Transferee Liability and the Application of Federal versus State Law

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We welcome back guest blogger Marilyn Ames.  Marilyn has retired from the Office of Chief Counsel, IRS to the 49th state where she enjoys shoveling snow and other outdoor activities.  She also works with me on the collection chapters of the Saltzman and Book treatise, IRS Practice and Procedure.  Today, she writes about a recent case in which the IRS asserted transferee liability.  Based on the number of transferee cases I am seeing, I believe that the IRS has stepped up activity in this area over the past couple of years.  For those of you interested in transferee liability, Marilyn wrote an earlier post on the subject that you may also want to view.  Keith

In an opinion issued on December 16, 2016, the Seventh Circuit Court of Appeals played Grinch in Eriem Surgical, Inc. v. United States and gifted the Internal Revenue Service and the taxpayer with an opinion calculated to make both unhappy.  The opinion can be found here and at 843 F3d 1160.

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Eriem Surgical purchased the inventory of Micrins Surgical, Inc. when it went out of business in 2009 without paying its taxes.  Eriem also took over Micrins’ office space, hired its employees, used its website and telephone number, and continued Micrins’ business of selling surgical instruments.  Eriem also used the name “Micrins” as a trademark, and Bernard Teiz, the former president of Micrins, continued to play a leading role in Eriem’s business. All of this raised the suspicions of the Internal Revenue Service, although Mr. Teitz attempted to quell those suspicions by having his wife hold the 40% interest in Eriem that he formerly held in Micrins.  But this was not enough, and the Internal Revenue Service concluded that Micrins had simply morphed into Eriem, and levied on Eriem’s bank account and receivables.  Eriem then filed a wrong levy suit under 26 USC §7426(a)(1). The district court applied Illinois state law to determine that Eriem was a successor to Micrins, and as such, was liable for Micrins taxes.  Although Eriem appealed, the United States used this as an opportunity to make an argument that the courts have rejected up to this time.

The courts have long held that whether a third party is liable under some doctrine of transferee liability is dependent on state law. However, for the past few years, the Internal Revenue Service has taken the position that federal common law should govern whether a third party is the alter ego of the taxpayer, arguing that the application of state law leads to different results depending on the law of the applicable state and, consequently, to disparate treatment of taxpayers in essentially the same position. In staking out this position, the IRS has relied in part on United States v. Kimbell Foods, Inc., 440 US 715 (1979) and Drye v. United States, 528 US 49 (1999). The Service’s argument can be found in Chief Counsel Notice 2012-002 (Dec. 2, 2011), which can be located here.  The essence of the Service’s position is that state law should not control in an alter ego dispute, as the question is not one of property rights, but is an issue of the identity of the taxpayer. Since the IRS is ultimately interested in reaching property, not just engaging in identification of the taxpayer, this seems to some extent to be a distinction without a difference – at least without a difference that would matter to the third party/taxpayer.

On appeal, the Seventh Circuit confronted the question of whether state or federal law governed with respect to corporate successorship, and held that since the Internal Revenue Code does not say anything about this issue, “it seems best to apply state law.”  The court held that Kimbell Foods is not dispositive, as the Supreme Court has failed to cite it in later cases for the proposition that federal law controls, and that Drye expressly states that “in tax cases state law determines the taxpayer’s rights in property that the IRS seeks to reach.” Although it is not clear from the opinion if the United States argued that this was really just a case of identity, it’s doubtful that the court would have bought the argument, given that this case was really about the IRS cleaning out Eriem’s bank account.  The Seventh Circuit affirmed the district court’s application of Illinois law, thus ensuring that Mr. Teitz and Eriem were also unhappy with the result.

In an interesting sideshow to the federal/state law question, the Seventh Circuit also rejected Eriem’s argument that the 40% change in ownership had “dispositive significance.” Although Illinois law holds that a complete change of ownership prevents a finding of successorship, the Seventh Circuit affirmed the district court’s conclusion that Mrs. Teitz was serving as a proxy for her husband, and so the purported change in ownership was irrelevant.

Whether the IRS and the Department of Justice will continue to argue that there is a federal common law that should determine when a third party is an alter ego for purposes of tax collection remains to be seen, since it has not been popular with the courts.  In most cases, it doesn’t seem to make a difference to the end result, and may simply be a cut-and-paste argument the government is making to bolster its position.

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