Controlling shareholder liable for the corporate tax as a transferee
Shareholder liable for the corporate level tax, interest and penalties
TAX ALERT |
On May 31, 2016, the Eleventh Circuit Court of Appeals affirmed the Tax Court’s decision in Cullifer v. Commissioner. In Cullifer, the Tax Court held that a controlling shareholder was liable for the corporate level tax as a transferee under section 6901. The case involved a ‘Midco’ transaction and demonstrates the IRS reliance on state law to allow the IRS to proceed against a transferee of property to recover tax, penalties and interest owed by a transferor.
Generally, a corporation can dispose of its interests in (1) an asset sale, or (2) a stock sale. In an asset sale, the corporation triggers the built-in gain in its appreciated assets, and upon a liquidating distribution to the shareholders, triggers the built-in gain of the stock itself. In addition, the corporation’s payment of the corporate-level tax reduces the amount of cash available for distribution to the shareholders. In a stock sale, the shareholders sell their stock to a third-party, requiring the new owner to take a carryover basis in the assets.
In most cases, buyers prefer to purchase assets and receive a stepped-up basis in the assets equal to the purchase price. In contrast, sellers disfavor the sale of assets because of the attendant corporate-level tax. Because a stock sale merely defers the corporate-level tax liability, a stock sale generally commands a lower sale price than an asset sale.
In Cullifer, Richard Cullifer, a controlling shareholder of Neches Industrial Park, Inc. (Neches), wanted to sell Neches to concentrate on other investments. After being approached by several buyers, a buyer was selected and an agreement reached. However, Cullifer was introduced to MidCoast Investments, Inc. (MidCoast) in an attempt to engineer a transaction to satisfy both buyers and sellers.
To accomplish this goal, the parties used a Midco as an intermediary. Specifically, MidCoast bought the Cullifer’s stock at a purchase price that did not discount for the tax liability. MidCoast did not have any intention, nor financial ability, to later pay the corporate income tax liability when it transferred the proceeds of the sale back to Cullifer. After the stock purchase, MidCoast sold the assets to the buyer. The buyer then got the purchase price basis in the assets. MidCoast kept the difference between the asset sale price and the stock purchase price and treated them as fees. MidCoast accomplished this asset sale without reporting tax liability by transferring distressed debt to Neches. The distressed debt was written off as worthless under section 165, creating losses that allowed it to absorb the built-in gain tax liability. Neches was rendered insolvent as a result of the transactions.
On examination, the IRS disallowed the bad debt deductions that effectively sheltered the gain from the sale of assets. However, Neches was out of business by the time the IRS went to collect the tax due. As a result, the IRS turned to Cullifer as the former shareholder to satisfy the tax liability as a transferee under section 6901.
The Tax Court held, and the Eleventh Circuit affirmed, that Cullifer was liable as a transferee under section 6901. Section 6901 permits the IRS to proceed against a transferee of property to recover federal tax, penalties and interest owed by a transferor if the following three elements are met:
- The transferor is liable for the unpaid taxes
- The party is a transferee within the meaning of section 6901
- The party is subject to transferee liability under state law
The only issue for the Eleventh Circuit was whether Cullifer was subject to a transferee liability under state law.
In this case, transferee liability existed under state law if the transfers at issue were fraudulent. Here, the applicable state law was the Texas Uniform Fraudulent Transfer Act (TUFTA). Under TUFTA, a transfer is fraudulent if the following three element are met:
- The creditor’s claim arose before the transfer was made
- The debtor did not receive a reasonably equivalent value for the transfer
- The debtor was insolvent at the time or the debtor became insolvent as a result of the transfer
The Eleventh Circuit affirmed the Tax Court’s ruling by determining that the transfers were fraudulent under state law, and therefore, transferee liability existed. Specifically, the Eleventh Circuit found that Neches did not receive reasonable equivalent value relating to the transfers made before Neches sold its appreciated assets. With respect to the transfers made after the asset sale, the Eleventh Circuit found that Neches was rendered insolvent by the various Midco-related transfers—transfers designed to shelter any taxable gain from the subsequent sale of assets.
Transactions involving intermediaries, such as Midco-type transactions, have long been identified by the IRS as potential tax shelters. In Cullifer, the IRS effectively used the Texas state fraudulent conveyance statute to establish an improper transfer. The state statute then became the predicate for the IRS to establish transferee liability for tax on the former shareholder. Taxpayers who are contemplating transactions that could be construed by the IRS as Midco transactions should be aware of potential exposure as transferees under section 6901. If engaged in such transactions, taxpayers can potentially find themselves liable for their counterparty’s unpaid taxes, interest and applicable penalties related to the sale or purchase of the property.