Transferee Liability When Selling a Corporation

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We welcome back guest blogger Marilyn Ames who writes about an important recent 9th Circuit opinion reversing and remanding a Tax Court decision regarding the proper standard to apply in transferee liability cases.  Marilyn, a Chief Counsel retiree and current resident of Alaska, is working with me to revise and update Chapter 17 of Saltzman and Book on transferee, trust fund and other derivative tax liability issues.  Keith

In its second opinion on the issue of transferee liability issued within a year, the Ninth Circuit recently took the Tax Court to task in the case of Slone v. Commissioner, 2015 WL 5061315 (August 28, 2015), and remanded the case, instructing the Tax Court to use the correct legal standard in applying Section 6901 of the Internal Revenue Code to the transaction in question.  In doing so, the Ninth Circuit expanded the analysis to be used in determining when a person is liable as a transferee, which it first set out as a two-prong test a year earlier in Salus Mundi Foundation v. Commissioner, 776 F.3d 1010 (9th Cir. 2014). In the Slone case, the Ninth Circuit recognized it was breaking new ground, holding: “Although we have not previously considered how a court should analyze a transaction for purposes of transferee liability under § 6901, both the Supreme Court cases, and our own precedent, require us to look through the form of a transaction to consider its substance.”

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In order to understand the breadth of the Ninth Circuit’s holding, a review of the facts in the Slone case is necessary. The facts in Slone are not simple.  Slone Broadcasting Co. sold all its assets to Citadel Broadcasting Co. for $45 million. Before this transaction closed, Fortrend International, LLC approached the shareholders of Slone and suggested a merger with Slone Broadcasting, with an alleged eye to restructuring the resulting company to engage in asset recovery. The shareholders agreed, and after the asset sale, sold their shares of Slone to Berlinetta, Inc., an affliate of Fortrend, for $35.8 million.   At this point, Slone no longer had its radio broadcasting network, but did have a lot of cash and a tax liability of about $15 million from the sale of its assets. Berlinetta agreed to assume Slone’s income tax liability, and the Slone shareholders received cash payments for their stock totaling $33.6 million.

Slone then merged with Berlinetta, and the remaining company changed its name to Arizona Media Holdings Inc. Within days of the sale of the stock, an unnamed shareholder of the new Arizona Media contributed Treasury bills with a basis of $38.1 million to the new company.  Arizona Media then sold the bills for $108,731.  When Arizona Media filed its tax return for this fiscal year, it reported a $37.9 million gain from the sale of Slone’s assets, claimed a loss of $38 million from the Treasury bill sale, and no tax liability.  It then requested a refund of the $3.1 million tax payment previously made by Slone, which the IRS granted.

Once the IRS took a closer look at Arizona Media’s return, it was not so agreeable.  Eventually, the Service assessed a deficiency against Arizona Media in the amount of $13.5 million, along with interest and penalties.  Arizona Media paid nothing towards this liability, and the next year the state of Arizona dissolved Arizona Media for failing to file its annual report.  Once again, the IRS was not happy and looked around for another party to tap for the unpaid bill.  Using Section 6901, the IRS determined that the shareholders were liable as “transferees” of Slone, taking the position that the substance of the transactions was that Slone dissolved when it sold its assets to Citadel, and the remaining assets – consisting of the cash from the asset sale – were then distributed to the shareholders through the transaction put together by Fortrend. According to the Commissioner, the Slone shareholders were transferees as they received the assets of a taxpayer who owes income tax. The Tax Court disagreed with the Commissioner, holding that it would respect the form of the transactions, so the shareholders were not the transferees of Slone.  The Service was again unhappy, and appealed to the Ninth Circuit.

It was here that the Commissioner got some limited satisfaction.  The Ninth Circuit found that the Tax Court had applied an incorrect legal standard in characterizing the transaction for tax purposes. The Court, at length, instructs the Tax Court on the standard it should have applied, holding that determining whether a person is a transferee requires a two-prong inquiry.  The first prong requires an analysis of federal law to determine if the person is a transferee under Section 6901 and federal tax law.  The second prong of the test requires an analysis of whether the person is substantively liable for the transferor’s unpaid taxes under applicable state law because of the receipt of the transferor’s property, using the state’s fraudulent conveyance law.  The two prongs are separate and independent inquiries, according to the Ninth Circuit.

The Ninth Circuit’s focus in Slone is on the first prong, with a new emphasis on looking at what a transaction actually is.  Citing Frank Lyon Co. v. United States, 435 U.S. 561 (1978), and Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990), the Ninth Court outlines another two-part test for determining whether a transaction is a sham: was there a business purpose for the transaction, and has the taxpayer shown the transaction had economic substance beyond the creation of tax benefits? Although the Ninth Circuit outlines a two-step test, which should consider both subjective and objective factors, the Court suggests a “holistic” analysis rather than a rigid application of the two steps.  In other words “If a common sense review of the transaction leads to the conclusion that a particular transaction does not have a non-tax business purpose or ‘any economic substance other than creation of tax benefits,’ the form of that transaction may be disregarded, and the Commissioner may rely on its underlying economic substance for tax purposes” (citing Reddam v. Commissioner, 755 F.3d 1051 (9th Cir. 2014)).

Using this newly articulated standard, the Ninth Circuit concludes that the factors the Tax Court looked at in reaching its decision were not relevant to determining whether the transactions in question had a “business purpose . . .other than tax avoidance, or whether the stock purchase transaction had economic substance other than shielding the Slone Broadcasting shareholders from tax liability.” The Tax Court’s findings were, the Court opined, factors that related to the question of whether the shareholders had knowledge that would make the transaction fraudulent under state law.  And so the Ninth Circuit sent the Slone cases back to the Tax Court to apply the correct legal standard.

Whether the IRS will be happy at the end of the day remains to be seen.  Although the Tax Court may not have applied the correct factors in reaching a conclusion as to the first prong, the Tax Court did make factual findings that would support a negative conclusion that the Slone shareholders had acted fraudulently under state law, the second prong of the test to impose transferee liability under Section 6901.  Since both prongs must be met to impose liability, the Commissioner may simply have won one battle, the overall impact of which remains to be seen.

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