Dillon Trust Company LLC v. United States, No. 2024-1314 (Fed. Cir. May 14, 2026)

For tax professionals handling the sale of closely held C corporations with highly appreciated assets, balancing the desire for single-level taxation against the risks of transferee liability is a familiar challenge. A recent decision by the United States Court of Appeals for the Federal Circuit, Dillon Trust Company LLC v. United States, serves as a critical cautionary tale. This decision highlights the severe consequences of willful blindness in stock sales to intermediary entities utilizing abusive tax shelters, underscoring that sellers cannot turn a blind eye to economically irrational bids without risking exposure to massive transferee tax liability, penalties, and interest.

Factual Background

The case originated from a group of trusts established by the Dillon family for the benefit of their descendants, which owned stock in two C corporations: Humboldt Corporation and Shelby Corporation. By the year 2000, these corporations held assets, primarily blue-chip stocks and prime farmland, that had appreciated to approximately $90 million, while holding an internal tax basis of only about $16 million. Consequently, the corporate assets carried over $71 million in unrealized built-in gains.

The Dillon family intended to sell the farmland and liquidate their positions, but recognized the substantial tax burden of an asset transfer. As their tax counsel from Shearman & Sterling advised, an asset sale would trigger two levels of tax on the built-in gains—at the corporate level upon sale, and at the shareholder level upon distribution—which could reduce the net proceeds to the trusts by almost half. Naturally, the family preferred a stock sale, as it transfers the embedded corporate-level tax liability to the buyer, allowing the sellers to realize only a single level of tax.

However, the family's tax counsel explicitly warned them of the potential pitfalls. In several memorandums, the attorneys cautioned that selling the stock to an investor who subsequently sold the assets could trigger IRS scrutiny. They specifically highlighted IRS Notice 2001-16, noting that the IRS had "cautioned taxpayers against participating in certain conduit or intermediary tax shelter transactions where a party with losses acquired assets with built-in gain for resale".

Despite these warnings, the trusts proceeded with a stock auction process, eventually selecting a bid from Diversified Group Incorporated (DGI) and its president, James Haber. DGI offered to pay approximately 95 percent of the net asset value of the corporations without discounting the purchase price for the substantial embedded tax liability. Rather than using its own capital, DGI established a thinly capitalized, newly formed entity, Humboldt Shelby Holding Corporation (HSHC), to serve as the purchaser. HSHC funded the purchase entirely through a $124 million loan from Rabobank, collateralized by the very assets it was purchasing.

Immediately upon closing the stock sale in December 2002, HSHC began selling off the investment portfolios and installment notes held by Humboldt and Shelby to pay off its Rabobank loan. To eliminate the massive tax liability triggered by these asset sales, HSHC engaged in abusive "Son-of-BOSS transactions" designed to generate fictitious losses. For the tax year ending in November 2003, HSHC reported $73.2 million in gains offset completely by $74.1 million in manufactured losses, paying no tax. The IRS later issued a statutory notice of deficiency, determining that the losses were artificial and assessing $25.6 million in income tax along with a $10.2 million gross valuation misstatement penalty and underpayment interest. Because HSHC was insolvent and failed to pay the assessment, the IRS looked to the Dillon trusts, issuing notices of transferee liability for the unpaid balances.

Taxpayers' Request for Relief

In response to the IRS asserting transferee liability, the Dillon Trust Company made a $71.7 million deposit in May 2015 under 26 U.S.C. § 6603 to stop the accrual of underpayment interest. However, because several of the original trusts had terminated, the deposit was made on behalf of successor trusts. When the trust company later requested the IRS apply these deposits as tax payments for the original trusts' liabilities, the IRS refused, noting that its procedures did not allow one taxpayer to direct a deposit to pay another taxpayer's liability.

After the IRS returned the unused deposits with interest, the Dillon trusts paid the full assessed transferee liabilities—totaling approximately $79.9 million—and filed suit in the Court of Federal Claims seeking a complete refund of the taxes, penalties, and interest. Furthermore, they brought an illegal exaction claim, arguing that the IRS unlawfully caused the continued accrual of approximately $11 million in underpayment interest by refusing to apply their § 6603 deposit to the assessed liabilities.

Court's Analysis of the Law

The appellate panel began its review by analyzing 26 U.S.C. § 6901, the statute providing the procedural mechanism for the IRS to collect unpaid taxes from a transferee. The court emphasized that Section 6901 does not create the substantive liability; rather, the existence and extent of a transferee's liability are determined by applicable state law, which in this case was the New York Uniform Fraudulent Conveyance Act (NYUFCA).

Under NYUFCA § 273, a conveyance is deemed constructively fraudulent if it renders the transferor insolvent and is made without fair consideration. To establish liability under this statute in the context of an intermediary tax shelter, the court relied heavily on the Second Circuit's framework established in Diebold Found., Inc. v. Comm'r. The Diebold framework allows courts to "collapse" multilateral transactions and treat them as a single scheme if two elements are met: first, the consideration received must be reconveyed by the debtor for less than fair consideration or with actual intent to defraud; and second, the initial transferee "must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent".

The court further clarified that constructive knowledge includes "inquiry knowledge," meaning situations where the transferees "were aware of circumstances that should have led them to inquire further into the circumstances of the transaction, but . . . failed to make such inquiry".

Application of the Law to the Facts

The Federal Circuit firmly agreed with the lower court's application of the Diebold factors, determining that the Dillon trusts had constructive knowledge of the fraudulent scheme due to their willful blindness. The appellate panel affirmed the trial court's finding that "there was no legitimate economically rational explanation for the DGI and TranStar bids," because an independent buyer would not pay a premium for built-in gains without an appropriate discount unless they planned to illicitly eliminate the tax liability.

The court pointed to several "red flags" that created a duty to inquire. First, the trusts knew they were marketing assets with a built-in tax liability of $26 million, yet accepted bids for 95 percent of the net asset value. Second, the trusts were advised by sophisticated tax attorneys who explicitly warned them that a stock sale followed by an asset sale could trigger IRS scrutiny. Third, the purchaser, HSHC, was a newly formed shell entity with no operating history or legitimate net operating losses (NOLs) to absorb the massive gains, operating entirely with funds borrowed against the target corporations' assets.

The Dillon Trust Company argued that they had no duty to inquire because the buyer claimed its post-transaction plans were "proprietary". The court strongly rejected this defense, quoting the trial court's conclusion that "the acceptance of [DGI's] explanation of 'proprietary' concerns was either monumental naivete, gross negligence, or a useful fig leaf". The appellate panel ruled that "[t]o relieve parties of this duty, when the surrounding circumstances indicate that they should further inquire, would be to bless the willful blindness the constructive knowledge test was designed to root out". Consequently, the court held it was proper to collapse the stock sale and subsequent asset sales into a single fraudulent transaction, cementing the trusts' transferee liability.

Net Value Limitation and Fraudulent Intent

The taxpayers alternatively argued that even if they were liable under the constructive fraud provisions of NYUFCA § 273, their liability should be capped at the net value of the transfer they received pursuant to NYUFCA § 278(2). Section 278(2) limits the recovery against a purchaser who acted "without actual fraudulent intent".

The court rejected this limitation, relying on the Second Circuit's precedent in Ruderman v. United States. The court noted that Ruderman directly addresses this distinction, holding that "actual fraud is not limited to fraudulent conveyances which fall within the definitions of § 276 . . . , but may include transfers which are denoted as 'constructively fraudulent' and which fall, for example, within § 273". Therefore, because the transaction was constructively fraudulent, the trusts could not utilize the liability cap designed for purchasers lacking actual fraudulent intent.

Inclusion of Penalties in Transferee Liability

The Dillon Trust Company also contested the inclusion of HSHC's $10.2 million gross valuation misstatement penalty in the transferee assessment, citing Eighth Circuit precedent (Stanko v. Commissioner) to argue that state fraudulent conveyance laws protect current creditors, not future tax penalties.

The appellate panel acknowledged a circuit split on the issue but chose to follow the framework utilized by the First, Ninth, and Eleventh Circuits, as well as the Tax Court. Citing Tricarichi v. Comm'r and Kreps v. Comm'r, the court held that federal law determines the right to collect pre-notice interest and penalties when the value of the assets received by the transferee exceeds the total tax liability. The panel ruled that "the transferee is retroactively liable for transferor's taxes in the year of transfer and prior years, and penalties (additions to tax) and interest in connection therewith, to the extent of the assets received from the transferor". Since the trusts received assets far exceeding HSHC's total tax and penalty liabilities, they were liable for the penalties.

Denial of the Section 6603 Deposit Refund

Finally, the court evaluated the taxpayers' illegal exaction claim concerning the $11 million in underpayment interest. The trusts argued the IRS abused its discretion by refusing to apply the successor trusts' Section 6603 deposits to the original trusts' liabilities, thereby thwarting the statute's purpose of allowing taxpayers to manage exposure to underpayment interest.

The court resolved this claim through a strict textual reading of 26 U.S.C. § 6603(a). The statute dictates that a taxpayer may make a cash deposit "which may be used by the Secretary to pay any tax imposed". The panel observed that "a deposit is not a tax payment until and unless the IRS uses the deposit for a payment," and emphasized that "§ 6603(a) is pointedly permissive". Because Congress used the double permissive phrasing—"may make a cash deposit" and "may be used by the Secretary"—the court concluded that the IRS was granted "discretion without statutory limits to decide when to use a deposit made pursuant to § 6603 as a payment". The court found that the IRS did not act unlawfully or abuse its discretion in refusing to interchange deposits between legally distinct entities based on existing IRS guidance.

Conclusions

The Federal Circuit affirmed the decisions of the Court of Federal Claims in all respects. The appellate panel concluded that the Dillon trusts were properly held liable as transferees because their willful blindness to obvious economic and tax-related red flags imparted constructive knowledge of the buyer's fraudulent scheme. The court affirmed that this constructive knowledge prevented the application of the state law liability cap, and that federal law required the transferees to bear the burden of the underlying tax deficiencies, penalties, and interest. Finally, the panel concluded that the IRS retains broad discretion under 26 U.S.C. § 6603 to determine whether to apply a deposit to a specific tax liability, defeating the taxpayers' illegal exaction claim.

Prepared with assistance from NotebookLM.