The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 7, February 2003, Panel Publishers, New York, NY.
TRANSFEREE LIABILITY: WHAT, ME WORRY?
By Robert W. Wood
With 2003 now well underway, it is not too soon to pontificate about deal flow. I'm guessing 2003 will be a year in which many troubled companies will be acquired. Even looking back at 2002, however, it seems clear that at least some companies will face tax liabilities. In some cases, their acquirers will have to assume those tax liabilities, either contractually (unhappy) or by operation of law (really unhappy).
Section 6901 of the Code provides the Internal Revenue Service with a procedural remedy when it seeks to impose transferee liability. This Code section allows the Service to assess (and collect) taxes from the transferee of property in the same manner as it does in the case of the transferor, the entity that originally incurred the tax liability. It is important to note that this section is only a procedural mechanism, and does not by itself create liability in a transferee. Rather, the existence and extent of the transferee's liability is determined under applicable state law, and may be grounded either in equity or at law. See Commissioner v. Stern, 357 U.S. 39 (1958).
The primary prerequisite for the IRS use of Section 6901 is that there be a transfer of property from the entity primarily liable for the taxes to a transferee. The regulations define "transferee" to include a shareholder of a dissolved corporation. Reg. §301.6901-1(b). Thus, where a liquidated corporation distributes its assets (or cash from the sale of its assets) to its shareholders, the shareholders are transferees within the meaning of this provision. See Vendig v. Commissioner, 229 F.2d 93 (2d Cir. 1956).
Direct or Indirect?
The transfer of property to a shareholder in liquidation can be direct or indirect, actual or constructive. In the case of a direct transfer, little controversy is engendered by the use of Section 6901. The recipient shareholders are transferees, and whether they may be held liable for the corporation's taxes will depend on state law.
Indirect transfers are far more problematic. The general rule regarding indirect transfers in liquidation is that corporate liquidating distributions made for a shareholder's benefit (such as in discharge of his debt or for some other personal purpose), are treated as a corporate liquidating distribution to that shareholder, establishing the basis for transferee liability. See Segura v. Commissioner, 77 T.C. 734 (1981) (payment of a dividend to shareholder by cancelling debt of the shareholder to the corporation held a transfer of property within the meaning of Section 6901).
Kean v. Commissioner, 91 T.C. 575 (1988), highlights the extent to which an indirect transfer of property may bring the shareholder-distributee within the scope of Section 6901. In Kean, the corporation was liquidated at a time when it had insufficient assets to cover its tax liabilities. Just prior to liquidation, the majority shareholder had caused the corporation to transfer cash to other corporations in which the majority shareholder also held a majority interest.
These diverted funds were used to satisfy debts of the other corporations guaranteed by the majority shareholder. Because the majority shareholder directly benefitted by the transfer of cash to the other corporations, the transfers were held to represent a transfer of property within the meaning of Section 6901. The Tax Court then looked to state law to determine if the majority shareholder would be liable for the liquidated corporation's taxes as a result of this property transfer.
The Law is an Ass?
Unless one has recently emerged from law school with a newly-minted understanding of traditional legal principles, the age-old distinction between law and equity is fuzzy. It is relevant in this area, because the existence and extent of the shareholder's liability for a liquidated corporation's unpaid taxes is determined under state law, either in equity or at law.
If liability is sought in equity, the Service must prove several facts, the most important being:
the corporation transferred assets to the shareholder;
the transfer was made subsequent to the accrual of the corporation's tax liability (but note this condition will be satisfied if the tax liability accrues after, but in the same tax year, as the transfer);
the transfer was made for no consideration or for less than adequate consideration;
the liquidated corporation was insolvent at the time of the transfer, or was rendered insolvent by the transfer, or the transfer was in fraud of creditors; and
all legal remedies against the liquidated corporation have been exhausted.
In most cases, transferee liability will arise in equity. Yet, there are times when transferee liability may arise at law. If the shareholder-transferee has expressly agreed to pay the tax liability of the liquidated corporation, for example, the Service can recover from the transferee on a third-party beneficiary theory. This makes Section 6901 unnecessary.
A couple of recent cases suggest that the transferee liability issue will be an important one going forward. William T. Butler, Transferee and Joseph P. McGraw, Transferee v. Commissioner, T.C. Memo 2002-314, Tax Analysts Doc. No. 2003-195, 2002 TNT 250-117, involves a merger that may seem eerily similar to many small transactions that seem to be all the rage lately. True, it involved a garbage company and some skimming and fraud (though not necessarily the organized crime variety for which garbage companies are justly famous — on The Sopranos and in real life).
Metro was a Minneapolis/St. Paul garbage company that, in 1990, was acquired by McGraw for publicly traded stock worth $1.5 million. The buyer? Browning Ferris Industries, Inc. (BFI), which in turn was subsequently acquired by Allied Waste Industries. But, I'm getting ahead of myself.
BFI acquired the Metro business in 1990 in exchange for its own BFI common stock in a C reorganization. Predictably, the BFI stock was distributed by Metro to its shareholders. The two Metro shareholders, McGraw and Butler, received $1,547,525 worth of BFI stock and $3,095,050 worth of BFI stock, respectively. Metro was then dissolved.
The bad garbageman was Butler, who received the larger share of the money. McGraw was the 1/3 owner who knew there was a great deal amiss in the business and, as its general manager, was doubtless worried about much of the off-the-books activities. The liquidation of the corporation occurred the year after the merger and distribution.
As evidence that transferee liability can have a long arm, though, the Tax Court had to face this issue twelve years later. Interestingly, the IRS audited Metro in 1990, and the State of Minnesota audited Metro in 1991. Evidently no one uncovered any of the wrongdoing. But in 1995, there was a civil lawsuit involving kickbacks that ultimately led to an indictment by the IRS against Butler for aiding and abetting the filing of a false Metro corporate tax return (plus filing a false personal tax return). Butler pled guilty, and as part of his plea agreement, agreed to pay $1.5 million toward his individual (and Metro's) tax liabilities.
What about McGraw? He seemed to be skating free of this hole in the ice until November 30, 1999, when the IRS issued notices of transferee liability (both to Butler and to McGraw) covering $1,946,292 of corporate income taxes and penalties for the years 1988 through 1990. To this whopping sum, interest had to be added (and there was a lot of interest, too). What about the statute of limitations?
The normal three-year statute had run, and the six-year statute had, too. But, a transferee liability assessment can be made up to one year after the statute runs on the corporation. Both McGraw and Butler asserted that the statute had run. So, the IRS had to assert (and show) that an underpayment of Metro's tax existed for each year, and that some portion of that underpayment was attributable to fraud.
A good part of the Tax Court decision covers this issue. Ultimately, the Tax Court found that the statute had not expired. Turning to whether Butler and McGraw were transferees, we go back to our usual rule about shareholders of a dissolved corporation. As noted above, either legal or equitable principles can result in the liability. Where the underlying transferee liability is under a state law dealing with fraudulent or illegal transfers (as here), the state statute of limitations for the transfers is trumped by the federal statute. The latter is one-year from the expiration of the transferor's federal tax statute of limitations. I.R.C. §6901(c).
As you might expect, the Tax Court had a relatively easy time of finding that both Butler and McGraw were transferees. McGraw (the ostensibly innocent fellow) had an additional argument, but unfortunately for him, it did not fly. McGraw argued that his transferee liability should be reduced because Butler had agreed (in a criminal plea) to pay $1.5 million towards Metro's tax liabilities. Finding this appealing fact unhelpful to McGraw, the Tax Court noted that each transferee had liability to the extent he received property without adequate consideration. McGraw might well have a claim against Butler, but that was not the government's problem, the court found.
Statutory Merger, Too
Can this kind of problem crop up in a statutory merger? Evidently yes. Cords Finance Corp. v. Commissioner, T.C. Memo 1997-162, aff'd without pub. opinion, 162 F.3d 1172 (10th Cir. 1998), involved another 1990 transaction. In 1997, Cords Finance (a finance company for the Cords family auto dealerships), merged into Eddie Cords, Inc. ("ECI"), one of the dealerships. As a result of the merger, Cords Finance went out of existence. Although this merger occurred on December 30, 1997, the tax year in question was 1990.
On August 14, 1998 (a whopping eight days before the one-year transferee liability statute would run), the IRS mailed ECI a notice of transferee liability based on Cords' finance tax obligations. When the matter hit Tax Court, ECI argued that the merger involved full value and good consideration, so that there could be no transferee liability. The Tax Court did not even raise the transferee liability issue, and could merely rely on the merger document which called for ECI being liable and responsible for the debts and obligations of both companies.
Was this a bad deal for ECI? Apparently so. ECI also argued that the value of the assets it received were worth less than the liabilities that the Service was seeking to impose. The rule that the liability of a transferee is limited to the value of the assets received applies only when transferee liability in equity is being asserted. Then, issues of valuation arise. Here, though, express language in the merger agreement that was filed under state law showed all liabilities of Cords Finance being assumed. It was hardly surprising that the taxpayer was out of luck. When a taxpayer is a transferee at law, said the Tax Court, the value of the assets is not relevant.
Transferee liability is never a happy circumstance. With more and more troubled company acquisitions (where often there are extant tax liabilities), we may see more of these in the future.
Transferee Liability: What, Me Worry?, Vol. 11, No. 7, The M&A Tax Report (February 2003), p. 1.