William Kardash was a minority shareholder in a Florida company involved in the construction industry; the majority shareholders were skimming cash from the company, apparently without his knowledge or complicity. Kardash wound up with a significant tax bill for the company’s taxes, as the Eleventh Circuit ruled that he was liable as a transferee under section 6901 of the Internal Revenue Code and applicable state law. Kardash v. Comm’r, No. 16-14254, 2017 U.S. App. LEXIS 14389 (11th Cir. Aug. 4, 2017).
Transferee liability represents one of several theories that the IRS can use to hold one person liable for another person’s taxes. Section 6901(a) of the Internal Revenue Code provides the IRS with authority to pursue “[t]he liability, at law or in equity, of a transferee of property,” including “a taxpayer in the case of a tax imposed by subtitle A (relating to income taxes).” I.R.C. § 6901(a)(1)(A)(i). Other potential targets include transferees of the decedent in estate tax cases and transferees of the donor in gift tax cases. I.R.C. § 6901(a)(1)(A)(ii), (iii). Transferee cases typically arise in two distinct ways:
- Cases from the collection division generally start when the IRS sends the target a notice of nominee or alter-ego tax lien; typically a notice of nominee or alter-ego levy follows quite quickly, and the target’s property gets seized.
- Transferee cases from the examination division proceed at a more civilized pace; the IRS has authority to issue a transferee assessment under section 6901 of the Code, and the alleged transferee then can petition the Tax Court to review that assessment.
Kardash arose from an examination of the relevant corporation, Florida Engineered Construction Products Corp. (“FECP” or the “Company”); the IRS audited the Company and assessed it with over $120 million in tax, penalties, and interest. Kardash, 2017 U.S. App. LEXIS 14389 at *3-*4. The IRS pursued Mr. Kardash and another minority shareholder because the Company could not afford to pay the amounts assessed.
The problem was that the two majority shareholders treated FECP as a personal piggy bank, siphoning off millions of dollars. Id. at *3 & n.2. After striking deals with the majority shareholders to recoup certain transfers, the IRS pursued Mr. Kardash and another minority shareholder to recover funds they had received from the Company. As the Court of Appeals explained, the IRS pursued two categories of payments: The first category of payments were “Advance Transfers” that Mr. Kardash received of $250,000 in 2003 and of $300,000 in 2004; the second category consisted of dividend payments of $1.5 million in 2005, $1.9 million in 2006, and $57,500 in 2007. Id. at *4-*5. The assessment against Mr. Kardash was based upon section 6901 of the Code and Florida law, specifically, its version of the Uniform Fraudulent Transfer Act.
While Mr. Kardash prevailed on the “Advance Transfers” in Tax Court, he lost on the more significant issue of the dividend payments. On appeal, Mr. Kardash raised a series of issues that the lower court had rejected:
- First, he argued that the IRS was required to exhaust all reasonable collection efforts against FECP before it could pursue him;
- Next, he argued that the payments labeled as dividend payments were really compensation that could not be recouped as a fraudulent transfer; and
- Finally, Kardash argued that his 2005 dividend payment was not recoverable because it was made before the Company became insolvent.
The Eleventh Circuit commenced its analysis with the exhaustion argument. Although the Tax Court had dismissed this argument summarily, the Court of Appeals weighed the issue carefully. Focusing on the text of section 6901, which provides for the IRS to pursue the liability of a transferee “at law or in equity,” the court ruled that there was an exhaustion requirement if the IRS pursued a transferee under federal equity principles. Id. at *8-*9. But the statute also authorizes the IRS to pursue transferee liability “at law,” and the relevant Florida statute did not include an exhaustion requirement. Id. at *10. Consequently, the Eleventh Circuit rejected the exhaustion argument.
The Court of Appeals then addressed whether the IRS could recover the dividend payments under Florida law. Initially, Kardash sought to recharacterize the payments as compensation, which would have permitted him to argue that the Company received reasonably equivalent value for the payments, taking them outside the ambit of the Uniform Fraudulent Transfer Act. While the theory was clever, several facts got in the way:
- The parties labeled them as dividends;
- The Company reported them to the IRS on Form 1099-DIV;
- The amounts were based on the number of shares that Kardash held;
- And for good measure, Mr. Kardash reported the payments on his returns as qualified dividends, thereby “paying a lower marginal rate on the distributed dividends than he would have paid if the transfers were reported as bonus compensation.” at *12.
Kardash pressed the court to look at the substance of the payments, but the Eleventh Circuit found no basis in the record to support an argument that the dividend payments were actually part of his compensation arrangements. Id. at *13-*14.
Next, the Court of Appeals examined Kardash’s 2005 payment of $1.5 million, which was made at a time when the Company was not insolvent. Under Florida’s Uniform Fraudulent Transfer Act, in the absence of actual fraud, a claimant has to show that the transferor was insolvent of the time of the challenged transfer or that the transferor was rendered insolvent by it, a common requirement under state law. The Eleventh Circuit noted that courts had interpreted this language to include situations in which a series of related transactions triggered insolvency. Id. at *15. The Tax Court had applied this principle and had grouped Kardash’s payment of $1.5 million together with dividend payments of $16.6 million and $21.5 million that were made to the majority holders.
While recognizing that Kardash’s own payment was modest, the Eleventh Circuit concluded that it was properly grouped with the other dividend payments, since all of the payments were dividends and the differences in amounts reflected the relative holdings of the recipients. Id. at *16. With the payments grouped together, the Court of Appeals ruled that the Tax Court properly concluded that they were sufficient to have rendered FECP insolvent. Id. at *17.
Kardash offers a textbook example of both how transferee liability operates and of how unfair it can seem to be. As the court notes, Mr. Kardash “was a victim of the fraud conducted by his friends and coworkers at FECP.” Id.
The case also provides a cautionary tale for investors in small businesses: Sometimes what you don’t know can hurt you.