Ninth Circuit finds transferee liability in asset sale
Former shareholders found liable for asset sale taxes
INSIGHT ARTICLE |
The Ninth Circuit Court of Appeals reversed a Tax Court decision in Slone v. Commissioner and held that the former shareholders of a closely held corporation were liable for the corporation’s federal tax obligations as transferees under section 6901.
Typically a corporation disposes of its interests in either an asset sale or a stock sale.
- In an asset sale, the resulting transaction will result in tax on any built-in gain in its appreciated assets, and upon a liquidating distribution to the shareholders, results in tax on the built-in gain of the stock. Prior to the liquidating distribution, the corporate-level tax reduces the amount of cash available for distribution.
- 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.
Most buyers prefer to structure transactions as asset sales so the purchased assets have a basis stepped-up the purchase price. Sellers prefer a stock sale to avoid the corporate level tax that accompanies an asset sale, and the corporate-level tax is deferred. As a result, transactions structured as stock sales generally are at a lower price than asset sales.
Slone case summary
In Slone, two separate transactions took place that resulted in a corporation without sufficient assets to pay the tax owed. Initially, Slone Broadcasting Co. (Slone) sold its assets to Citadel Broadcasting Co. Following the asset sale, the Slone shareholders sold their shares to Berlinetta, Inc. and Berlinetta assumed Slone’s income tax liability.
Berlinetta, using borrowed funds, paid the former shareholders an amount equivalent to Slone’s net value after the asset sale, plus a premium representing nearly two-thirds of the amount of Slone’s tax liability. Thus, the former shareholder received two-thirds of the amount Slone should have paid in income tax as a result of the asset sale.
Berlinetta and Slone then merged into a new company.
After the newly formed entity repaid the loan Berlinetta used to purchase Slone’s stock, it had no assets to pay the tax due on the asset sale. The IRS asserted that the former shareholders of Slone owed the taxes resulting from the asset sale as as transferees under section 6901.
In a prior appeal of the same case, the Ninth Circuit held that the correct test to determine whether taxpayers were subject to transferee liability under section 6901 is if:
- The objective and subjective factors show that under federal law the transferor, Berlinetta here, lacked independent economic substance apart from tax avoidance; and
- The transferees are liable for the tax obligation under applicable state law.
Upon remand, the IRS argued that the taxpayers effectively received a liquidating distribution and the form of the stock sale to Berlinetta should be disregarded. The Tax Court applied the Arizona Uniform Fraudulent Transfer Act, but determined it could only disregard the form of the stock sale if the taxpayers knew that the transaction was intended for the surviving entity to avoid paying taxes on the original asset sale. On appeal, the government argued that the Tax Court misinterpreted the Arizona statute to require actual or constructive knowledge.
Overturned on appeal
To determine whether the taxpayers were liable to the government for Slone’s tax liability resulting from the asset sale, the Ninth Circuit applied the Arizona Uniform Fraudulent Transfer Act. In Arizona, a transaction is constructively fraudulent as to a creditor, the IRS, if the debtor, Slone, did not receive a reasonably equivalent value in exchange for the transfer or obligation and the debtor either:
- was engaged or was about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
- intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.
The appellate court determined that reviewing whether the Tax Court misinterpreted the Arizona statute was unnecessary because the record contained sufficient information to show that the taxpayers were on constructive notice that the sale to Berlinetta was a tax avoidance scheme.
Rather than arrange financing that could result in an ongoing business capable of ongoing business operations, the loan Berlinetta obtained to purchase the Slone stock was paid back almost immediately. The resulting transaction was a cash-for-cash exchange that lacked independent economic substance beyond tax avoidance. Indeed, the taxpayer’s own lawyer stated that he had never seen a transaction structured like this transaction.
Transparency and intention matter
The court reviewed what information the taxpayers knew about the transaction. Berlinetta marketed its ability to pay the Slone’s shareholders a premium on account of its ability to eliminate the company’s tax liabilities by “resolv[ing] liabilities at the corporate level,” and Slone’s president and partial owner was surprised that Berlinetta was interested in purchasing Slone after the asset sale.
Slone’s tax advisors recognized that the stock deal with Berlinetta only made sense from Berlinetta’s perspective if the asset sale tax liability was eliminated. Slone’s inquiries into the transaction details were rebuffed by Berlinetta with Berlinetta stating that the details were proprietary. Additionally, a memo from the taxpayers’ counsel stated that Berlinetta would distribute almost all of Slone’s cash to repay the loan used to finance the deal.
As a result, the Ninth Circuit did now allow the taxpayers to shield themselves through willful blindness, rather found that they were on constructive notice.
By looking to the substance of the transaction, rather than the form, the court found that Berlinetta was merely the entity through which Slone passed its liquidating distribution.
The court determined that the sale of Slone’s stock to Berlinetta and Berlinetta’s assumption of Slone’s tax liability was substantively a liquidating distribution. Following the distribution, neither Slone nor Berlinetta was able to satisfy Slone’s tax liability.
Key takeaways for business transactions
Transactions, sometimes called Midco transactions, with an intermediary entity, such as Berlinetta, that result in an insolvent entity unable to satisfy its tax obligations have long been identified as tax shelters.
The IRS, in Slone and other section 6901 cases, has successfully used state statutes to shift tax liability to transferees. Taxpayers considering similar transactions must recognize that they face the potential tax liability of the entity from which they are trying to divest themselves, and should consult with a tax advisor to perform a thorough review of the potential transaction.