Transferee Liability for Tax on Sale of Business
In Hawk,1 the Court of Appeals for the Sixth Circuit affirmed the Tax Court's decision imposing transferee liability for unpaid taxes arising from the sale of a privately held corporation.
Billy Hawk and his wife, Nancy Sue Hawk, owned a bowling business, Holiday Bowl. After Billy died in 2000, his two sons attempted to operate the bowling alleys for some time but did not succeed. Thus, in 2003, Nancy Sue and Billy's estate sold the bowling alleys to a third party in exchange for $4.2 million in cash, generating a liability of about $1 million in federal taxes and $200,000 in state taxes.
Later that year, in an effort to lower the corporate taxes triggered by the sale, the Hawks' sold Holiday Bowl to another company, MidCoast, for $3.4 million, a price equal to Holiday Bowl's cash less 64.25% of its estimated tax liability for the year. To finance the transaction, MidCoast borrowed $3.4 million from Sequoia Capital, LLC. That same day, MidCoast resold 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.
After the sale, MidCoast transferred Holiday Bowl to Sequoia in exchange for the cancellation of Sequoia's loan and about $320,000 cash. The Hawks expected to keep an extra $200,000 to $300,000 by structuring the transaction this way. They would soon come to learn that there is no such thing as a free lunch.
Holiday Bowl's outstanding taxes were never paid, thus prompting a government investigation, from which the Tax Court concluded that Sequoia's loan to MidCoast was a sham, that Holiday Bowl simply distributed cash to the Hawks, and that the Hawks were liable as Holiday Bowl's fraudulent transferees. The U.S. filed suit against Nancy Sue and Billy's estate to recover Holiday Bowl's unpaid taxes.
Section 6901 permits the IRS to pursue action against the transferees of delinquent transferor taxpayers. 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.
Applied to the instant case, Section 6901 prompts three questions:
- Did Holiday Bowl owe any taxes?
- Are the Hawks transferees of Holiday Bowl?
- If so, are the Hawks liable to the government under Tennessee's fraudulent transfer statute?
First, it is undisputed that Holiday Bowl incurred taxes on the sale of its assets. As to question two, the Hawks allege that they were "distributees" of funds from MidCoast, not Holiday Bowl. They argue 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. However, the court agreed with the government's arguments that the transaction should be characterized as a transfer from Holiday Bowl: Either (1) the Sequoia loans were shams, and the Hawks received Holiday Bowl cash as payment of the purchase price, or (2) the MidCoast transaction was in substance a disguised corporate liquidation, and the Hawks 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 because the Sequoia loans remained outstanding for one day, the fee would represent an annual interest of over $6.2 million, nearly twice the Sequoia loans.
- Fifth, the parties intended to use Holiday Bowl's cash to pay the full purchase price and therefore did not need the Sequoia loan.
Alternatively, the court found that the stock purchase by MidCoast should be characterized as a complete liquidation of Holiday Bowl and a liquidating distribution to the Hawks. In reaching this conclusion, the court focused on whether the Hawks 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 Hawks 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 Hawks and their advisors, including a purchase price above book value. The court also noted that the Hawks 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 Hawks.
The court answered question three pursuant to Tennessee's version of the Uniform Fraudulent Transfer Act (TUFTA). The Uniform Fraudulent Transfer Act provides that a creditor can recover a judgment against a transferee. TUFTA imposes transferee liability based on both actual and constructive fraud. The Act provides three definitions for constructive fraud that apply regardless of the transferor's or transferee's actual intent. The government argued that the Hawks 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.
The Act prompts three inquiries of its own to determine whether a constructively fraudulent transfer has occurred:
- Did the Holiday Bowl transaction count as a transfer?
- Did Holiday Bowl receive an exchange of reasonably equivalent value?
- Was Holiday Bowl rendered insolvent (i.e., does the sum of its debts exceed all of its assets at a fair valuation)?
The threshold requirement for liability under TUFTA is that a transfer has occurred. For much the same reasons that the Holiday Bowl transaction amounts to a transfer under federal law, it also counts as a transfer to the Hawks under Tennessee law. Having held that there was a transfer from Holiday Bowl to the Hawks, the court next considered whether the transfer was fraudulent.
Under TUFTA, a transfer is constructively fraudulent as to present creditors if: (1) the transferor did not receive reasonably equivalent value in the exchange, and (2) the transferor became insolvent as a result of the transfer. As an initial matter, the Hawks argued that the statute should not apply since 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, that is, when Holiday Bowl sold its assets.
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 Hawks and the redeemed shares had no value because 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 Hawks are subject to substantive liability under TUFTA on the basis of constructive fraud.
The court concluded by holding that the Hawks were transferees under Section 6901 and therefore liable for the tax liability.
The Hawks' attempted tax-reduction strategy failed because it lacked economic substance. In the court's words, "it was nothing but misleading labels and distracting forms." The Hawks' professional advisors were apparently aware of the potential application of transferee liability to their clients, but they failed to take sufficient actions to protect them from the application of transferee liability.
1 924 F.3d 821 123 AFTR2d 2019-1822 (CA-6, 2019)
Frank S. 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.
This article originally appeared in the October 2019 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets. Robert E. Madden, the author of Tax Planning for Highly Compensated Individuals (Thomson Reuters/WG&L), and Scott A. Bowman, a partner in the law firm of McDermott Will & Emery LLP in Washington, D.C., co-wrote the article.