Shareholders Constructively Aware Transaction Left IRS With No Way to Collect Tax, Transferee Liability Imposed

The Ninth Circuit Court of Appeals returned again to the case of Sloan v. Commissioner, CA 9, No. 16-73349, and again disagreed with the Tax Court’s finding in favor of the taxpayer.

This case began with the Tax Court’s opinion 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 where 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. 

The Tax Court subsequently ruled again on the case on remand, and again found in favor of the taxpayer, finding no transferee liability under IRC §6901 (Sloan v. Commissioner (Slone II), TC Memo 2016-115).  The IRS again appealed the Tax Court’s ruling to the Ninth Circuit Court of Appeals.

In this case a C corporation had sold the assets of the corporation to a third party. Such an asset sale is the situation that CPAs working with private companies have always noted was the big problem with a closely held C corporation—a buyer will most often want to buy assets rather than the corporation stock. When that happens in a successful corporation, there will almost certainly exist a large, taxable gain inside the C corporation as well as a second tax imposed when the corporation uses the funds (net of taxes) to redeem the shareholders.

Following that sale of assets, the corporation’s accountant received a flyer from an organization that claimed to solve such problems. The organization expressed an interest in buying the stock of such corporations.  The buyer was willing to pay significantly more for the stock of this corporation than the shareholders would have received from a liquidation distribution taken after the corporation had paid the taxes due.  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 the tax return that would have been filed for the year of the sale of the assets.  The buyer agreed to take on the payment of those taxes.

The buyer inquired of the accountant about whether this program would result in the claimed tax savings.  The accountant and one of the shareholders consulted legal counsel.  The advisers recognized that this transaction only made economic sense to the buyers if there existed some method to reduce the tax due for the corporation that was being bought.  When they inquired of the buyer how they managed to offset the tax, the buyer refused to divulge the method, arguing their tax structure was proprietary. 

The legal advisers concluded that, although they did not have information on how the tax would be offset, regardless of whether the “proprietary” system would be successful, the sellers weren’t at risk of transferee liability.  Thus, the shareholders went ahead with the sale of the stock of the old corporation to this seller.

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.

In both decisions, the Tax Court found that the shareholders did not have transferee liability, as they could not have reasonably anticipated that the buyer would end up failing to pay the tax due.  Thus, the Tax Court found that the IRS could not look to the taxpayers to pay this tax debt.

The Ninth Circuit panel had first sent back the case to the Tax Court, requiring the court to look behind the form of the transaction to look at its economic substance and, after doing that, apply the tests for transferee liability on that basis.  The panel, on sending the case back to the Tax Court, noted that the taxpayers would be liable for the tax under the transferee liability provisions of IRC §6901 if the following two tests were met:

We held that the Petitioners would be subject to transferee liability if two conditions were satisfied: first, the relevant objective and subjective factors must show that under federal law the transaction with Berlinetta lacked independent economic substance apart from tax avoidance; and second, we explained Petitioners must be liable for the tax obligation under applicable state law. See id. at 604–08.

The panel summarized the Tax Court’s findings on remand as follows:

On remand to the Tax Court, the Commissioner argued that the Petitioners received, in substance, a liquidating distribution from Slone Broadcasting, and that the form of the stock sale to Berlinetta should be disregarded. Petitioners emphasized that the proceeds they received came from Berlinetta, not Slone Broadcasting. The Tax Court chose to address only state law issues. It correctly looked to the Uniform Fraudulent Transfer Act (“UFTA”) that Arizona has adopted, but the Tax Court concluded it could disregard the form of the stock sale to Berlinetta and look to the entire transactional scheme only if Petitioners knew that the scheme was intended to avoid taxes. The Tax Court concluded Petitioners had no such knowledge and ruled once again for the Petitioners.

The IRS appealed the Tax Court’s ruling, arguing the Court had misapplied the relevant state law (Arizona) on fraudulent transfers:

On appeal the Commissioner argues that the Tax Court misinterpreted the Arizona statute to require actual or constructive knowledge, but that even if the statute requires such a showing, the Commissioner satisfied its burden.

The Ninth Circuit found that the question of how to interpret the state statute on this issue didn’t matter because the sellers were “at the very least on constructive notice that the entire scheme had no purpose other than tax avoidance.”  That is, the seller did know or should have known the scheme was intended to avoid taxes, rather than simply have the buyer pay those taxes or legally offset them.

The Court noted that the seller’s incentive to participate in this transaction was to receive a payment for their shares that did not get reduced by the $15 million of tax otherwise due at the corporate level:

It is not disputed that Slone Broadcasting, following its asset sale to Citadel, was not engaged in any business activities. It held only the cash proceeds of the sale and receivables, plus the accompanying $15 million tax liability. When Petitioners sold the stock to Berlinetta, along with that tax liability, Petitioners received, in substance, an ostensibly tax-free liquidating distribution from Slone Broadcasting. There was no legitimate economic purpose other than to avoid paying the taxes that would normally accompany a liquidating asset sale and distribution to shareholders. See Diebold Found., Inc. v. Comm'r, 736 F.3d 172, 175 (2d Cir. 2013).

The financing that was being used to obtain the funds in the transaction also gave evidence there was no intention to pay that $15 million of taxes on the part of the buyer:

The financing transactions further demonstrate that the deal was only about tax avoidance. Berlinetta borrowed the funds to make the purchase. After the merger with Slone Broadcasting into Arizona Media, that entity, 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, Slone Broadcasting’s significant cash holdings went immediately out the door to repay the loan Berlinetta used to finance its purchase of the Slone Broadcasting stock and tax liability. In the first appeal, Judge Noonan observed that this case bears a striking resemblance to Owens v. Commissioner, 568 F.2d 1233 (6th Cir. 1977), in which a similar cash-for-cash purchase was held to be a liquidating distribution to the shareholder. See Slone, 810 F.3d at 608–09 (Noonan, J., concurring in part and dissenting in part). The analogy is apt.

The Ninth Circuit, while not ruling on the issue in the first appeal, now finds clearly that the transaction lacked economic substance under federal law.

The Petitioners’ sale to Berlinetta was a cash-for-cash exchange lacking independent economic substance beyond tax avoidance. See Feldman v. C.I.R., 779 F.3d 448, 455–57 (7th Cir. 2015). Indeed Petitioners’ own advisors expressed surprise over this transaction; one of Petitioners’ lawyers testified that in his nearly twenty years of private practice he “had never seen a transaction like this.”

The last sentence hints at the issue the panel seems to have found most significant.  While the shareholders wouldn’t necessarily understand how odd this structure appeared, the Court found that the advisers understood that the only way the transaction could work for the buyer is if the tax “went away” and that they never understood how that feat was to be accomplished without leaving a tax unpaid.

The panel specifically commented on the fact that the buyers refused to provide information on how they planned to deal with the tax.

That Berlinetta provided little information regarding how it would eliminate Slone Broadcasting’s tax liability, coupled with the structuring of the transactions, provided indications that would have been hard to miss. Slone Broadcasting’s advisors understood that the transaction made sense from Berlinetta’s perspective only if Slone Broadcasting’s tax liability were eliminated. This deal was, after all, an uneven cash-for-cash exchange in which Berlinetta paid Petitioners most of what Slone Broadcasting should have paid in taxes. Yet Petitioners’ retained counsel testified that when he and Jack Roberts asked for details, Berlinetta told them “it was proprietary, it was a secret, and it was theirs, and we weren’t going to be a party to it, and I said fine.” And in a lengthy memo retained counsel prepared in November of 2001 analyzing the subject of potential transferee liability, counsel wrote that Berlinetta would distribute almost all of Slone Broadcasting’s cash to repay the loan used to finance the deal. The memo never analyzed how Berlinetta could legally offset Slone Broadcasting’s taxable gain from the asset sale. The memo merely concluded that Petitioners would not be liable as transferees of the proceeds of Slone Broascasting’s asset sale if the Commissioner successfully challenged the entity’s attempt to offset the tax liability.

This decision raises issues for advisers.  It appears the Court found the advisers simply accepted the buyers’ claim that their system would take care of the taxes, even if the advisers themselves couldn’t come up with a method via which the tax could be offset.

Also of interest is the fact that panel concentrated almost entirely on whether the advisers should have figured out the tax would most likely not be paid and does not discuss whether the taxpayers were aware of that fact.  The panel specifically refused to look at whether such Arizona law required such knowledge. That presumes that the knowledge the tax would not be paid existed.

One way to view the knowledge question is that the Court found that it should have been “obvious” to the shareholders that there would be an unpaid tax in this situation.  That seems to be a grossly unfair burden to impose on the taxpayers—that’s why they sought independent advice.  And, to be fair, a lot of tax benefits that seem “too good to be true” (like being about to write off 100% of newly acquired equipment under bonus depreciation) are specifically allowed under the IRC.

Another way the shareholders “might have known” would be based on the fact that the attorney’s memorandum discussed transferee liability, something that would only be an issue if the tax went unpaid.  But it would be a bit of a leap from a discussion of a contingency to grasping that the contingency is probable unless the memorandum made that clear—a fact not suggested in the opinion.

So, if we don’t assume the taxpayers had such knowledge, then the fact that their advisers “should have known” the tax would be paid may have been imputed to the shareholders.  That’s troubling if that is what the panel meant, since the adviser would meet a “should have known” standard based on the broad knowledge of the adviser.  In this case it would suggest the adviser should have told the taxpayer that since the buyer would not disclose its method for offsetting the tax and the adviser was not able to independently arrive at methods that would work in such circumstance, that the taxpayer must assume the tax wouldn’t be paid.

For now, advisers likely are going to need to balk in a situation like this where a third-party refuse to provide information on their own tax planning methods—just accepting that the third party’s system will solve the matter is, at least in the Ninth Circuit, not acceptable.