Tax Court (Judge Lauber) Rejects Shareholders' Attempts to Reduce Transferee Liability (2/10/22)

In Slone v. Commissioner, T.C. Memo. 2022-6, TC Dkt Entry 107 *, here, and GS here, after two reversals by the Ninth Circuit, the last of which held the related taxpayers liable for transferee liability from a Midco transaction, the Tax Court was tasked with determining the amount of the liabilities of the related taxpayers in order to enter judgment (decision) for the Commissioner. Judge Lauber took over the case from Judge Vasquez on 10/19/21. See Dkt Entry 103 *. The related taxpayers raised various arguments to reduce the amount of the liabilities. Hence, as Judge Lauber noted (Slip Op. pp. 2 & 3),

The IRS has calculated these numbers to include a deficiency of $13,494,884, an accuracy-related penalty of $2,698,997, and interest of $8,559,729, for a total of $24,753,610.

* *  * *

             The parties have submitted dueling Rule 155 computations. They agree that the transferor corporation’s total tax liability is $24,753,610. But they disagree as to the extent to which petitioners are liable for this debt. Petitioners contend that they are not liable for the penalty or “prenotice” interest, that the IRS has “double counted” the transfers, and that they are entitled to reductions for “equitable recoupment.” Finding no merit in the arguments petitioners tender in support of their computations, we will enter decisions as requested by respondent.

 Judge Lauber helpfully provides readers a synthesized summary of the prototypical Midco transaction (Slip Op. p. 3, case citations omitted):

            Although Midco tax shelters took various forms, they shared several key features. These transactions were chiefly promoted to shareholders of closely held C corporations that had large built-in gains. The shareholders, while happy about the gains, were typically unhappy about the tax consequences. They faced the prospect of paying two levels of income tax on these gains: the usual corporate-level tax, followed by a shareholder-level tax when the gains were distributed to them as dividends or liquidating distributions. And this problem could not be avoided by selling the shares. Any rational buyer would insist on a discount to the purchase price equal to the built-in tax liability that he would be acquiring. 

            Promoters of Midco transactions offered a purported solution to this problem. An “intermediary company” affiliated with the promoter—typically a shell company, often organized offshore—would buy the shares of the target company. The target’s cash would transit through the Midco to the selling shareholders. After acquiring the target’s embedded tax liability, the Midco would engage in a sham transaction purporting to offset the target’s realized gains and eliminate the corporate-level tax. The promoter and the target’s shareholders would agree to split the dollar value of the corporate tax thus avoided. The promoter would keep as its fee a negotiated percentage of the avoided corporate tax. The target’s shareholders would keep the balance of the avoided corporate tax as a premium above the target’s true net asset value (i.e., assets net of accrued tax liability).

            In due course the IRS would audit the Midco, disallow the fictional losses, and assess the corporate-level tax. But the Midco, having distributed its cash to the selling shareholders, would typically be asset-less and judgment-proof. The IRS would then be forced “to seek payment from other parties involved in the transaction in order to satisfy the tax liability the transaction was created to avoid.” 

Here, the IRS used transferee liability under § 6901 against the selling shareholders of the target company with the built-in tax liability that was avoided. Essentially, since the target company was the economically liable party and had effectively transferred its assets (less the promoters’ cut) to the shareholders of the target company through the Midco commotion, the shareholders (taxpayers here) are liable for the tax that the transaction was structured to avoid up to the amount they received.

With that background, we get into the nitty-gritty of the taxpayers’ claims to reduce the transferee liability for their, shall we say, misbehavior. (Sure, the promoters misbehaved, but the taxpayers as shareholders did also by sharing in the avoided tax seemingly undeterred by the truism that things too good to be true probably aren’t.)

In the Rule 155 proceeding to determine the bottom-line numbers for the decision document (the Tax Court equivalent of a judgment), the parties submitted competing computations. The steps in Judge Lauber’s analysis are (some citations omitted):

1. “Because petitioners are ‘transferees’ under section 6901, they are liable for Slone Broadcasting’s tax liability “up to the limit of the amount transferred” to them. The parties agree that Slone Broadcasting’s unpaid liability includes (among other things) a deficiency of $13,494,884. Mr. and Mrs. Slone each received $13,012,396, and the GST Trust received $2,550,456. Because the deficiency by itself exceeds each of these amounts, the IRS’s recovery against these three transferees is capped at the value of the assets that each received.” (Slip Op. 7.)

2. The Slone Trust (a  separate entity) received $30,819,544, exceeding the total liability of the corporation for the avoided tax.

3. The taxpayers first sought to exclude penalty liability because penalty liability had not been asserted at the time of the transactions. Under the Arizona UFTA, the claim includes “a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured. (Slip Op. 8.)  Further, the Arizona UFTA did not require a specific existing creditor. Accordingly, Judge Lauber rejected the argument that the transferee liability did not include the accuracy related penalty. (Slip Op. p. 9.)  Further, Judge Lauber rejected the arguments that § 6751(b)(1) and 7491(c) prevented assertion of the penalty. (Slip Op. 9-10). I won’t go further into that because those holdings are not particularly novel.

4. The taxpayers next sought to exclude pre-notice interest.   The Court said (Slip Op. p. 11):

            On this point the salient facts of these cases are the same as in Tricarichi II. The Slone Trust received cash totaling $30,819,544, but Slone Broadcasting’s aggregate Federal tax liability was only $24,753,610. Because the Slone Trust received assets with a value that exceeded the transferor’s total tax liability (including pre-notice interest), the Slone Trust’s liability for interest is governed by Federal law, and the availability of interest under Arizona law is irrelevant. We thus hold that respondent is entitled to recover pre-notice interest as provided in sections 6601(a) and 6621. 

5. The taxpayers next claimed that, by imposing several liability among the taxpayers, the aggregate liabilities exceeded the corporate tax liability avoided and thus would be inappropriate “double counting.” The Court rejected that, saying the liability can be imposed on all qualifying as liability transferees, but that “the tax liability of the transferor can be collected only once.” (This is a similar concept for the Trust Fund Recovery Penalty, which can be asserted against multiple responsible persons but, in the aggregate, can be collected only once.)

6. The taxpayers next asserted Equitable Recoupment. The taxpayers included their shares of the avoided tax liability in their tax calculations for the year of the transaction and felt that now that they had the transferee liability to pay back the avoided tax, there should be some equitable recoupment of the overreporting of the sale amounts received. Judge Lauber rejected the argument because a condition of the equitable remedy of equitable recoupment is that the remedy at law is inadequate. Judge Lauber felt that § 1341, the claim of right remedy, could provide a remedy “if a deduction is allowable” for the year the taxpayers paid back the avoided tax in which they had shared. Judge Lauber offered some solace in footnote 9 on p. 15: “If in a subsequent refund action petitioners are denied relief under section 1341, an equitable recoupment claim may then become available (so long as they meet the relevant requirements). See Estate of Stein, 37 T.C. at 956 n.10 (stating that “District Courts have permitted equitable recoupment” if section 1341 does not apply).”

 *    The Tax Court apparently does not have static links to opinions that do not time out. I am told that the work-around is to link the docket entries that have a static link, and then the opinion can be retrieved from the docket number. I am not sure why the Tax Court does not provide a static link to the opinion.