The Corporate “Shield”

Ask any shareholder of a closely held corporation whether they may be held liable for the tax obligations of the corporation, and they will likely respond “of course not, that’s why we established the corporation – to benefit from the limited liability protection it provides.”

Some of these shareholders will be surprised when you explain that they may be personally liable for the employment taxes and sales taxes that the corporation was required, but failed, to collect and remit to various taxing authorities – even where the “corporate veil” has not been pierced – if the shareholders were “responsible persons” or “under a duty to act” as to such taxes.

However, the scenario by which a shareholder is most likely to be taken aback is the one in which they are held liable for the corporation’s own income taxes, notwithstanding that they may not be a controlling owner, or even a responsible officer, of the corporation.

The U.S. Court of Appeals for the Ninth Circuit recently ruled on a case in which the IRS sought to collect a corporation’s (“Corp”) income tax from its former shareholders (“Taxpayers”).

Let’s Make a Deal

Corp was taxable as a C-corporation. It sold its assets to Buyer-1 for $45 million cash, which generated a Federal corporate income tax liability in excess of $15 million. At that point, Corp did not conduct any business, nor did it have any immediate plans to liquidate.

Following the asset sale by Corp, Taxpayers were approach by Investor, who claimed that they could structure a transaction that would “manage or resolve” Corp’s tax liability.

Pursuant to an agreement with Investor, and despite their suspicions regarding Investor’s plans for Corp’s taxes, Taxpayers sold all of their Corp stock to another corporation, Buyer-2, in a taxable transaction. Using borrowed funds, Buyer-2 paid Taxpayers an amount of cash representing the net value of Corp after the asset sale, plus a premium; Buyer-2 also promised to satisfy Corp’s tax liability.

Buyer-2 and Corp then merged into a new corporation, Holding, which was purportedly engaged in the business of debt collection. As a result of the merger, and by operation of law, Holding assumed the liabilities of Corp and of Buyer-2, including Corp’s income tax liability and Buyer-2’s acquisition debt.

Using the cash acquired from Corp, Holding repaid the loan that Buyer-2 had incurred to purchase Taxpayers’ stock in Corp. After satisfying this debt, however, Holding had no assets with which to pay the income taxes due from the earlier sale of Corp’s assets.

The IRS Smells a Rat

The IRS sent notices of tax liability to Taxpayers – the former shareholders of Corp – as the ultimate transferees of the proceeds of the sale of Corp’s assets. The IRS sought to establish that Taxpayers were liable for Corp’s tax liability.

The IRS argued that Taxpayers received, in substance, a liquidating distribution from Corp, and that the form of the stock sale to Buyer-2, and the subsequent merger with Holding, should be disregarded.

Taxpayers emphasized that the proceeds they received came from Buyer-2, not from Corp; therefore, there was no liquidation.

The U.S. Tax Court considered whether Taxpayers were “transferees” within the meaning of that provision of the Code which enables the IRS to collect from a transferee of assets the unpaid taxes owed by the taxpayer-transferor of such assets, if an independent basis exists under applicable State law for holding the transferee liable for the transferor’s debts.

The Tax Court looked to State’s Uniform Fraudulent Transfer Act (“UFTA”) and concluded that it could disregard the form of the stock sale to Buyer-2, and look to the entire transactional scheme, only if Taxpayers knew that the scheme was intended to avoid taxes. The Tax Court concluded that Taxpayers had no such knowledge, and ruled in their favor. The IRS appealed.

The Court of Appeals

The Ninth Circuit explained that Taxpayers would be subject to transferee liability if two conditions were satisfied: first, the relevant factors had to show that, under Federal law, the transaction with Buyer-2 lacked independent economic substance apart from tax avoidance; and second, Taxpayers had to be liable for the tax obligation under applicable State law.

Economic Purpose

After reviewing the record, the Court found there was ample evidence that Taxpayers were, at the very least, on constructive notice that the entire scheme had no purpose other than tax avoidance.

According to the Court, the purpose of Taxpayers’ transaction with Buyer-2 was tax avoidance; reasonable actors in Taxpayers’ position, it stated, would have been on notice that Buyer-2 never intended to pay Corp’s tax obligation.

It was not disputed, the Court continued, that following its asset sale to Buyer-1, Corp was not engaged in any business activities. It held only the cash proceeds of the sale, subject to the accompanying income tax liability. When Taxpayers sold their stock to Buyer-2, along with that tax liability, Taxpayers received, in substance, a liquidating distribution from Corp. There was no legitimate economic purpose for the stock sale other than to avoid paying the corporate income taxes that would normally accompany a liquidating asset sale and distribution to shareholders.

The financing transactions demonstrated that the deal was only about tax avoidance. Buyer-2 borrowed the funds to make the purchase. After the merger of Corp into Holding, the latter, had it been intended to be a legitimate business enterprise, could have repaid the loan over time and retained sufficient capital to sustain its purported debt collection enterprise and cover the tax obligation. Instead, the financing was structured so that, after the merger, Corp’s cash holdings went immediately to repay the loan Buyer-2 used to finance its purchase of the Corp stock from Taxpayers.

The Court stated that Taxpayers’ sale to Buyer-2 was a “cash-for-cash exchange” lacking independent economic substance beyond tax avoidance.

Liability under State Law

The Court then turned to whether, under State law, Taxpayers were liable to the IRS for Corp/Holding’s tax liability. According to the Court, this question had to be resolved under State’s UFTA.

The IRS argued that Taxpayers were liable under that the UFTA’s constructive fraud provisions.

The Court explained that State’s UFTA’s constructive fraud provisions protect a creditor in the event a debtor engages in a transfer of assets that leaves the debtor unable to pay its outstanding obligations to the creditor. Specifically, the UFTA provides that a transaction is constructively fraudulent as to a creditor (the IRS) if the debtor (Corp/Holding), did not receive “a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either: (a) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (b) Intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.”

The Court reviewed the record and found that Taxpayers’ sale of their Corp stock to Buyer-2 and Buyer-2/Holding’s assumption of Corp’s tax liability, were, in substance, a liquidating distribution to Taxpayers, which left neither Corp, Buyer-2, nor Holding able to satisfy Corp’s tax liability. Such a transfer, in which the debtor – Corp – received no reasonably equivalent value in return for its transfer to its shareholders, and was left unable to satisfy its tax obligation, fell squarely within the constructive fraud provisions of State’s UFTA.

Liquidation?

The Tax Court, however, had decided that Taxpayers had no actual or constructive knowledge of Buyer-2’s tax avoidance scheme, and thus concluded it had to consider merely the “rigid form” of the deal. According to the Tax Court, because Taxpayers received their money from Buyer-2, and not formally from Corp, there was no transfer from the “debtor” for purposes of the UFTA.

The IRS contended that the Court should look to the substance of the transactional scheme to see that Buyer-2 was merely the entity through which Corp passed its liquidating distribution to Taxpayers.

The Court agreed with the IRS, remarking that the Tax Court had incorrectly “viewed itself bound by the form of the transactions rather than looking to their substance.”

The Court disagreed with the Tax Court’s finding that the IRS had not established the requisite knowledge on the part of the participants in the scheme to render Taxpayers accountable.

“Reasonable actors” in Taxpayers’ position, the Court stated, would have been on notice that Buyer-2 intended to avoid paying Corp’s tax obligation. After all, Investor communicated its intention to eliminate that tax obligation, and offered to pay a premium for Taxpayers’ shares; yet despite their suspicions surrounding the transaction, Taxpayers failed to press Investor or Buyer-2 for more information.

That Buyer-2 provided little information regarding how it would eliminate Corp’s tax liability, coupled with the actual structuring of the transactions, provided indications that should have been “hard to miss.” Indeed, Taxpayers’ counsel testified that when he asked for details, Buyer-2 told them “it was proprietary”; and in a lengthy memo analyzing the subject of potential transferee liability, counsel wrote that Buyer-2 would distribute almost all of Corp’s cash to repay the loan used to finance the deal, though the memo never analyzed how Buyer-2 could legally offset Corp’s taxable gain from the asset sale – it merely concluded that Taxpayers would not be liable as transferees of the proceeds of Corp’s asset sale.

The Court concluded that Taxpayers were, at the very least, on constructive notice of Buyer-2’s tax avoidance purpose. It was clear that Taxpayers’ stock sale to Buyer-2 operated, in substance, as a liquidating distribution by Corp to Taxpayers, but in a form that was designed to avoid tax liability.

Thus, the Court held that Corp’s constructive distribution to Taxpayers of the proceeds from its asset sale was a fraudulent transfer under State’s UFTA, and Taxpayers were liable to the IRS for Corp’s federal tax obligation as “transferees.”

Too Good to Be True

Indeed. How can any reasonable person argue that the shareholders of a corporation can strip the corporation of its assets through a liquidation yet avoid responsibility for the corporation’s outstanding tax liabilities? They can’t.

The fact that the liquidation is effected through a complex scheme involving several steps does not change this conclusion – it merely evidences a taxpayer’s attempt at concealing the true nature of the transaction.

Speaking of which, tax advisers are often drawn to the challenge of structuring complex transactions. Unfortunately, that is not necessarily a good thing, especially if the economic or business purpose for the transaction – the sight of which should never be lost – may become less discernable. Just as importantly, the transaction structure should not, if possible, be made so complex that it raises the proverbial red flag and the inevitable question of “what are they hiding?”

The old adage of “keeping it simple,” and the old rule of thumb, “does it pass the smell test?” still have their place in moderating what may be described as the “complex approach” to tax planning.