Ninth Court Sends Transferee Liability Case on Sale of Corporation Back to Tax Court, Rejecting Tax Court Holding the Form Must Be Respected Under Federal Law

In the case of Slone v. Commissioner, TC Memo 2012-57, vacated and remanded,  CA9, 2015 TNT 110-18, No. 12-72464, 12-72495, 12-72496, and 12-72497 the Tax Court rejected the IRS’s argument of substance over form in attempting to recast a sale of a corporation’s stock, following the sale of its assets, as a liquidating distribution to which transferee liability could attach under IRC §6901.  But, on appeal, the Ninth Circuit found that Tax Court had not properly considered the issue and sent the matter back to the Tax Court.

In the case in question the corporation had sold the assets of the corporation to a third party.  Following that sale of assets, the corporation was contacted by another entity that expressed an interest in buying the stock of the corporation.  The sale of the stock to that entity was completed prior to the corporation making any distribution to the old shareholders and before the year end for a the tax return that would have been filed for the year of the sale of the assets.

The IRS subsequently investigated the purchaser, who had put together a “system” to eliminate the corporate level tax and then be able to take the funds out tax free at a later date.  The IRS disallowed the strategy on the corporate return and attempted to collect the substantial tax now due from the new purchaser, but was unable to do so.  So the IRS now argued that the prior owners had entered into, when substance was considered over form, a liquidating distribution.  In that case, the unpaid tax would attach to the assets received (the cash) allowing the IRS to collect the tax from the old owners.

However the Tax Court found credible the testimony of the old owners that no tax strategies had been discussed prior to the sale of the assets to avoid paying any tax on the gain on the sale.  The Court also noted that the buyer had approached the taxpayers, and the Court found the buyer had no reason to believe the buyer was engaged in tax avoidance.  The Court found no duty to inquire further on the part of the seller when the buyer indicate it had proprietary strategies it did not wish to disclose to offset the gains.

However, on appeal the Ninth Circuit returned the case to the Tax Court, finding it had failed apply the proper standard to the transaction to determine whether there existed transferee liability.

Under the Stern test (based on a U.S. Supreme Court case) the Ninth Circuit found that the Tax Court needed to address two issues.  First, the Court was to determine if the taxpayers were a transferee under federal law, specifically IRC §6901.  After finding that, the Court needed to determine if the taxpayers would be substantively liable for the taxes under state law.

The Ninth Circuit complained that the Court had never actually addressed the first issue.  The Court found that this issue would turn on a finding of whether there existed “a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax­avoidance features that have meaningless labels attached.” (citing Frank Lyon Co. v. United States, 435 U.S. 561, 583­84 (1978))

The Ninth Circuit held that the Court must consider both subjective and objective matters in coming to this conclusion.  As the panel noted:

In Casebeer, we applied "a two-part test for determining whether a transaction is a sham: 1) has the taxpayer shown that it had a business purpose for engaging in the transaction other than tax avoidance? 2) has the taxpayer shown that the transaction had economic substance beyond the creation of tax benefits?"

The panel complained that the Tax Court had not applied this test—rather the Court looked at factors that would be relevant only to the second test (would there be liability under state law?) but used them to claim that no §6901 liability existed.  The majority of the panel sent it back to the Tax Court to decide this matter and then, if it finds that §6901 liability exists, to apply the state law standard.

The dissent in the case argued that there was no need to let the first prong be tested by the Tax Court, finding that the record was such that the panel should have found that there was no business purpose nor economic substance to the transaction.  Thus, the only issue the dissent argued that should go back to the Tax Court is that of whether a state law liability would attach in this case.

This decision does not mean the taxpayers will end up being held liable—rather the case is going back to the Tax Court to decide these issues.  But by having pushed the issues considered by the Tax Court into the “state law” realm (which means a holding that could vary from state to state) it denies absolute “protection” for the fact pattern in question based on federal law.