Last week’s posts described a situation in which the IRS was able to collect a deficiency in corporate income tax from a minority shareholder of the taxpayer-corporation on the basis of transferee liability under state law. Recently, another decision addressed the question of transferee liability, this time in the instance of a dissolved corporation’s unpaid federal taxes.

The Sale

The “transferees”  were the former shareholders of a closely held “C” corporation (“Corp”) that had been owned and operated by the same family for many years. The latest generation, however, had no interest in continuing to run the business, and the shareholders – all descendants of its founder – were approaching, or had already reached, retirement age. They decided it was time to sell.

Selling the business raised a number of concerns. In particular, the shareholders anticipated that Corp would incur significant tax liability. Corp’s assets had been purchased long ago, and their bases had been depreciated, so an asset sale would give rise to a large taxable gain.

The shareholders attempted to negotiate a stock sale of Corp to Buyer, but Buyer rejected it out of hand and insisted on an asset sale.

The shareholders eventually accepted Buyer’s terms and the transaction closed, netting a substantial amount of cash, resulting in a large taxable gain, and generating significant corporate income tax liabilities.

After the asset sale, Corp ceased carrying on any active business. It was basically  an “empty shell” holding only the sale proceeds.

Have I Got A Bridge for You

However, while the asset sale was still pending, Corp’s shareholders were approached by Shelter, who specialized in structured transactions designed to avoid or minimize tax liabilities.no tax

Through an intricate tax-avoidance transaction, Shelter offered to purchase the stock of C corporations like Corp that had recently experienced a taxable asset sale, promising to pay more for the shares than they were worth in a liquidation. Then, using bad debts and losses purchased from credit-card companies, Shelter would offset the unpaid tax liabilities of the  acquired corporation by way of a net-operating-loss carryback. Billed as a “no-cost liquidation,” Shelter proposed this strategy to Corp’s shareholders as an attractive tax-avoidance alternative to liquidating the corporation.

Corp’s board of directors opted to pursue the tax-avoidance strategy, and its shareholders ultimately approved it.

The closing involved a number of steps in quick succession, at the end of which the shareholders held the proceeds from Corp’s asset sale.

Corp, however, never paid federal taxes on the gain from the asset sale. Its federal tax return for the year of the sale to Buyer showed a tax due based on the gain from the asset sale, but no amount was paid with this filing. Corp’s tax return for the following year claimed a net operating loss that was then carried back to the sale year, reducing Corp’s federal tax liability to zero.

Not So Fast

The IRS issued a notice of deficiency to Corp for the year of the asset sale. The IRS had determined that the net operating loss was based on sham transaction and was part of an illegal distressed asset/debt tax shelter. Corp never responded.

The IRS then sent notices to the former shareholders, seeking to hold them responsible for Corp’s unpaid taxes and penalties as transferees of the defunct corporation under federal and state law of fraudulent transfer and corporate dissolution.  The amount of the proposed individual assessments varied according to each shareholder’s ownership interest.

The shareholders petitioned the Tax Court seeking to overturn the IRS’s determination. The Tax Court sided with the IRS and found the shareholders liable for the unpaid taxes and penalties. The Court of Appeals affirmed  At trial before the Tax Court, the shareholders stipulated that the tax shelter was illegal, but contested transferee liability.

The Court Speaks

The Court held that the “stock sale” transaction with Shelter was in substance a liquidation with no purpose other than tax avoidance, making the shareholders transferees of Corp under State law governing fraudulent transfers and corporate dissolutions.

The Court noted that the Code authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts.  However, the Code provides only a procedural device for proceeding against a taxpayer’s transferee. Substantive liability is governed by state law. Accordingly, the Court explained, transferee-liability cases proceed in two steps.

  1. The IRS must establish that the target is a “transferee” of the taxpayer.
  2. The IRS must establish that the transferee is liable for the transferor’s debts under some provision of state law.

Transferee-Shareholders?

The term “transferee” in the Code is defined broadly to include any “donee, heir, legatee, devisee, and distributee.” The Court found that the stock sale was structured to avoid the tax consequences of Corp’s asset sale, which the shareholders would have had to absorb had they pursued a standard liquidation.

Formally, the shareholders sold their Corp stock to Shelter, but the Court looked past these formalities to the substance of the transaction – using a “substance over form” and “economic substance” analysis – to recast it as a liquidation. In other words, the court found that Shelter did not actually pay the shareholders for their stock; instead, each shareholder received a pro rata distribution of Corp’s cash on hand— the proceeds of the asset sale—making them “transferees.”

The Court noted that from the beginning Shelter had characterized the transaction as a “no-cost liquidation.” The Corp, it said, had no active business at the time of the transaction. To the contrary, it was a shell corporation, and the transactions were “a mere accounting device, devoid of substance,” that were “all about creating tax avoidance” and thus lacked any valid nontax business purpose. Looking past the form of the transaction to its substance, the Court found that the stock sale was in reality a liquidation, and that the funds received by the shareholders came not from Shelter but from Corp’s sale proceeds.

Liability Under State Law

Establishing transferee status under the Code, the Court said, was only the first step in the analysis. The next step required an independent determination of transferee substantive liability under State law. Here, the Court found the shareholders liable under two constructive-fraud provisions of State law.

A transferee, the Court said, is liable to a creditor whose claim arose before the transfer if the debtor made the transfer “without receiving a reasonably equivalent value” and “the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.”

The Court found the shareholders liable for Corp’s tax debt. The asset sale—the triggering event for the tax liability—occurred before the transfer of Corp’s cash to the shareholders, and the cash from the asset sale was transferred to the shareholders “without receiving a reasonably equivalent value.” Indeed, Corp received nothing. The Court also found that the transaction left Corp insolvent, a requirement for liability under State’s law. Finally, the tax court found that the shareholders knew or should have known that Corp’s federal tax liability could not and would not be paid. What was left in Corp’s bank account after the transaction was insufficient to cover the tax liability. And the entire transaction was premised on the assumption that Shelter would offset the tax liability by a net-operating loss carryback; in other words, the transaction was premised on the assumption that the taxes would not be paid. Accordingly, the Court concluded that the shareholders were liable for Corp’s tax debt under State law, and that this conclusion was sufficient to sustain transferee liability under the Code.

Too Good to be True

What were Corp’s shareholders thinking? Even on a visceral level, one would be hard-pressed to argue that the shareholders of a corporation can strip the corporation of its assets through a liquidation, and then avoid responsibility for the corporation’s outstanding liabilities. The very complexity of the transaction with Shelter supported the finding that its sole purpose was tax-avoidance.

It is a fact of business life that there will be times when taxes simply cannot be avoided. They may be reduced or deferred, perhaps, but not avoided. The goal is to manage the tax exposure and to plan for it as best and as early as possible. Subchapter S election, anyone?