Current Tax Developments: Trusts Liable as Transferees for Tax on Estate Asset Sale Hawk, TCM 2017-217
In Hawk, the Tax Court held that testamentary trusts were liable as transferees for the tax liability incurred by an estate as a result of the sale of estate assets.
At the time of his death in February 2000, Billy Hawk managed two bowling alleys in Tennessee that he and his wife owned through Holiday Bowl, a corporation. Mr. Hawk owned approximately 81% of Holiday Bowl's stock, and Mrs. Hawk owned the remaining 19%.
In July 2003, the co-executors of Mr. Hawk's estate, Mrs. Hawk and a corporate trust company, sold the two bowling alleys owned by Holiday Bowl to Corley Family Realty, LP, an unrelated third party, for $6.5 million. From the sale, Holiday Bowl received net proceeds of approximately $4 million, realized gain of approximately $2.7 million, and owed approximately $1 million in federal income tax. After the asset sale, Holiday Bowl's assets consisted of cash and prepaid taxes. It had no operating assets and ceased to engage in any business activity.
In November 2003, MidCoast Investment, Inc., an unrelated third party, purchased from the estate the stock of Holiday Bowl for approximately $3.4 million, a price equal to Holiday Bowl's cash less 64.25% of its estimated 2003 tax liability. At closing, Holiday Bowl was required to deposit its cash of approximately $4.2 million into escrow. Five minutes after receiving the escrow, the escrow agent transferred to the estate the purchase price of $3.4 million. The estate distributed the sales proceeds from the stock sale to a generation-skipping transfer (GST) exempt trust and a GST non-exempt trust.
On the same day it purchased the Holiday Bowl stock, MidCoast borrowed $3.4 million from Sequoia Capital, LLC. Also on the same day, MidCoast resold the Holiday Bowl stock to Sequoia for a slightly higher purchase price. Sequoia paid for the Holiday Bowl stock through a credit against the Sequoia loan. The taxpayers and their advisers were not aware of MidCoast's plan to immediately resell the Holiday Bowl stock to Sequoia. Neither Sequoia nor MidCoast placed Holiday Bowl into an active business after the closing.
During the negotiations, MidCoast represented that it was in the asset recovery business and as such was among the largest purchasers of delinquent consumer receivables. MidCoast also represented that the stock transaction would maximize the after-tax proceeds to the estate as compared to a liquidation of Holiday Bowl. In addition, MidCoast represented that it was interested in purchasing the stock of Holiday Bowl so that MidCoast could develop an asset recovery business within Holiday Bowl and use the start-up expenses to offset Holiday Bowl's gain. The accountant for Holiday Bowl calculated that the estate received an after-tax benefit from the MidCoast transaction of $386,237 over a liquidation of Holiday Bowl.
Holiday Bowl filed its corporate income tax return for 2003 and reported no tax liability. The IRS examined the income tax return and issued a notice of deficiency to Holiday Bowl in July 2007. The deficiency determination resulted primarily from the disallowance of loss deductions relating to the disposition of interest rate swap options and offsetting DKK/USD binary options executed after the MidCoast transaction. In December 2007, the IRS assessed tax and a penalty against Holiday Bowl for 2003 as determined in the notice of deficiency, plus interest. Holiday Bowl did not pay any portion of the assessment. The IRS investigated Holiday Bowl's financial status and determined that it did not have assets to pay the deficiency. In September 2009, the IRS issued notices of deficiency to the GST exempt trust, the GST non-exempt trust, and Mrs. Hawk determining that they were liable for Holiday Bowl's 2003 unpaid tax as transferees.
Section 6901(a)(1) provides that the IRS may proceed against a transferee of property to assess and collect federal income tax, penalties, and interest owed by the transferor. Section 6901(a) does not create a substantive liability but merely provides a procedural mechanism for the IRS to collect the transferor's existing unpaid tax liability. Under Section 6901(a), the IRS may establish transferee liability if an independent basis exists under applicable state law or equity principles for holding the transferee liable for the transferor's debts. The IRS bears the burden of proving that the taxpayer is
liable as a transferee but not of proving that the transferor is liable for tax.
To impose transferee liability under Section 6901 , the court must determine whether three conditions exist:
- The taxpayer (transferor) is liable for the unpaid tax.
- The taxpayer is liable as a transferee within the meaning of Section 6901.
- The taxpayer is subject to substantive liability as a transferee under applicable state law or state equity principles.
The applicable law in this case is Tennessee because that is the state where the transfer occurred. Tennessee has adopted the Uniform Fraudulent Transfer Act (TUFTA), which provides that a creditor can recover a judgment against a transferee. TUFTA imposes transferee liability on the basis of both actual and constructive fraud. TUFTA provides three definitions for constructive fraud that apply regardless of the transferor's or transferee's actual intent. The IRS argued that the taxpayers were liable as transferees on the basis of actual fraud and each of the three definitions of constructive fraud. Under TUFTA a transfer is fraudulent as to a present creditor if the debtor did not receive a reasonably equivalent value for the transfer and the debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.
Tennessee courts use a three-part test to determine whether a constructively fraudulent transfer has occurred:
- The claim arose before the transfer.
- The debtor did not receive a reasonably equivalent value.
- The debtor was insolvent or rendered insolvent by the transfer.
This provision applies regardless of the transferee's or transferor's actual intent. A debtor is insolvent if the sum of its debts exceeds all of its assets at a fair valuation.
The threshold requirement for liability under TUFTA is that a transfer has occurred. The taxpayers argued that they did not receive a transfer from Holiday Bowl but rather that they received the purchase price from MidCoast through the loan from Sequoia. The IRS presented two alternative arguments for its position that the transaction should be recharacterized as a transfer from Holiday Bowl:
- The Sequoia loans were shams, and the taxpayers received Holiday Bowl cash as payment of the purchase price.
- The MidCoast transaction was in substance a disguised corporate liquidation and the taxpayers received a liquidating distribution from Holiday Bowl.
The court found that the Sequoia loans were shams, finding that Sequoia provided funds to MidCoast not as a bona fide lender but to create the appearance of a loan and to disguise the true nature of the transaction as a liquidating distribution. The court held that the Sequoia loans were not true extensions of credit for several reasons. First, Sequoia and MidCoast failed to execute loan documents. Second, the loans were extended and repaid on the same day through a credit on the resale of Holiday Bowl to Sequoia. Third, the parties contemplated immediate repayment as the loans were payable on demand and did not bear interest except upon default. Fourth, the loans included a $17,250 loan fee and since the Sequoia loans remained outstanding for one day, the fee would represent an annual interest charge of over $6.2 million, nearly twice the amount of the Sequoia loans. Fifth, the parties intended to use Holiday Bowl's cash to fully pay the purchase price and, therefore, did not need the Sequoia loan.
Alternatively, the court found that the stock purchase by MidCoast should be recharacterized as a complete liquidation of Holiday Bowl and a liquidating distribution to the taxpayers. In reaching this conclusion, the court focused on whether the taxpayers knew or should have known that MidCoast would cause Holiday Bowl to fail to pay its 2003 income tax liability. The court found that the taxpayers knew from the beginning that the underlying purpose of the transaction was to obtain a financial benefit from the nonpayment of Holiday Bowl's tax liability. The court also noted that there were facts that should have raised concern for the taxpayers and their advisors, including a purchase price above book value.
The court did not place any weight on the fact that MidCoast misrepresented its business plan because the advisors did not request sufficient documentation to verify MidCoast's representations. Instead, the court placed great weight on the fact that the advisors knew of the existence of IRS Notice 2001-16, which identified intermediary transactions similar to the MidCoast transaction that the IRS considered abusive tax shelters. The court also noted that the taxpayers should have known that Holiday Bowl would be insolvent after the MidCoast transaction and exist only as a shell. The court imputed the knowledge of the advisors to the taxpayers.
Having held that there was a transfer from Holiday Bowl to the taxpayers, the court next considered whether the transfer was fraudulent. Under TUFTA, a transfer is constructively fraudulent as to present creditors if these two factors are present:
- The transferor did not receive reasonably equivalent value in the exchange.
- The transferor became insolvent as a result of the transfer.
As an initial matter, the taxpayers argued that the statute should not apply because the IRS was not a present creditor at the time of the MidCoast transaction and stock redemption because Holiday Bowl's 2003 income tax did not accrue until the end of the tax year. The court rejected this argument and held that the IRS became a creditor when the taxable gain was realized-i.e., when Holiday Bowl sold its assets to Corley Family, LP. Next the court applied the two-part test.
With respect to the first prong, the court held that Holiday Bowl did not receive any value in the transaction because the MidCoast transaction was a disguised liquidating distribution from Holiday Bowl to the taxpayers and the redeemed shares had no value since Holiday Bowl was insolvent at the time. With respect to the second prong, the court held that the redemption and the MidCoast transaction rendered Holiday Bowl insolvent. Therefore, the court concluded that the taxpayers are subject to substantive liability under TUFTA on the basis of constructive fraud.
The court concluded by holding that the taxpayers were transferees under Section 6901 and, therefore, liable for the tax liability. The taxpayers argued that they are not liable as transferees because the IRS failed to make reasonable efforts to collect the 2003 tax from Holiday Bowl. The court noted, however, that TUFTA does not require a creditor to pursue collection efforts against a transferor as a prerequisite to transferee liability. In addition, the court stated that the IRS determined that Holiday Bowl did not have any assets from which to collect tax and, therefore, made a reasonable collection
The taxpayers also argued, without citing any authority, that the IRS cannot pursue transferee liability against them because the IRS did not pursue transferee liability against MidCoast or Sequoia. The court noted that transferee liability is several under Section 6901 and that the IRS may proceed against any or all transferees in no particular order.
While this case presents unique facts, it nevertheless provides a lesson for those administering estates. The advisors in this case were aware of the potential application of transferee liability to the estate and to the beneficiaries of the estate. However, they failed to take sufficient actions to protect the estate or the beneficiaries from the application of transferee liability. In reading the opinion, one is left with the belief that the advisors, while harboring some doubt regarding the representations being made by MidCoast, were not sufficiently skeptical of what they were being told and did not think
that MidCoast's problems with the IRS with respect to the transaction would become problems for their clients.
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at 301-657-0175 or firstname.lastname@example.org.
The article originally appeared in the April 1, 2018 edition of Estate Planning Journal, a monthly periodical with a national circulation directed to estate planning professionals such as lawyers, accountants, financial advisers, and trust officers that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.