The experienced or well-informed investor recognizes that there is an element of risk in every business venture. They understand that the cash or other property they have contributed to the venture may be lost for any number of reasons – an economic downturn, a very competitive industry, the incompetence of officers, an adverse decision by a court or administrative agency, etc. Although the loss of one’s investment will likely cause some economic pain, the careful investor can take comfort in knowing that their exposure will generally be limited to the amount of their investment.[i]
Of course, there are other liabilities that may attach to an investor, in their capacity as such. For example, if the entity is a C corporation, the investor-shareholder will be liable for personal income tax on any dividend distribution actually or constructively made to the investor. In the case of an S corporation or an LLC that is treated as a partnership, the investor-shareholder/member will be liable for income tax on their share of the pass-through entity’s taxable income, whether or not distributed to them.
The foregoing liabilities and losses are not unexpected. They are recognized and accepted by investors as the kinds of risks and costs that are an inherent part of an investment in almost every closely held business. They do not represent a breach in the wall of limited liability protection that is accorded an investor in a corporation or in a limited liability company by virtue of the status of the business entity as a juridical person that is separate from its owners, with its own assets and its own liabilities.
It is this concept of legal separateness that underlies the derivative concept of limited liability, according to which an equity investor’s personal assets cannot be reached by the business entity or by the entity’s creditors simply because of the investor’s status as an owner. It is the concept of limited liability that encourages investors to acquire equity in a closely held business entity without fear of putting their other assets at risk for the liabilities of the business.[ii]
In light of the foregoing, imagine the reaction of a non-controlling shareholder of a corporation who receives a notice from the IRS asserting millions of dollars of liability against the shareholder for income taxes owing by the corporation.[iii]
That’s what happened to Taxpayers when they – as distinguished from their corporation – received a notice of deficiency[iv] from the IRS which asserted an aggregate amount of transferee liability in excess of $64 million, relating to Taxpayers’ ownership interest in Corp.
Needless to say, Taxpayers filed a petition with the U.S. Tax Court.[v]
Among the issues before the Court were: (1) whether Taxpayers were liable as “transferees” for their respective shares of the corporate income tax deficiency assessed against Corp by the IRS, and (2) whether Taxpayers’ transferee liabilities were limited to the extent Taxpayers were “good faith transferees” who provided value to Corp.
What preceded the above-referenced notice of transferee liability issued to Taxpayers? How did they get into this mess?
Corp was a closely held corporation that was engaged in the radio and television broadcasting business. As its business expanded, Corp brought in additional investors to help fund its expansion, including Taxpayers, who insisted they be represented on Corp’s board of directors.
Under the terms of a shareholders’ agreement to which Taxpayers were a party, Taxpayers were granted a right of redemption (a “put option”) that, upon exercise after a prescribed period, would have required Corp to redeem all of Taxpayers’ Corp shares in exchange for an amount of consideration equal to the fair market value of those shares, payable in cash and an interest-bearing note.
The shareholders’ agreement also provided a “drag-along” provision that permitted a supermajority of Corp’s shareholders to compel the remaining Corp shareholders to sell their Corp shares.
As they approached retirement age, Corp’s majority shareholders (the “Founders”) began exploring several strategic alternatives. They consulted an adviser who presented six potential alternatives by which they could realize Corp’s value: (1) a sale of assets by Corp followed by its liquidation, (2) a sale of Corp stock, (3) a tax-free exchange/reorganization,[vi] (4) a “spin-off” of Corp’s radio assets followed by a sale of Corp’s stock,[vii] (5) redemption of Corp stock from the shareholders,[viii] and (6) a sale of Corp stock using an employee ownership plan.[ix]
After comparing a stock sale with an asset sale, Corp’s board decided to pursue a stock sale because the adviser’s analysis projected that a stock sale would produce a much greater return of net after-tax proceeds to Corp’s shareholders.[x]
Shortly thereafter, Corp entered into a brokerage agreement with Broker, who began seeking potential buyers for Corp. It wasn’t long before Corp realized that buyers in the broadcasting industry generally preferred an asset sale. While Broker was able to find potential buyers interested in Corp’s assets, Broker struggled to find a buyer interested in buying the stock of a company, like Corp, that had both television stations and radio stations.
At some point, Corp was introduced to Facilitator,[xi] a firm that facilitated stock sales of companies. Facilitator discussed the possibility of using an “intermediary” or “Midco” transaction strategy,[xii] to which Corp’s board eventually agreed.[xiii]
Facilitator organized a shell company to acquire Corp’s stock and, immediately thereafter, to sell Corp’s television assets to unrelated Buyer. Facilitator also organized a slew of other transactional entity shells that had no apparent business purpose, but which were utilized in such a way as to eliminate Corp’s tax liability for the asset sale.[xiv]
The closings of the sale of all of Corp’s stock, as well as the sale of Corp’s assets, and the subsequent mergers, transfers and liquidation among the other transactional entities, took place on the same day, over a three-hour period.
Taxpayers – who may have been compelled to sell their shares pursuant to the drag-along provision in the shareholders’ agreement – neither raised the possibility of exercising their right of redemption nor sought compensation for surrendering such right at any point before the sale of Corp’s stock.
Reporting the Sale
According to Corp’s Form 1120, U.S. Corporation Income Tax Return, for its short tax year ending with the day of the stock sale, Corp had no assets by the end of such tax year, and it had no tax liability. The return also reported that Corp had been “reorganized” out of existence through transfers involving the various transactional entities.
After examining the stock sale and the related, practically simultaneous, transactions arranged by Facilitator, the IRS issued multiple notices of deficiency relating to the sale of Corp’s assets.
Thereafter, the IRS undertook transferee examinations of eight of the largest Corp shareholders who sold their shares, including Taxpayers. The IRS sent notices of transferee liability to Taxpayers, asserting that they were liable for Corp’s unpaid deficiency for Federal income tax, penalties and interest.
The IRS’s theory of these cases was that Corp was liable for Federal income tax related to its sale of its assets, and that Corp’s shareholders, including the Founders and Taxpayers, were each liable for a portion of that unpaid corporate tax because they received transfers from Corp. To reach this outcome, the IRS sought to disregard the stock sale undertaken pursuant to the Midco transaction; instead, Corp would be treated as having sold its assets, following which it would be deemed to have made a liquidating distribution to its shareholders. Thus, Corp’s shareholders would be deemed to have received distributions from Corp rather than having received consideration in exchange for their Corp stock from an entity organized by Facilitator.
Applying a “substance over form” analysis, the Tax Court agreed with the IRS,[xv] and concluded that Corp should be deemed to have sold all its assets, incurred the inherent taxable gains, liquidated, and distributed the net proceeds from its asset sales to its shareholders which, for our purposes, included Taxpayers.
Having traced Taxpayers’ path to the Tax Court, we turn now to Taxpayers’ arguments that they were not liable as transferees under State law for their respective share of Corp’s income tax deficiency.
According to the Court, the Code provides that the liability, at law or in equity, of a transferee of property of a taxpayer owing Federal income tax “shall * * * be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.”[xvi]
The Court explained that the Code does not independently impose tax liability upon a transferee, but merely provides a procedure through which the IRS may collect unpaid tax – owed by a transferor of assets – from the transferee who received those assets. Thus an independent basis for liability must be available, and this basis is generally found under applicable State law or equity principles. [xvii]
Accordingly, the Court continued, “three requirements had to be met for the IRS to assess transferee liability against a party” under the Code:
(1) The party must be subject to liability under applicable State law,
(2) The party must be a transferee pursuant to Federal law, and
(3) The transferor must be liable for the unpaid tax.
The Court added that the IRS bears the burden of proving that a party is liable as a transferee of the transferor-taxpayer’s property,[xviii] but not of proving that the transferor-taxpayer is liable for the tax.[xix]
State Law Liability
As the transactions took place in State, the Court used State law to determine whether Taxpayers were liable, as transferees, for Corp’s unpaid tax.
According to the Court, applicable State law defined “transfer” very broadly as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease and creation of a lien or other encumbrance.” The Court observed that, where a debtor transferred property to a transferee and thereby avoided creditor claims by depriving itself of the means by which to satisfy such claims, State law provided creditors with certain remedies against the transferee.
Under State law, the Court continued, transferee liability “looks to equitable principles like ‘substance over form.’” In the present case, the Court stated, “There is no dispute regarding our prior opinion disregarding the form of the transactions or our finding that in substance a transfer from” Corp to Corp’s shareholders had occurred.[xx]
Exchange for Value?
Having found a transfer from Corp to Taxpayers, the IRS argued that Taxpayers failed to provide reasonably equivalent value to Corp in exchange for such transfer and were, therefore, liable as transferees under State law.[xxi] Taxpayers disagreed, and argued that by surrendering their right of redemption (the put option) in exchange for the distributions, they provided reasonably equivalent value to Corp.
Under State law, a transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the debtor made the transfer without receiving a reasonably equivalent value in exchange for the transfer, and the debtor was insolvent at that time, or the debtor became insolvent as a result of the transfer.
The Court explained that any transfer had to be viewed exclusively from the perspective of the creditor – the subjective intent of the putative transferee played no role in the application of State’s constructive fraud provisions, which focus on an objective result.
Whether reasonably equivalent value was received by the transferor was a question of fact, the Court stated, and the “test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and to compare it to what was received.”
According to the Court, the record reflected that Taxpayers collectively received distributions in excess of $64 million from Corp’s asset sale proceeds. In exchange for this, Taxpayers claimed to have surrendered their put option along with their Corp stock. According to the express terms of Corp’s shareholders’ agreement, Taxpayers’ put option vested immediately. However, the agreement also limited Taxpayers’ ability to exercise such right. The earliest date that Taxpayers could exercise their right of redemption was approximately one year after the sale of Corp’s stock and of its assets. The Court also observed that while the record extensively documented the negotiations leading up to the sale of Corp’s assets, it was silent as to whether Taxpayers ever discussed surrendering their right of redemption at any point during that process. Furthermore, Taxpayers never discussed the specific value of their right of redemption, let alone sought a formal valuation.
The Court concluded that Taxpayers’ “incidental surrender” of their right of redemption as part of the transfer of their Corp shares constituted neither value nor reasonably equivalent value. Thus, Taxpayers’ right of redemption was worthless, and Corp (as the deemed transferor) did not receive value, reasonably equivalent or otherwise, in exchange for the proceeds from the sale of its assets.
Because there was no dispute regarding (1) Corp’s liability for the Federal income tax arising from the asset sale, (2) Corp’s insolvency after the transfer, (3) the existence of the IRS’s claim, or (4) the IRS’s creditor status at the time of the transfers in question, the Court concluded that Taxpayers were liable for such Federal income tax as Corp’s transferees under State law.
Federal Transferee Requirement
Having disposed of Taxpayers’ argument that they had exchanged value for the deemed distribution of the sale proceeds from Corp, the Court turned to the issue of Taxpayers’ “transferee” status under Federal law.
For purposes of the Code’s transferee liability rules, the Court explained that the term “transferee” includes a donee, heir, legatee, devisee, distributee, and shareholder of a dissolved corporation. The Court added that the principle of “substance over form” applies to determinations of transferee liability issues. In accordance with the substance over form analysis it applied in re-characterizing the transactions organized by Facilitator, the Court determined that Taxpayers, as distributees of Corp, were transferees for purposes of the Code’s transferee liability rules.[xxii]
And That’s The Way It Is[xxiii]
How can any reasonable person argue that the shareholders of a corporation can, in effect, strip the corporation of its assets through the equivalent of an asset sale and liquidation, yet avoid responsibility for the corporation’s outstanding tax liabilities?
The fact that the desired “tax reduction” is effectuated through a complex scheme involving multiple entities and steps that seek to dissemble the actual transactions does not change this conclusion – on the contrary, it should put the shareholders on alert that the proponent of the scheme is attempting to conceal the true nature of the transaction from the IRS.
How is it, then, that many business owners, when confronted with a large tax bill, are often willing to throw caution to the wind? In part, their predilection 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, on the one hand, and falling for a foolish scheme, on the other, that results in the shareholders being held personally liable for their corporation’s income tax liability.
What’s more, the consequences of not being able to distinguish one from the other may be dire – for although the corporate income tax would have been payable regardless, the IRS may now proceed to collect it from the personal assets of the transferee-shareholder.
[i] I say “generally” because it may be that an investor has agreed to guarantee a lease or an indebtedness incurred by the business entity, or has provided collateral to secure such an indebtedness. They may have agreed to a limited obligation to respond to a capital call under certain circumstances.
It may also be that the investor has managerial duties in the business, and may be held personally liable for damages attributable to their activities in that managerial capacity. For example, “responsible person” status – and the personal liability that goes with it – may attach for purposes of the entity’s employment taxes and sales taxes. https://www.taxlawforchb.com/2016/11/when-irresponsible-partners-are-responsible-persons/
If they are a compensated service provider, they will owe income and employment taxes in respect of such compensation.
[ii] Of course, if the owners of a business fail to respect to separate status of their business entity, if they treat with the entity other than at arm’s length, then the creditors of the business may, likewise, be allowed to disregard the separate legal status of the entity and to pursue the personal assets of the entity’s owners to satisfy the entity’s obligations to such creditors – “piercing the corporate veil.”
An owner may also effectively waive their limited liability protection by guaranteeing an entity’s obligations or by agreeing to make capital calls. This is rarely done “voluntarily” in the sense that the owner offers, unprompted, to drop their shield. However, when a lender or a landlord, for example, requires such a guarantee before agreeing to a line of credit or a lease, well, there may not be much choice.
[iii] Did you hear that? No? Sounded to me like a body hitting the floor.
[iv] IRC Sec. 6212. The taxpayer to whom/which the notice is addressed has 90 days within which to file a petition with the Tax Court for a redetermination of the asserted deficiency. IRC Sec. 6213.
[vi] IRC Sec. 368.
[vii] Note that these discussion with the adviser occurred a couple of years after the enactment of IRC Sec. 355(e). https://www.taxlawforchb.com/2019/10/tax-free-spin-off-that-may-depend-on-post-spin-off-events/
[viii] IRC Sec. 302.
[ix] IRC Sec. 1042.
[x] A single level of tax at the shareholder level, at a federal income tax rate of 20-percent.
[xi] “The Facilitator” – you can just picture Arnold as the main character, bespectacled and in a bespoke suit. Hey, if Ben Affleck can get away with portraying a math wiz who provides accounting services to disreputable businesses, why can’t Arnold play the part of a business broker or investment banker with an ax to grind – literally – who tracks down expats who never received their “sailing permits” and, so, should never have been allowed to leave their country?
[xii] A “Midco transaction” was structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer in an asset purchase. In such a transaction, the selling shareholders sold their stock in a corporation to an intermediary entity (or “Midco”) at a purchase price that did not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sold the corporation’s assets to the buyer, who obtained a purchase price basis in the assets. The Midco kept the difference between the asset sale price and the stock purchase price as its fee for facilitating the transaction. At the same time, the Midco might have losses or credits that would offset its tax liability on the asset sale.
[xiii] Shortly before Corp’s Midco transaction, the IRS released a Notice which described certain transactions as types of an “intermediary transactions tax shelter,” identified those transactions as “listed transactions,” and took the position that direct or indirect participants of the same or substantially similar transactions would be required to disclose their participation to the IRS. Notice. 2001-16, 2001-1 C.B. 730, clarified by Notice 2008-111, 2008-51 I.R.B. 1299.
When Corp’s board met with Facilitator regarding the possible use of a “Midco” transaction for the stock sale of Corp, the Founders were informed that there was a risk that the IRS might re-characterize the transaction as an asset sale. However, Facilitator represented that none of the similarly structured transactions it had facilitated over an 18-year period had been successfully challenged or unwound.
[xiv] As the Tax Court put it: “This manipulating of the Internal Revenue Code is a prime example of how a transaction can be structured so that its form might meet the letter of the law, but it nevertheless is being used in a manner incongruous with the intent of that law.”
[xv] Shockley v. Comm’r, T.C. Memo. 2015-113.
[xvi] See IRC Sec. 6901 and Sec. 6902.
[xvii] IRC Sec. 6901(a)(1)(A).
[xviii] Before continuing its analysis, the Court explained that the determinations of Taxpayers’ substantive liability under State law and transferee status under Federal law were separate and independent determinations. The Court stated that it would first consider whether Taxpayers were liable as transferees under State law before determining the application of the Code for the collection of such liability.
[xix] See IRC Sections 6902(a), 7454(c); Tax Court Rule 142(d).
[xx] See Shockley v. Comm’r, T.C. Memo. 2015-113.
[xxi] In other words, they did not transfer to the corporation assets with a value equal to that of the assets transferred to them by the corporation.
[xxii] IRC Sec. 6901.
[xxiii] Remember Walter Cronkite?