Transferee Liability – A Win for the Taxpayers

August 11, 2016

“Knowledge itself is power,” in its various forms, is a familiar phrase attributed to Sir Francis Bacon. However, in some cases, a lack of knowledge can be just as powerful. On June 13, 2016, the Tax Court again ruled that shareholders were not liable under a transferee liability theory for the taxes generated from a sale of their company’s assets, followed by a sale of all of the company’s stock. The shareholders’ lack of knowledge of the grand tax scheme was an important factor that saved them from a grand tax bill.

Internal Revenue Code §6901 provides for transferee liability on a taxpayer, allowing the Internal Revenue Service (IRS) to collect the tax debts of a transferor of property from the transferee of that property. The definition of a “transferee” includes distributees, such as shareholders of dissolved corporations, successor corporations, and parties to corporate reorganizations.

The Courts have further clarified §6901, establishing a two-prong test that must be met to impose such liability. First, the taxpayer has to qualify as a transferee under §6901. Second, the taxpayer must be liable for the transferor’s debts under state law.

In Slone v. Commissioner, Slone Broadcasting Co., a radio broadcasting company, realized a sizable capital gain on a sale of all of the company’s assets, which generated income taxes of $15.3 million. Prior to the consummation of this transaction, Slone’s shareholders – two trusts, of which Mr. and Mrs. Slone were the grantors and trustees – decided to sell all of their shares to a third party, Fortrend International, LLC. Fortrend represented that it would assume, and reduce, all of Slone’s income tax liability.

When the shareholders asked how Fortrend would accomplish this, Fortrend claimed its methods were proprietary and only assured Slone Broadcasting that the plan for reduction in taxes would not be a tax evasion strategy. An investigation by Slone’s shareholders indicated that Fortrend and its offer were indeed legitimate; subsequently, the shareholders sold their stock.

Shockingly, Fortrend’s tax reduction method failed to withstand an IRS audit, and the IRS failed to collect Slone’s tax debts from Fortrend. The IRS then attempted to collect from Slone’s former shareholders. The IRS argued that the sale to Fortrend was, in fact, a liquidating distribution from Slone to its shareholders — a distribution which should subject the shareholders to transferee liability.

The Tax Court initially heard the case and ruled in favor of the Slones, refusing to apply substance over form to treat the sale as a liquidating distribution. The Ninth Circuit Court of Appeals then remanded the case to the Tax Court to apply the two-prong test, and again, the Tax Court found that no such transferee liability existed.

In applying the state law prong, the Court found that the shareholders had no knowledge of the tax avoidance scheme, and therefore, the form of the stock sale had to be honored. Based on state law, in order to recolor the transaction as a distribution, the IRS had to prove that the taxpayers in question had “actual or constructive knowledge of the entire scheme.” Here, Mrs. Slone was not involved in the business, and Mr. Slone relied on his advisers’ tax expertise and their reasonable inquiries into Fortrend’s plan to reduce the tax liabilities. Based on this due diligence, they had no reason to believe that Fortrend’s strategy was anything but legitimate. Once the Court found that the state law prong was not satisfied, there was no reason to analyze the case under the federal prong, and the transferee liability was denied.

If you believe this situation applies to you, or have any questions, please contact Aronson’s Tax Advocacy team, Laurence C. Rubin, CPA, or Patrick M. Deane, JD, MBA, LLM at 301.231.6200.