Tag! You’re It: Transferee Liability under the Internal Revenue Code
Written by Guy Schmitz J.D., LL.M.
Clients know little or nothing about transferee liability. If the need arises, it’s your job to give them advice about transferee liability, assumedly not the kind of advice the taxpayers got in Feldman, et al. v. Comm., 115 AFTR 2d 2015-xxxx (7th Cir. 2015).
The Facts: William Feldman founded Woodside Ranch in the 1920s in Wisconsin. The ranch was incorporated in 1952 as Woodside Ranch Resort, Inc. (Woodside) and taxed as a C corporation. Until its sale in 2002, Woodside was owned and operated by descendants of its founder. The family business followed the path of many family businesses. By the late 1990s there was competition from nearby casinos and water parks, the next generation of Feldmans had no interest in running the ranch, and the generation running the ranch was nearing retirement. The shareholders of Woodside wanted to sell the stock of the corporation, but the buyer, in typical fashion, wanted assets, not stock, presumably to assure the sale price was allocated among depreciable and amortizable assets rather than being trapped in the stock.
Because Woodside’s assets had been purchased so long ago, there was a large capital gain tax owed. While the sale was pending, Woodside’s accountant and financial advisor introduced the Woodside shareholders to the representatives of MidCoast Credit Corp. and Midcoast Acquisition Corp. (collectively Midcoast). Midcoast specialized in structured transactions designed to avoid or minimize tax liability. Midcoast offered to buy the stock of Woodside that had recently had a taxable sale, promising to pay more on the sale to Midcoast than the Woodside shareholders would have received upon liquidation of Woodside, taxes paid. After the Midcoast purchase of the stock, Midcoast would use bad debts and losses purchased from credit-card companies to eliminate the unpaid tax liability of Woodside by way of a net operating loss carryback. (Yes, you are reading that correctly.) It is unnecessary to describe all the closing transactions and the entities involved. Some of Woodside’s only tangible asset, cash, went to the shareholders (more than they would have received upon liquidation, after taxes), and the rest went to Midcoast. No taxes were paid. The whole transaction can perhaps be described in an image—one of the ancient pyramids balanced upside down, on its tip.
The Holding: Needless to say, the pyramid fell over. The Tax Court and the Circuit Court of Appeals found the Feldmans liable for the transferee liability. The Circuit Court applied a twofold test.
- Liability under Code section 6901 (Transferred assets). This Code section is a procedural mechanism to collect taxes, here from the Feldmans, who were clearly transferees under Code section 6901.
- Liability under the Wisconsin version of the Uniform Fraudulent Transfer Act. The Wisconsin law was the substantive law. State fraudulent transfer law is based upon equitable principles. The structure the Feldmans bought into was anything but equitable, which is why they lost.
Feldman is an example of equitable principles to insure transferee liability. If your client is buying a business, you should make sure that your client is aware of two other kinds of transferee liability, particularly if your client is represented by an attorney who knows nothing or little of tax law.
Transferee Contractual Liability: If your client is buying assets, it is obviously important to make it clear in the sale contract that all pre-closing tax liability and tax liability from the sale itself are the liabilities of the seller and not the buyer. If this requires a substantial escrow, so be it.
Transferee Liability under State Law: There can also be liability under state law that has nothing to do with equitable principles (as in Feldman). As you know, many states do not impose a sale tax on tangible personal property when an entire business is sold. That is far different from old and cold (but unpaid) sale taxes on pre-closing ordinary course of business sales. That kind of liability follows the tangible personal property. The buyer may pay the sales tax and sue the seller but not if the seller has left town.
(As a sidebar, it goes without saying that if your client buys stock in a corporation, pre-closing taxes are just there. This has nothing to do with transferee liability. There must be enough cash in the corporation to pay pre-closing taxes, and if there are open tax issues, an escrow large enough to let your buyer/client sleep at night.)