SECTION 6901’s TWO-PRONG INQUIRY by LACEY STRACHAN
Although shareholders are generally not liable for debts of a corporation, shareholders may be liable for a corporation’s tax liability if they are considered transferees under a state’s fraudulent conveyance laws. Where such liability exists, § 6901 of the Internal Revenue Code (“IRC”) allows the IRS to assess and collect the tax liability from the transferee. In a decision published December 22, 2014, the Ninth Circuit explains the two-prong inquiry required by this code section—a determination must be made under federal law of whether the IRS may procedurally assess the tax against a party if transferee liability exists, and an independent, substantive determination must be made under the applicable state law of whether such liability exists.
In Salus Mundi Foundation v. Commissioner, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014), the Ninth Circuit reversed the Tax Court’s holding that a foundation was not liable under IRC § 6901 as a transferee of a transferee for a corporation’s tax liability resulting from a “Midco” transaction. In that case, the shareholders of the corporation Double-D Ranch, Inc. sold their stock in the corporation to an intermediary that had losses that the intermediary expected to be able to use to offset gains on the sale of Double-D Ranch, Inc.’s assets.[i] The intermediary in turn sold the assets of the corporation, keeping the difference between the price it paid for the stock and the amount it received for the corporation’s assets. However, after determining that the intermediary’s losses were artificial losses resulting from a Son-of-BOSS transaction, the IRS recharacterized the Midco transaction as a sale by the shareholders of the assets of Double-D Ranch, Inc., followed by a liquidating distribution to the shareholders.[ii] The IRS assessed a capital gains tax liability against Double-D Ranch, Inc. for the gain on the sale of its assets, which the corporation did not dispute.[iii]
When the IRS was unable to collect the tax liability from either Double-D Ranch, Inc. or the intermediary corporation, the IRS pursued transferee liability under IRC § 6901 against the selling shareholders of Double-D Ranch, Inc.[iv] Section 6901 allows the IRS to assess a tax liability against the transferee of assets of a taxpayer who owes the income tax liability, as well as against the transferee of a transferee.[v] The term “transferee” is defined for income tax purposes as a “donee, heir, legatee, devisee, and distribute,” which includes, in pertinent part, the shareholder of a dissolved corporation and the successor of a corporation.[vi] Section 6901 is a procedural statute that allows the IRS to collect taxes from a transferee, but it does not create a substantive liability—it is state law that determines the existence of a substantive liability.[vii]
On appeal, the Ninth Circuit clarified the two-prong test for liability under § 6901, which requires two inquiries: (1) is the party a “transferee” under § 6901 and federal tax law?; and (2) is the party substantively liable for the transferor’s unpaid taxes under state law?[viii] The Ninth Circuit held that these two tests are separate and independent inquiries, concluding that the two prongs of § 6901 are “independent requirements, one procedural and governed by federal law, the other substantive and governed by state law.”[ix] That is, the state law substantive inquiry of whether a transferee is liable for the transferor’s tax liability is independent of the procedural inquiry under Federal law of whether a party is considered a “transferee” under § 6901.
One of the shareholders of Double-D Ranch, Inc. was a charitable foundation that had distributed the proceeds of the sale to three foundations organized by the children of the foundation’s founder, one of which is the Salus Mundi Foundation, the appellee in this case. The Tax Court had treated the two-prongs of section 6901 as independent inquiries, and held that the children’s foundations were not liable as transferees of transferees, because the shareholder foundation did not have actual or constructive knowledge of the entire scheme that renders its exchange with the debtor fraudulent, which is required under the New York Uniform Fraudulent Conveyance Act for a transaction to be recharacterized.[x]
On appeal, the IRS argued that the tests are not independent, such that the Federal tax law “substance over form” doctrine can be used to recharacterize a transaction for purposes of determining both whether a party is a “transferee” for procedural purposes under § 6901 as well as for purposes of determining a party’s substantive liability under state law. The Ninth Circuit rejected this argument, and held that federal tax law cannot be used to recharacterize a transaction for purposes of determining whether a substantive transferee liability exists for the party under state law.[xi]
However, the Ninth Circuit found on appeal that the transaction should be recharacterized under the New York Uniform Fraudulent Conveyance Act, reversing the Tax Court’s finding that the foundation did not have constructive knowledge of the entire scheme.[xii] The Tax Court’s holding had also been appealed to the Second Circuit by another of the foundations on the same issue, in the case Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2nd Cir. 2013). In that case, the Second Circuit held on the same set of facts, issues, and applicable law that the foundation had constructive knowledge sufficient to support transferee liability under New York law.
The Ninth Circuit decided to follow the Second Circuit’s reasoning in vacating the Tax Court’s decision, explaining that “absent a strong reason to do so, we will not create a direct conflict with other circuits.”[xiii] The Ninth Circuit concluded that “[w]hile the question of the shareholders’ constructive knowledge is a difficult issue, we conclude that the Second Circuit’s decision is not demonstrably erroneous.” The Ninth Circuit accordingly reversed the Tax Court’s holding, and remanded the case to the Tax Court for a determination on (1) whether the foundation was a “transferee” under the first prong of the two-prong test; and (2) whether the tax was assessed within the statute of limitations.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at https://www.taxlitigator.com.
[i] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240, 9-12 (9th Cir. Dec. 22, 2014).
[ii] Id. at 12-15.
[iii] Id. at 15-17.
[v] IRC § 6901(a)(1)(A)(I), (c)(2).
[vi] IRC § 6901(h); Treas. Reg. § 301.6901-1(b).
[vii] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014) (citing Comm’r v. Stern, 357 U.S. 39, 42, 44-45 (1958)).
[viii] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014).
[ix] Id. at 22-23 (quoting Diebold Foundation v. Comm’r, 736 F.3d 173, 186 (2nd Cir. 2013)).
[x] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240, 17 (9th Cir. Dec. 22, 2014).
[xi] Id. at 19-23.
[xii] Id. at 23-25.
[xiii] Id. at 24 (quoting United States v. Chavez-Vernaza, 844 F.2d 1368, 1374 (9th Circuit)).