Tax Litigation Update: Ninth Circuit Enforces Two-Prong Test to Determine Transferee Tax Liability
June 23rd, 2015
On June 8, 2015, the United States Court of Appeal for the Ninth Circuit reversed the decision of the United States Tax Court after the Tax Court failed to apply the correct legal standard to determine transferee tax liability, which resulted in an improper determination to disregard the form of a transaction. In Slone Revocable Trust v. Cir., available here, the Ninth Circuit presented the correct test to impose tax liability on a transferee. The test, which the Court applied from Comm’r v. Stern, 357 U.S. 39 (1958), available here, requires asking both:
- Is the party a “transferee” under 26 U.S.C. § 6901 and federal tax law?
- Is the party substantively liable for the transferor’s unpaid taxes under state law?
The Ninth Circuit held that the Tax Court erroneously analyzed both prongs, and therefore remanded the case back to Tax Court for proper determination.
The Slone Revocable Trust case involved two sales related to Slone Broadcasting Co., a radio broadcasting business. In the first sale, Slone Broadcasting Co. sold almost all of its assets to Citadel Broadcasting Co. for $45 million. Slone Broadcasting realized a capital gain of about $38.6 million, which carried with it an income tax liability of $15.3 million. After the sale, no distributions were made to the shareholders. Slone Broadcasting made its first federal income tax payment three months after the sale for $3.1 million.
Before the transaction closed, Fortrend International, LLC proposed a merger deal with Slone wherein Fortrend would purchase all of Slone Broadcasting’s shares for $29.8 million. Fortrend then offered to restructure Slone to engage in the asset recovery business. Slone Broadcasting’s tax attorney green-lighted the deal, but the shareholders continued to ask for information regarding the methods Fortrend would use to reduce the shareholders’ tax liability. Fortrend only said the methods were “proprietary” and assured Slone that the transaction would not be “listed” pursuant to IRS Notice 2001-51, 2001-2 C.B. 190. Slone Broadcasting’s shareholders sold their shares to another company, Berlinetta Inc. (later known as Arizona Media) for $33 million. Several years later Arizona Media was administratively dissolved for failure to file an annual report.
The IRS ultimately sent notices of liability to the former shareholders of Slone Broadcasting for a tax deficiency in the amount of $13.5 million, along with a penalty of $2.7 million and interest of $7.3 million. The notice said the shareholders were liable as “transferees” of the assets. The IRS aimed to disregard the form of the shareholders’ sale of stock to Berlinetta, but the Tax Court concluded that the form of the stock sale should be respected, rejecting the IRS’s theory.
Properly Applying Stern
The Commissioner of the IRS can assess tax liability against a taxpayer who is the transferee of assets of a taxpayer who owes income tax under 26 U.S.C. § 6901. The Court noted that while federal law addresses the procedure for collecting tax liabilities from a transferee, state law determines whether that transferee is substantively liable. This is where the Ninth Circuit brought in the Stern test, which is a two-prong inquiry the Court uses to determine transferee tax liability
In the first prong, which asks whether the party is a transferee under federal law, a transferee can be a “done, heir, legatee, devisee, or distributee,” but can also be a “shareholder of a dissolved corporation” under 26 C.F.R. § 301.6901-1(b). As for the second prong, the Stern test asks about substantive liability, and while it depends on the law of the state where the transfer occurred, the test typically requires showing that the transferee had “actual or constructive knowledge of the entire scheme that renders its exchange with the debtor fraudulent.”
If the form of stock sale transaction between the shareholders and Berlinetta is respected, the shareholders did not receive a liquidating distribution and therefore are not transferees of the assets. Thus, the question was whether the Tax Court erred in respecting the form. The Commissioner argued that the Tax Court erred in analyzing the first prong of the Stern test, and the Ninth Circuit agreed.
The Ninth Circuit held that case law requires courts to consider both subjective and objective factors in characterizing a transaction for tax purposes. This test turns on whether the taxpayer has shown a business purpose other than tax avoidance, and whether the transaction had economic substance beyond the creation of tax benefits. The Court related this idea to the “economic substance doctrine,” and the “substance-over-form doctrine” as part of similar common law which looks at the transaction’s business purpose and economic reality. If an analysis of these factors leads to the conclusion that the transaction has no non-tax business purpose or economic substance, then the form of the transaction should be disregarded.
With all of this in mind, what was the Tax Court’s mistake, exactly? The Ninth Circuit found that the court did not address either subjective or objective factors in characterizing the transaction, as it did not determine any business purpose or economic substance. The Ninth Circuit held that the Tax Court mainly focused on evidence of the shareholders’ lack of actual or constructive knowledge of the tax evasion scheme. It only used this evidence to conclude the form of the sale should be respected under the first prong of the Stern test, but did not use it to analyze shareholders’ liability under the state law in the second prong.
The Commissioner argued that the Tax Court should have found the transaction to be liquidating in substance, just a “shell with nothing but cash and significant tax liabilities.” The Slone Broadcasting shareholders disagreed, arguing that they had potential to acquire another radio station and no improper motivations for the sale. The shareholders also pointed to Fortrend’s debt recovery proposal as evidence of economic substance. The Ninth Circuit felt it could not resolve the dispute because the Tax Court failed to apply the proper test in the first place.
The Ninth Circuit instructed the Tax Court to apply relevant subjective and objective factors to determine whether the Commissioner erred in disregarding the form of the transaction in order to impose tax liability on shareholders as “transferees” in the first prong, and instructed the court to analyze whether the shareholders were substantively liable under state law in the second prong.
The takeaway from the Ninth Circuit’s decision is that the Courts of Appeal will require the Tax Court, and the taxpayers litigating in the Tax Court, to apply the proper test and introduce into the record sufficient evidence to justify and support a taxpayer’s claim that he/she should not be subject to transferee liability. While not a total win for the IRS, neither is it a total loss for the taxpayer. Both parties are now left to, again, try the case before the Tax Court, which must determine whether the taxpayer is subject to transferee liability.
The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation. They will continue to monitor developments in this area of the law. If you have any questions, an attorney can be reached by emailing us at firstname.lastname@example.org or by calling 305.350.5690.