meaning of State law, and that the IRS could recover a judgment under State law equal to the lesser of the value of the asset transferred or the amount necessary to satisfy its claim.
Having determined that the IRS was entitled to a judgment against the shareholders to satisfy a portion of its claim against Corp for its unpaid tax, the Court then determined that the shareholders were transferees within the meaning of the Code. The Court held: “[T]he [IRS] may proceed . . . against any ’transferee’ who is liable under state law for the debts of the transferor/taxpayer.”
The Court noted the expansive reading that has been given the term “transferee” under the Code. A person can be a transferee if he is an indirect transferee of property, a constructive recipient of property, or if he merely benefits in a substantial way from a transfer of property. The determinative factor is liability to the IRS for the tax debt of another (the transferor) under a State fraudulent conveyance or similar law.
Thus, the Court held, the shareholders were collectively liable to the IRS as Corp’s transferees within the meaning of the Code.
There appears to be no limit to the variety of schemes in which taxpayers are willing to participate in order to avoid taxes that are properly owed. These schemes, however, do share some very important traits of which the taxpayers and their advisors must be aware: they involve multiple and complex steps, and their promised results are almost unbelievable. As the court in last week’s blog put it: “This should have called to mind the warning that ‘if something seems too good to be true, then it probably is.’ But alas, it did not.”