Nothing Ventured…?
Ask any tax practitioner, “Have you ever advised a client not to do something, only to discover later that they did it anyway?” Or, have you ever reminded a client of the old adage, “if something sounds too good to be true, it probably isn’t?” The likely responses would be “Oh yeah.”
How is that these clients, who are intelligent and successful people, when confronted with a large tax bill, are often willing to throw caution to the wind?
In part, it may be attributable to the fact that they are also risk-takers – after all, they did not grow successful businesses without taking some chances.
On the other hand, there is a difference between taking a calculated risk and a foolish gamble, especially where taxes are involved, as one group of taxpayers recently learned.
Large Tax Bill? No Worries
Brothers each owned 50% of Corp, which was taxable as a C corporation. Corp operated as a construction contractor. Corp entered into a construction contract for which it borrowed money (the “Project Loan”). Brothers guaranteed the loan.
A contract dispute arose, the contract was terminated, and Corp filed a claim for equitable adjustment. The claim was denied, and Corp appealed (the “Appeal”).
Corp won the Appeal and received a $40.8 million litigation award which represented contract damages and interest, all of which Corp received during its FYE March 31, 2003 (the “FY”).
Following receipt of the litigation award, Corp made estimated tax payments to State, and to the IRS.
In anticipation of Corp’s receipt of the litigation award, Brothers asked Big-4 CPA to find out what tax liability Corp and Brothers would incur, and whether there were any strategies that could help them shelter some of the income.
Brothers were eventually introduced to Buyer, a company which represented itself as specializing in “structuring transactions to solve specific corporate tax problems.”
Buyer was interested in purchasing Corp’s stock, but Brothers informed Buyer that they wanted to keep Corp’s land, its interest in Condo LLC, and Corp’s machinery and equipment – basically, Corp’s operating assets.
Buyer sent Brothers a letter of intent (the “LOI”) to purchase their Corp stock (the “Transaction”). At the time that Brothers received the LOI, Corp’s assets consisted of: (i) land, improvements, machinery, and equipment; (ii) an interest in Condo LLC; (iii) $34.5 million in cash; (iv) projected future litigation proceeds; and (vi) prepaid taxes. Corp’s liabilities consisted of: (i) the Project Loan; and (ii) income taxes due on the litigation award from the Appeal.
The LOI reflected that the purchase price for the Corp stock was to be calculated based upon the discounted value for Corp’s prepaid taxes, plus 100% of Corp’s cash at closing, plus a premium (based upon a percentage of Corp’s tax liability) over Corp’s net asset value. The letter reflected that a portion of the purchase price would consist of a promissory note “secured by tax refunds” that would be generated by losses to be realized by Corp after the closing.
The purchase price for the Corp stock was calculated at $24.2 million, an amount greater than Corp’s net asset value.
Buyer proposed to use Corp’s own cash to pay the purchase price for the Corp stock.
The Advisers Speak
Brothers engaged Big-4 and Law Firm to advise them in connection with the LOI.
Law Firm was concerned that Corp could be pulled into bankruptcy if Buyer used Corp’s cash to pay the purchase price to Brothers. Law Firm told Brothers that “there is the possibility that the proposed stock sale can be attacked as a fraudulent transaction.”
Law Firm also considered the risk of transferee liability and communicated to Brothers that if Buyer took steps to render Corp unable to pay its tax liability at the time of the redemption and the stock sale, “there could be a basis for the IRS to seek to impose transferee liability on the selling shareholders” with respect to the stock sale.
After conducting an analysis of the stock sale proposed by the LOI, Big-4 became concerned about Buyer’s plan to offset Corp’s income with its losses because it was similar to a “listed transaction.”
Big-4 spoke with Brothers about its concerns regarding the proposed stock sale, and the chances that the Transaction could be challenged by the IRS. It told them that the proposed stock sale was similar to a “listed transaction,” and tried to discourage Brothers from entering into the proposed stock sale.
Big-4 informed Brothers that it could not assist them in their negotiations with Buyer. Corp did not remain a client of Big-4, although Brothers did remain clients.
Did You Say Something?
Brothers decided to sell its Corp stock in the Transaction under the negotiated terms despite being advised of the risks of the Transaction by Law Firm and Big-4.
The redemption and stock sale were effected as integrated transactions. Under the redemption agreement, Corp redeemed 18% of its capital stock from Brothers in exchange for Corp’s noncash tangible assets, consisting of equipment, machinery, land, and Corp’s interest in Condo LLC. At the direction of Brothers, Corp conveyed these noncash tangible assets to LLC, which had been formed by Brothers to hold them.
Once these noncash assets were held by LLC, Corp’s only assets were $26.3 million of cash, and its estimated tax payments.
At Buyer’s direction, Corp deposited this cash with Bank (which had funded many of Buyer’s other acquisitions). Buyer borrowed funds from Bank, from which it paid to Brothers the purchase price for their remaining Corp stock. This loan was then repaid using the cash in Corp’s account at Bank.
Post-closing Activities
When Corp filed its corporate income tax return for FY, Corp claimed a bad debt deduction of almost $40 million to offset its taxable income from the litigation award on the Appeal. The loss deduction claimed by Corp was based upon Treasury bills that had purportedly been contributed to Corp by one of Buyer’s shareholders, who claimed that it had a very large tax basis in the Treasury bills.
Corp’s return reflected a refund due of $3.8 million.
Eventually, Corp was administratively dissolved pursuant to State law.
Brothers filed their respective tax returns. They reported the redemption and sale of their Corp stock and, on Big-4’s advice that the Transaction was similar to a listed transaction, Brothers included protective disclosures of the Transaction.
Notice of Deficiency to Corp
The IRS disallowed Corp’s claimed bad debt deduction because Corp could not support or substantiate its basis in the purported bad debt. The IRS issued a notice of deficiency to Corp and also determined a gross valuation misstatement penalty and, alternatively, a substantial understatement penalty.
When Corp did not petition the Tax Court (“TC”), the IRS assessed income tax of $15.5 million, accuracy-related penalties of $6.2 million, and interest of $9.6 million against Corp.
Collection of Corp’s liability was assigned to a field revenue officer, who conducted database searches for Corp’s assets, filed notices of Federal tax liens on Corp’s assets, and issued levies to banks where Corp maintained accounts.
Notices of Transferee Liability to Petitioners
After determining that Corp had no assets from which it could collect, the IRS sent a notice of liability to Brothers in which it was determined that they were liable as transferees for $14 million of Corp’s tax liability, plus interest.
The IRS also sent a notice of liability to LLC, in which it determined that LLC was liable as a transferee, and as a transferee of a transferee, for $6.8 million of the tax liability of Corp, plus interest.
Brothers and LLC petitioned the TC in response to the notices.
Transferee Liability Under the Code
The Code authorizes the assessment of transferee liability in the same manner and subject to the same provisions and limitations as in the case of the tax with respect to which the transferee liability was incurred.
It does not create or define a substantive liability but merely provides the IRS a remedy for enforcing and collecting from the transferee of property the transferor’s existing liability. Once the transferor’s own tax liability is established, the IRS may assess that liability against a transferee only if two requirements are met.
First, the transferee must be subject to liability under applicable State law. Second, under principles of federal tax law, that person must be a “transferee” within the meaning of the Code.
The IRS had the burden of proving that Brothers were liable as transferees. Brothers had the burden of proving that Corp was not liable for the tax and penalty.
Transferee Status/Liability Under State Law
Because the Transaction took place in State, the TC applied State law to determine whether Brothers and LLC were liable as transferees for the unpaid tax of Corp.
The IRS’s arguments were predicated on the assumption that the series of transfers among Corp and Buyer should be collapsed and treated as if Corp had sold its assets and then made liquidating distributions to Brothers. If the transfers were collapsed, then Corp would have transferred substantially all of its assets to Brothers and received less than reasonably equivalent value.
The TC reviewed the requirements for establishing transferee liability under State law. State law established that a transfer is fraudulent with respect to a creditor where: (1) the creditor’s claim arose before the transfer; (2) the transferor did not receive “a reasonably equivalent value in exchange for the transfer”; and (3) the transferor was insolvent at the time of the transfer or became insolvent as a result of the transfer.
“Long story short,” as they say, the TC found that Brothers and LLC were liable as transferees under State law. Corp received the litigation award that generated the federal tax liability prior to the transfer of Corp’s assets to Brothers. Before the Transaction closed, Brothers were warned of the risks of transferee liability and that the stock sale was similar to a listed transaction and was advised not to engage in the stock sale. They knew that the litigation award would be considered income to Corp and be subject to corporate income tax. This knowledge motivated them to enter into a transaction to mitigate this tax liability. Brothers received approximately $9 million in consideration in excess of the value of their Corp stock. Thus, Corp did not receive reasonably equivalent value in exchange for the proceeds from the sale of its assets.
Federal Transferee Liability
Under the Code, the term “transferee” includes a distributee, and shareholder of a dissolved corporation. Having found Brothers liable under State law, TC then determined that they were liable under Federal law.
The Transaction had no economic effects other than the creation of a loss for Corp. Brothers recognized the income tax liability from the litigation awards and entered into a series of transfers solely to evade their tax liability. For this reason and the reasons discussed above, the TC disregarded the form of the Transaction and found that Brothers and LLC were transferees within the meaning of the Code.
As the Transaction was collapsed and treated as a de facto liquidation to Brothers, the TC concluded that Corp was liable for the unpaid tax for its FY.
Accordingly, TC concluded that (1) Brothers and LLC were liable under State law for the full amount of Corp’s tax deficiency and penalty and (2) the IRS could collect this liability from them as “transferees” under the Code.
“I Told You So”
No client wants to hear that, especially after they’ve been hit with a large tax bill. (Gloat in private if you must.) At that point, the tax adviser is charged with damage control, though it may be too late for that, as in the case above.
How, then, does an adviser protect a client from itself? Ideally, the adviser will be consulted before the client begins discussions with the buyer or other interested party. (Too often, this is not the case.) Once a proposal is in play, a thorough analysis, including the presentation of calculations, risks, and alternatives, coupled with a frank discussion, are imperative. In the face of a recalcitrant client, the adviser may have to inform the client that it is withdrawing entirely from the deal, as Big-4 did above, though even that measure failed to convince the client of the very serious risks being assumed.
You can lead a horse to water, but you can’t shoot it.