Transferee Liability: Recent Developments
by David E. Kahen, Elliot Pisem
Published: April 21, 2011
Source: New York Law Journal
Originally published in: The New York Law Journal April 21, 2011 Transferee Liability: Recent Developments By: David E. Kahen and Elliot Pisem Sellers of corporate stock have long been concerned about whether and under what circumstances they may be held liable for unpaid Federal income tax liabilities of the corporation for the tax year during which the stock is sold (or prior periods). Obviously, a selling stockholder who has assumed the liability or indemnified the buyer by contract may be liable, and liability may also arise under specialized tax regimes, such as the rules applicable to an affiliated group of corporations electing to file a consolidated return. Even apart from such situations, however, a selling stockholder might conceivably be held liable for such taxes under provisions of the Internal Revenue Code (“Code”) relating to “transferee liability” and under doctrines of state law intended to protect creditors against fraudulent conveyances. The Code provides, in general, that liabilities of a transferee of property for specified taxes of the transferor may be assessed, collected, and paid in the same manner as provided elsewhere in the Code for collecting such taxes from the transferor. This provision of the Code, however, is only procedural, and it does not provide an independent basis for the imposition of liability on the transferee. Rather, the transferee’s liability may arise under David E. Kahen and Elliot Pisem are partners in the law firm of Roberts & Holland LLP. State statutes and case law, such as under state laws that provide protection to creditors with respect to a debtor that makes a fraudulent transfer. The IRS has within the past decade advocated on multiple occasions the application of concepts of transferee liability as one of its tools to combat so-called “Intermediary” or “Midco” transactions, which were listed as abusive by IRS Notice 2001-16. In one form of such transaction, the stock of one corporation (T) is sold by its shareholder (X) to another corporation (M). Pursuant to a single overall plan, the assets of T are then sold to a buyer (Y) for a gain, but M (or T, or another member of the group of which M and T are members) reports losses that purportedly offset the gain from the sale of assets by T. The IRS has argued, among other things, that, if T or M ultimately fail to pay the taxes owed with respect to the asset sale, X may be held liable under various theories, for example, on the theory that the assets should be viewed as having been sold by T before the sale of T stock by X, and that the sales proceeds should then be viewed as having been distributed by T to X in a constructive liquidation, thereby making X liable as a “transferee” for T’s unpaid tax. If a selling stockholder was to be liable as a general matter for potential corporate tax liabilities of the target in the year of sale, the selling stockholder would face a conundrum, whenever a corporation has a built-in tax liability by reason of, say, low-basis but high-value assets, in terms of how to protect himself against potential liability that might result from actions by the purchaser of the stock, after the closing of the stock sale, that the seller cannot effectively foresee or control. However, in two recent Tax Court memorandum decisions (with opinions issued on the same date by two different judges of the court), the court rejected arguments made by the Commissioner for the imposition of transferee liability on selling stockholders. Griffin v. Commissioner Douglas Griffin was a founder and ultimately the sole stockholder (before the transactions that were the principal focus of the case) of HydroTemp Manufacturing Company, Inc., a corporation incorporated and doing business in Florida that manufactured, designed, and sold swimming pool heat pump equipment and hot water generators. Pentair Corporation, the largest customer of the heat pump equipment business, made repeated offers to purchase that business, and ultimately the assets of that business and the rights to the HydroTemp name were sold to Pentair on January 30, 2003, for $8.3 million. The projected federal and state income tax liabilities of HydroTemp resulting from the sale were approximately $2.6 million. HydroTemp retained manufacturing and other equipment, inventory unrelated to the heat pump assets, and accounts receivable, and continued to employ five to ten employees. The corporation agreed to change its name following the sale, but encountered delays in the certification by the Secretary of State of the name change. To facilitate the investment of corporate funds pending completion of the name change and the opening of an account under the new name, $5 million of the sale proceeds was lent to Griffin for an interest-bearing demand note payable to HydroTemp. Griffin held the proceeds in a brokerage account in his own name pending completion of the name change. HydroTemp also lent $300,000 to Griffin on a non-interest bearing basis, but retained approximately $500,000 of cash in its own non-interest bearing account. Griffin was approached by several people that desired to assist HydroTemp in investing the sale proceeds or to purchase the stock of HydroTemp. He ultimately decided to sell the stock to MidCoast Credit Corporation, which, according to its representatives, was engaged in an asset recovery business intended to maximize the value of delinquent accounts receivable and other residual assets of formerly robust businesses. MidCoast proposed initially to purchase the stock of HydroTemp for a purchase price computed as the amount of its cash, minus 52% of its estimated tax liability, plus $25,000 for reimbursement of expenses. The stock sale was ultimately effected on June 13, 2003, though a series of transactions in which: HydroTemp redeemed a portion of its outstanding stock by extinguishing $3.8 million of the interest-bearing debt owed to it by Griffin; Griffin sold the balance of his stock to MidCoast for a note from MidCoast equal to the amount that Griffin still owed HydroTemp under his interest-bearing note ($1.4 million); and the MidCoast note was assigned by Griffin to HydroTemp in satisfaction of the balance of Griffin’s debt in the same amount to HydroTemp. Griffin repaid $200,000 of the interest-free loan to him by HydroTemp and treated the balance of the loan (presumably forgiven) as income. Griffin also received $37,000 in cash from MidCoast, and MidCoast agreed to satisfy all tax liabilities incurred by HydroTemp before the stock sale. Following the stock sale/redemption transactions, HydroTemp has assets on its balance sheet of $2.6 million (primarily cash and the MidCoast note) and tax liabilities of $2.4 million, resulting in a net equity of approximately $200,000. HydroTemp filed a tax return for its fiscal year ended June 30, 2003, reporting the gain from the asset sale and an almost entirely offsetting loss from what appears to have been a “structured transaction” involving the sale of “binary options.” Following an audit of HydroTemp, the IRS disallowed the binary option loss and determined a corporate tax deficiency together with a 40% accuracy-related penalty. HydroTemp did not dispute the resulting notices of deficiency. However, the IRS had no success in its efforts to collect the tax assessment from HydroTemp, so a notice of transferee liability was then issued by the IRS to Griffin, asserting that substantially all the assets of HydroTemp, including the Pentair sales proceeds, had been transferred to Griffin following the sale of the assets of HydroTemp to Pentair. Griffin, after making extensive but ultimately unsuccessful efforts to cause MidCoast to pay the tax assessed against HydroTemp, filed a petition in Tax Court to contest the IRS determination that he was liable for that tax as transferee. The parties before the Tax Court agreed that Florida law was controlling in determining whether Griffin was liable for HydroTemp’s taxes. The Tax Court concluded that the transactions with Pentair and MidCoast could not be collapsed, as asserted by the Commissioner, into an asset sale followed by a liquidating distribution of the proceeds, but were independent transactions that had to be analyzed separately. The court further concluded that neither the asset sale nor the transfers of stock represented a fraudulent conveyance, in that HydroTemp remained solvent, with assets in excess of its liabilities (principally the income taxes resulting from the asset sale), after each of the transactions in which Griffin was involved. The court also concluded that the Commissioner failed to demonstrate that either the asset sale or the stock redemption/sale was (otherwise) fraudulent. Accordingly, the court found that Griffin was not liable as transferee for the unpaid taxes of HydroTemp. Starnes v. Commissioner In Starnes, Tarcon, Inc., a C corporation the stock of which was owned by four individuals residing in North Carolina and South Carolina, terminated its business operations (relating to freight consolidation) and, between January 1 and October 31, 2003, sold its vehicles (to its shareholders) and its North Carolina and South Carolina real property. Prior to the final sale of real property, a transaction was negotiated with MidCoast Credit Corp. (the purchaser that was involved in Griffin!), whereby the stock of Tarcon would be sold to MidCoast after the final asset sale for a price calculated as Tarcon’s remaining cash of $3 million minus 56.25% of its estimated federal and state corporate tax liabilities ($880,000), with an adjustment to reimburse Tarcon’s shareholders for their legal and accounting fees. On November 13, 2003, the Tarcon shareholders entered into a share purchase agreement with MidCoast and, on or about the same day, received the price calculated in the manner described above ($2.6 million) in exchange for their shares. MidCoast agreed to assume responsibility for filing tax returns for Tarcon for 2003 and to pay any tax due for that period. The Tarcon corporate tax return for 2003 reported the gains from the asset sales, and losses from the disposition of other property that was shown on the tax return as having been acquired and sold by Tarcon during the last 3 days of December. Those losses were disallowed on audit. After Tarcon failed either to contest or to pay the resulting tax deficiency (with penalty) of approximately $1.2 million, the IRS issued notices of transferee liability to the former shareholders of Tarcon for those amounts. An explanation accompanying the notices stated that “the stock sale and the transactions involving the sale of Tarcon, Inc.’s assets . . . are determined to be, in substance, a sale of the assets of Tarcon, Inc. followed by a distribution by Tarcon, Inc. of its proceeds to its shareholders.” The explanation further asserted that the transaction was substantially similar to an “Intermediary” transaction shelter described in Notice 2001-16 or, alternatively, that the transaction was a sale of assets followed by a redemption of stock owned by the former shareholders (with those shareholders presumably being viewed as having received the proceeds of the asset sale through the redemption). The Tax Court opinion observes that the existence of liability on the part of the transferee must be determined by reference to the law of the state where the transaction took place - in this case, North Carolina. The opinion further observes that the transactions at the closing -- which included the movement of cash from Tarcon’s old bank account to an account of the purchaser’s attorney, followed by a transfer from that account to a new account of Tarcon the day after the closing -- did not cause Tarcon to be insolvent at any time; that Tarcon had assets well in excess of its estimated tax liabilities at all times though the date of closing; and that there was no other indication that Tarcon was insolvent on the date of transfer. The court concluded that the evidence did not establish that the former shareholders of Tarcon had knowledge of Tarcon’s post-closing activities, or that the transfers in which those shareholders were involved were made to defraud creditors. Because the Commissioner had failed to establish either that a fraudulent transfer occurred un der North Carolina law, or that there were circumstances establishing that the former shareholders, as directors, otherwise owed a fiduciary duty to the government under state law, the petitioners were not liable for the unpaid tax of the corporation. Observations The government may continue to press the arguments that it made in Griffin and Starnes, on appeal or against other transferees in similar circumstances. However, the likelihood of the government being able to collect unpaid corporate taxes from selling stockholders appears to be dwindling, at least in circumstances where the stockholders (i) sold their stock for funds furnished by the buyer from sources other than the asset sales and (ii) had no actual knowledge of any plan by the purchaser to seek to shelter income from asset sales with other losses or in some other manner to avoid payment of the taxes due from the corporation.