When a taxpayer cannot pay its liabilities, Section 6901 of the Internal Revenue Code authorizes the IRS to issue assessments of those tax liabilities against direct and indirect transferees of the taxpayer’s property. The provision is procedural: it doesn’t define who is liable, it merely provides for the use of the assessment procedure in cases against transferees.
Courts have construed Section 6901 to require an examination of two issues:
- Whether a party is a transferee, which is decided under federal law;
- Whether that party is liable as a transferee, which is decided under applicable state law governing fraudulent transfers.
The Second Circuit recently considered the application of Section 6901 in a Midco transaction. Diebold Foundation, Inc. v. Comm’r, 2013 U.S. App. LEXIS 22964 (2d Cir. 2013). The case involved the disposition of a C Corporation, Double D Ranch, with highly appreciated assets. In an effort to maximize the economic benefits from the disposition, its shareholders, which included a foundation, Diebold New York, executed a Midco transaction, selling the stock to an intermediary, which then sold the assets; the intermediary, Shap Acquisition Corporation II, supposedly had tax attributes that would permit it to absorb the gain on the sale of the Corporation’s assets when they were sold.
Shap planned to finance the acquisition with a loan and agreed to repay that loan through an immediate liquidation of Double D’s securities portfolio. 2013 U.S. App. LEXIS 22964, slip op. at *14-*15. It also gave an affiliate of the Double D shareholders an option to purchase certain real estate held by Double D. After closing, the property was sold.
After the shareholders of Double D received their payments from the transaction, Diebold New York dissolved and distributed all of its assets to three new foundations, the Diebold Foundation, the Salus Mundi Foundation, and the Ceres Foundation.
Ultimately, the IRS issued a notice of deficiency against Double D for 100 million dollars, resulting from its determination that the Midco transaction was actually an asset sale followed by a liquidating distribution, and not a stock sale. Id., slip op. at *23. After concluding that the C Corporation had no assets, the IRS began to pursue its remedies against the transferees.
The case in the Second Circuit involved the three foundations that received distributions from Diebold New York upon its dissolution, which were assessed as transferees of a transferee under Section 6901. The Tax Court ruled that Diebold New York was not liable as a transferee, eliminating any liability on the part of the successor foundations.
In considering the government’s appeal, the Court of Appeals began its analysis by considering how to approach the two prongs of Section 6901. The government argued that to satisfy the “transferee” requirement under federal law, it was free to recharacterize the Midco transaction under federal standards to demonstrate that Diebold New York was a transferee and then apply state law to the recharacterized transaction to determine if Diebold New York was liable. Id., slip op. at 32-33.
In contrast, the foundations argued that the two prongs were independent, positing that Section 6901 called for the court to first assess whether there was a transfer under federal law, applying applicable federal standards such as substance over form. If a transfer existed under federal law, the foundations argued that the court also had to determine whether it could recharacterize the transaction under state law in assessing liability. Id., slip op. at 33.
The Tax Court had followed the approach proffered by the foundations and had concluded that New York law required a showing that a transferee had actual or constructive knowledge of the entire scheme that made the challenged transaction fraudulent. When the Tax Court applied this standard, it concluded that there was not a sufficient showing of constructive knowledge and ruled for the foundations. Id., slip op. at *33-*34.
While the Second Circuit agreed with the Tax Court’s decision that Section 6901 required it to determine whether the transaction could be recharacterized under New York law and agreed that the Tax Court applied the correct standard, it reversed on the question whether there was a showing of constructive knowledge. In the Second Circuit’s view, “[t]he Tax Court did not sufficiently address the totality of the circumstance from all of the facts . . . .” Id., slip op. at *43.
It is fairly unusual for an appellate court to reverse a trial court in its application of a correct legal standard to specific set of facts, and the Second Circuit’s opinion is quite detailed in its analysis. Consequently, I will drill into this a bit more in a future post.
Jim Malone is a tax lawyer in Philadelphia. © 2013, Malone LLC.