Thursday, April 4, 2013

Transferee-of-Transferee Liability (4/4/13)

In Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597 (1st Cir. 2013), here, the First Circuit recognized that something suspicious had gone on in the "Midco" transaction case.  The quintessential circumstance that give rise to the Midco transaction is a closely-held C corporation that has sold all of its appreciated assets at a substantial gain, thus having only cash and a potential tax liability coming due at the end of the year.  For example, assume a sale of a $150,000,000 asset with $100,000,000 gain arising from the sale.  Assume a tax liability that likely would arise from the sale of $20,000,000.  The net value of the corporation is $130,000,000 -- i.e., $150,000,000 cash (the net sales proceeds) less $20,000,000 tax.  The shareholders can realize that value  by liquidating the corporation after paying the tax.  Or they can sell the stock to a third party who, logically, would be willing to pay only $130,000,000 because that is all the buyer would realize by taking the cash out of the corporation, provided that the corporate level tax were paid.  I am sure readers see an opening here.  What if the buyer could do something to cause the corporation to pay less tax? Then so long as the buyer can do that at less cost than the tax savings, then the buyer might be willing to pay more than $130,000,000.  For example, assume that the buyer could put an asset into the corporation that has a built-in loss of $100,000,000 and then use that loss to offset the $100,000,000 gain, so that there is no corporate level tax and thus there is $150,000,000 cash available for the buyer to take out.  Sweet.  And, what if the loss asset was phony, but the buyer stripped the $150,000,000 cash out of the company before the IRS realized the loss was phony and came looking for its $20,000,000 tax, plus penalties and interest?  And, what if the buyer through some complicated transactions, stripped the cash out in a way that the IRS cannot recover from the buyer (say the buyer spent it all or disappeared).

Now, go back and focus on the seller's side.  In a logical world, the seller might still sell the corporate stock for $130,000,000, for that is all that it is worth.  Why would the seller demand more?  All the seller has is corporate stock worth $130,000,000.  So, at least in theory, why would a buyer -- even one who thinks he can cause the tax liability to disappear -- pay much more than $130,000,000?  Presumably, in such a case, the logical buyer might pay just enough more to the seller that seller would have some incentive to fool with the buyer.  For example, in this case, the seller might insist upon $130,500,000 (that is a $500,000 sweetener to sell to the buyer rather than liquidate and get $130,000,000).  But that is not the way these deals -- at least the abusive ones -- get done.  The buyers put in a real sweetener -- that is they split the pot of gold, the tax of $20,000,000 -- between the buyer and seller.  For example purposes, let's say that the buyer agrees to pay $140,000,000 cash, meaning that the buyer gets $10,000,000 otherwise going to tax and the seller gets $10,000,000 otherwise going to tax.  (In the case, the deal was described as:  "a price equal to the value of the companies' assets (which by that point consisted only of cash) minus 50% of the value of the companies' tax liabilities.")  Sweet deal for both.

Sticking with this $10,000,000 extra purchase price paid to the seller, what is up with that?  Why would a buyer -- whether the buyer really could eliminate the tax or simply steal the money that would have otherwise paid the tax -- agree to pay the seller more than just enough above $130,000,000 to incentivize the seller to take his offer ($130,500,000, say) rather than take $130,000,000 on liquidation?  Logically, the buyer would not.  And, if the buyer came with such an offer, why would not the seller smell a rat.  And, from a pure economic standpoint, however the complexity built in, the $10,000,000 extra that the seller gets does come directly or indirectly from the $10,000,000 tax not paid.  (This can be seen if the buyer borrows the $140,000,000 stock purchase price, then immediately takes the $150,000,000 cash out, repaying the $140,000,000 loan; no one can doubt that the corporate tax not paid has funded the $10,000,000 extra payment for the stock and the buyer's $10,000,000 profit on the deal.)

That is the Frank Sawyer Trust situation.  The Government's argument was that the combination of Section 6901 transferee liability (the procedural tool) and the Massachusetts Fraudulent Transfer Act (the remedial tool) permitted the IRS to assert transferee liability.  The Tax Court rejected transferee liability because it read the Massachusetts Fraudulent Transfer Act requiring knowledge of the buyer's maneuvers to underpay the tax liability and strip the cash out of the corporation.  The Tax Court concluded the IRS had not shown enough to invoke the knowledge or constructive knowledge requirement.  And, the Tax Court refused to collapse the transaction.  Collapsing -- or some substance over form variant -- would show (as I show above) that $20,000,000 that should have gone to pay the tax went directly or indirectly 50% to each of the buyer and seller.  Collapsing would thus have proved that there was a transfer and the requirements of the Massachusetts Fraudulent Conveyance Act were met.

The First Circuit essentially approved the Tax Court's key fact findings and declined to apply a collapsing theory.  But it came up with another theory -- apparently not argued by the parties -- that pretty much amounts to the same thing.  It called this theory a "transferee-of-transferee liability."  Essentially, the theory is that (again going to the simplified example), there is no question in the example that the buyer would be a transferee under the Massachusetts Fraudulent Conveyance Act as to the $20,000,000.  And, in effect, the seller could be used as a transferee from the buyer of the $10,000,000 share of the pie the buyer receives.  Then the inquiry does not turn upon knowledge or constructive knowledge, but whether the seller was given more than it gave up in the transaction.  The answer to that, on the simplified example, would clearly be yes to the tune of $10,000,000.  And, to that extent, under this transferee-of-transferee liability theory, it is possible that the seller could be subject to transferee liability.

The First Circuit remanded for the Tax Court to determine the facts necessary to apply this theory.


I refer readers to the following article:  Peter J. Reilly, First Circuit Tells Tax Court To Look Harder For Fraudulent Transfer (Forbes 3/31/13), here.

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