Corporations & Shareholders
The Tax Court held that the four former shareholders of a corporation were liable as transferees for a portion of the tax debts of the corporation arising from a land sale that occurred before they sold their stock in the corporation to a third party.
Background
William Stuart, Arnold Walters Jr., James Stuart Jr., and Robert Joyce (the taxpayers) were the shareholders of Little Salt Development Co. (Little Salt), a Nebraska C corporation. Little Salt owned 160 acres of saline wetlands on the outskirts of Lincoln, Neb., that it sold to the City of Lincoln on June 11, 2003, for $472,000. After it sold the land, Little Salt's only asset was cash. Little Salt realized a gain of $432,148 on the land sale, and, after the sale, the company did not engage in any business activity.
The taxpayers then entered into an agreement to sell their stock in Little Salt to MidCoast Investments Inc. for a price equal to the cash held by Little Salt on the date of sale closing reduced by 64.92% of the company's combined state and federal corporate income tax liability for its current tax year (i.e., its tax liability related to the sale of the land). As part of the transaction, Little Salt was required to transfer on or before the closing date its cash on hand (which was not to be less than $467,721) to MidCoast's attorneys' trust account.
MidCoast agreed to "cause" Little Salt to file its returns for 2003 and to pay its federal and state tax liabilities arising from the land sale. According to their later testimony in Tax Court, before they signed off on the sale agreement, none of the taxpayers made any real effort to understand the terms of the agreement, and none of them knew why MidCoast was purchasing Little Salt or what it planned to do with the corporation after the purchase.
Pursuant to the sale agreement, on Aug. 7, 2003, the attorney for the taxpayers wired the cash held by Little Salt at that time ($467,721) to MidCoast's attorney, and minutes later MidCoast's attorney wired back to the taxpayers the agreed-upon purchase price for the stock ($358,826, or the total cash reduced by 64.92% of Little Salt's tax liability). The following day, the taxpayers' attorney distributed the cash from the purchase to them pro rata. MidCoast's attorney distributed the cash transferred to him from Little Salt to an account in the name of Little Salt and on the next day to an account held by MidCoast. Little Salt treated the transfer of funds on its books at the end of its fiscal year on Sept. 30, 2003, as a shareholder loan of $327,000, with the remainder of the money transferred apparently representing payment of operational expenses and fees to MidCoast.
On Dec. 15, 2003, Little Salt filed its 2003 Form 1120, U.S. Corporation Income Tax Return. It reported taxable income of $432,148, total tax of $146,930, and tax due of $148,456. No payment was made with the return. The company reported on Schedule L, "Balance Sheets per Books," that, as of the end of the year, it had cash of $278, a loan of $467,000 due from MidCoast, and no other assets; it reported no liabilities.
On Feb. 18, 2005, Little Salt filed its 2004 Form 1120. It reported interest income of $1,739, a bad debt deduction of $450,370 resulting from the worthlessness of the shareholder loan, and, taking into account certain other deductions, negative taxable income of $483,970. It reported no gross receipts or cost of goods sold. The bad debt deduction produced a net operating loss that Little Salt carried back to, and deducted for, 2003. It reported on Schedule L that, as of the end of the year, it had trade notes and accounts receivable of $903 and no liabilities.
The IRS examined Little Salt's 2003 and 2004 returns and disallowed both the 2004 bad debt deduction and the loss carried back to, and deducted for, 2003. On Oct. 5, 2007, the IRS determined a deficiency in Little Salt's 2003 federal income tax of $145,923 and an accuracy-related penalty of $58,369. The IRS later issued Little Salt a notice of deficiency for these amounts. Little Salt did not challenge the notice, and the IRS assessed the deficiency; however, it was unable to collect the amounts assessed from Little Salt.
The IRS, after it failed to collect the tax due from Little Salt, sent the taxpayers notices of transferee liability in November 2010. In the notices, the IRS recast the transaction by which the shareholders disposed of their shares in Little Salt as a liquidating distribution of all of Little Salt's cash to its shareholders in redemption of its outstanding shares, followed by the shareholders' payment of a portion of that cash to MidCoast as an accommodation fee for its participation in the assumed sale. The taxpayers in turn petitioned the Tax Court, disputing the deficiency the IRS claimed Little Salt owed and their liability for any amount owed as transferees of Little Salt's assets.
Sec. 6901 Transferee Liability
Sec. 6901 provides that the liability, at law or in equity, of a transferee of property "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." Sec. 6901(h) provides that the term "transferee" includes "donee, heir, legatee, devisee, and distributee." However, Sec. 6901 only provides the mechanism through which the IRS may collect unpaid taxes owed by a transferor; whether a basis exists for holding a transferee liable for a transferor's debts is determined under the applicable state or federal law.
The Parties' Arguments
The IRS argued that, in determining whether under Sec. 6901 it could use administrative procedures to collect Little Salt's unpaid 2003 tax liability from the taxpayers, the Tax Court should engage in a two-step analysis. First, it said, the court should determine under federal law whether the transaction that gave rise to the liability was properly characterized and whether the recipients were transferees under Sec. 6901(h). If the court recasts the transaction or otherwise disregards it under federal tax law and finds that the recipients were transferees in the first step, it should then determine under state law whether the transferees received fraudulent transfers.
The IRS contended that under federal tax law the transaction by the taxpayers, Little Salt, and MidCoast was a sham transaction that should be recharacterized as a liquidation of Little Salt and that under Nebraska corporate law and Nebraska's version of the Uniform Fraudulent Transfer Act (UFTA), the IRS could collect Little Salt's liability from the taxpayers as its shareholders.
The taxpayers argued that under the applicable state law, they were not liable for Little Salt's debts because none of the proceeds of the land sale were ever transferred directly to them. Further, they claimed it would be improper to recharacterize the overall transaction as a redemption of their shares because they did not know that MidCoast would never pay Little Salt's taxes on the land sale.
The Tax Court's Decision
The Tax Court held that the taxpayers were liable as transferees for the taxes owed by Little Salt. However, in making its decision, it rejected, based on its own precedent, that the IRS's two-step analysis should be applied to the case. Rather, it looked first at whether a state law basis existed for transferee liability for the taxpayers and then at whether the taxpayers were transferees for purposes of Sec. 6901.
With respect to whether it should use the IRS's two-step analysis, the Tax Court found that this method of analysis was foreclosed by its decision in Swords Trust, 142 T.C. 317 (2014). In addition to the reasons set out in that case, the court offered an additional reason for rejecting the analysis because the IRS had, since that case, persisted in pushing its arguments for using the two-step analysis.
The Tax Court explained that the purpose of the change in the law in Sec. 6901 was to provide for the enforcement of third-party liability to the IRS by the procedures already in existence for the enforcement of tax deficiencies. The procedures were to be effective against a transferee of property of the taxpayer without in any way changing the extent of the transferee's liability under existing law. Also, nothing in the statute was to afford the IRS any rights it would not have if it sought to enforce a tax liability through judicial mechanisms outside of Sec. 6901. The court noted that if the IRS cannot fix the liability on the transferee without invoking Sec. 6901, it cannot use Sec. 6901 to obtain a different result. Thus, transferee liability must exist under applicable state or federal law before Sec. 6901 is considered.
Having concluded that it must first determine whether there was a basis under state or federal law for the IRS's claim that the taxpayers were liable for Little Salt's taxes, the Tax Court analyzed Little Salt's transfer of its cash to MidCoast's lawyer under the Nebraska version of the UFTA (Neb. Rev. Stat. §§36-701 through 36-712). In particular, the court evaluated whether Little Salt, a debtor of the IRS for the taxes on its land sale, made the transfer "without receiving a reasonably equivalent value in exchange for the transfer," which, pursuant to Nebraska Revised Statutes Sections 36-705(a)(2) and 36-706(a), was constructively fraudulent with respect to the IRS as a creditor of Little Salt. After identifying the requirements of these two statutes and reviewing the transactions, the court found that under the Nebraska UFTA, the transfer of funds to MidCoast's lawyer was constructively fraudulent with respect to the IRS.
Because the transfer was fraudulent, the court further found that under the Nebraska UFTA, the transfer was voidable and that the IRS could have the transfer voided and could recover the amount necessary to satisfy its claim (i.e., the tax and penalties owed due to the land sale, which were $145,923 and $58,369, respectively). However, with respect to the taxpayers, the court determined that they were only liable for the benefit they received from the transfer, which the court concluded was the difference between the after-tax amount they would have received if they had simply liquidated Little Salt and the amount that they received in the sale of their shares to MidCoast. This was a very favorable finding for the taxpayers, as the court calculated that this amount was only $58,842.
Finally, the Tax Court considered whether the taxpayers were transferees for purposes of Sec. 6901. After reviewing the applicable precedent, the court said that "[t]he determinative factor is liability to a creditor (the Commissioner) for the debt of another under a State fraudulent conveyance, transfer, or similar law." Since it had found that the shareholders were collectively liable for $58,842 as persons for whose benefit Little Salt transferred its cash holdings to MidCoast, it accordingly concluded that the taxpayers were transferees within the meaning of Sec. 6901.
Reflections
This case stands in stark contrast to Starnes, 680 F.3d 417 (4th Cir. 2012), in which the taxpayers were held not to be liable for corporate taxes as transferees after selling their stock to MidCoast. In that case, the Tax Court held, and the Fourth Circuit affirmed, that the IRS had failed to prove an independent substantive basis for liability for the taxpayers under the applicable North Carolina fraudulent transfer law. As the Tax Court pointed out, a crucial distinction between the cases in determining whether the taxpayers were liable as transferees was that the agreement between the taxpayers and MidCoast in Starnes obligated MidCoast, after the stock sale closed, to return the cash its attorney received before closing from the corporation being sold, whereas the Little Salt agreement was silent on this point.
Stuart, 144 T.C. No. 12 (2015)
