On November 14, 2013, the United States Court of Appeals for the Second Circuit clarified the standard of review for mixed questions of law and fact in a case on review from the Tax Court. The case, Diebold Foundation, Inc. v. Commissioner of Internal Revenue, involved a group of shareholders who wished to dispose of the stock they owned in a corporation which in turned owned appreciated property. Further, the Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of §6901, dealing with transferred assets, are independent, and that the Tax Court did not err by only addressing the second prong of that section. A copy of the decision can be found here.
Upon the disposition of appreciated property, taxpayers, including corporate entities, generally owe tax on the property’s built-in gain—that is, the difference between the amount realized from the disposition of the property and its adjusted basis. 26 U.S.C. §§ 1(h), 1001, 1221, 1222. When shareholders who own stock in a C Corp that in turn holds appreciated property wish to dispose of the C Corp, they can do so through one of two transactions: an asset sale or a stock sale. If the shareholders sell the assets, the company is liable for tax on the built-in gain of appreciated property and therefore, there is less money to distribute to the shareholders. If the shareholders sell the stock, they must sell it at a lesser value so that the buyer will be insulated from the property’s built-in gains which will trigger a tax liability when sold. For shareholders to get the benefit of selling stock at a good price and buyers to get the benefit of buying assets without built-in gains, parties engage in “Midco transactions.”
“Midco transactions” or “intermediary transactions” are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or “Midco”) at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets, as opposed to the lower basis the corporate entity formerly had. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco’s willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, which allow it to absorb the built-in gain tax liability. See I.R.S. Notice 2001-16, 2001-1 C.B. 730. It is important to note that if these tax attributes of the Midco prove to be artificial, then the tax liability created by the built-in gain on the sold assets still needs to be paid. In many instances, the Midco is a newly formed entity created for the sole purpose of facilitating such a transaction, without other income or assets and thus likely judgment-proof. The IRS must then seek payment from the other parties involved in the transaction in order to satisfy the tax liability the transaction was created to avoid.
Double D Ranch, Inc., a personal holding company taxed as a C Corp., owned assets worth approximately $319 million, all of which had substantial built-in gain, such that the sale of the assets would have triggered a tax liability of approximately $81 million. The shareholders, Dorothy R. Diebold Marital Trust and Diebold Foundation, Inc., wanted to get rid of the assets of the corporation without triggering this tax liability but also without having to sell their shares at a substantial discount. Therefore, they decided to engage in a Midco transaction.
The parties to this Midco transaction all filed tax returns. On its tax return, the Midco claimed sufficient losses to offset the gain from the sale of assets, resulting in no net tax liability. The IRS issued a notice of deficiency against Double D Ranch, determining a deficiency of income tax, penalties, and interest of approximately $100 million. The deficiency resulted from the IRS’s determination that the Shareholders sale of Double D Ranch stock was, in substance, actually an asset sale followed by a liquidating distribution to the Shareholders. Double D Ranch did not contest this assessment, but the IRS was unable to find any Double D Ranch assets from which to collect the liability, as they had all been sold as part of the “Midco” transaction.
Deciding that any additional efforts to collect from Double D Ranch would be futile, the Commissioner attempted to collect from the Shareholders as transferees of Double D Ranch. Section 6901 of the Internal Revenue Code authorizes the assessment of liability against both (a) transferees of a taxpayer who owes income tax and (b) transferees of transferees. 26 U.S.C. § 6901(a)(1)(A)(I), (c)(2). The IRS issued a notice of transferee liability against Mrs. Diebold, trustee of the Marital Trust and director of Diebold Foundation, as a transferee of Double D Ranch. The Tax Court determined that she was not liable because the Marital Trust was the actual Double D Ranch shareholder, and the court saw no reason to ignore its separate existence. The Tax Court’s decision is available here.
SECOND CIRCUIT OPINION
Standard of Review
The Second Circuit started its discussion by setting forth that its previous standard of review for mixed questions of law and fact was clear error. See Wright v. Comm’r, 571 F.3d 215, 219 (2d Cir. 2009). However, the Court noted that, according to statutory mandate, all Courts of Appeals are to “review the decisions of the Tax Court … in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.” 26 U.S.C. §7482(a)(1). That is, all Courts of Appeal are to review decisions of the Tax Court de novo to the extent that the alleged error is in the misunderstanding of a legal standard and for clear error to the extent the alleged error is in a factual determination. Consequently, the Second Circuit acknowledged that its case law enunciating the standard of review for mixed questions of law and fact in an appeal from the Tax Court was in direct tension with this statutory mandate. Thus, because all Article III courts, with the exception of the Supreme Court, are solely creatures of statute, see U.S. Const. art. III; 28 U.S.C. §§ 1-463, the Second Circuit found that the statute must be determinative. Moreover, the Second Circuit Court held that there is no reason to review the Tax Court under a different standard than a district court, as “its relationship to us [is] that of a district court to a court of appeals.” Scheidelman v. Comm’r, 682 F.3d 189, 193 (2d Cir. 2012) (internal quotation marks omitted). Therefore, the Court held that “the Tax Court’s findings of fact are reviewed for clear error, but that mixed questions of law and fact are reviewed de novo, to the extent that the alleged error is in the misunderstanding of a legal standard.” See 26 U.S.C. § 7482(a)(1).
The Merits of the Tax Controversy
In its discussion of the merits of the case, the Second Circuit Court studied IRC Section 6901, which provides that the IRS may assess tax against the transferee of assets of a taxpayer who owes income tax. The section provides that the tax liability will “be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred” and allows for the collection of “[t]he liability, at law or in equity, of a transferee of property…of a taxpayer.” A “transferee” includes a “donee, heir, legatee, devisee, [or] distributee.”
Furthermore, the Second Circuit stated that although the provision with respect to transferees is not expansive in its terms, the IRS may assess transferee liability under § 6901 against a party if two distinct prongs are met: (1) the party must be a transferee under § 6901; and (2) the party must be subject to liability at law or in equity. Rowen v. Comm’r, 215 F.2d 641, 643 (2d Cir. 1954) (discussing predecessor statute, 26 U.S.C. § 311). Under the first prong of § 6901, courts look to federal tax law to determine whether the party in question is a transferee. The second prong, whether the party is liable at law or in equity, is determined by the applicable state law, in this case, the New York Uniform Fraudulent Conveyance Act (“NYUFCA”), N.Y. Debt. & Cred. Law §§ 270-281.
The Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of § 6901 are independent and that the Tax Court did not err by only addressing the liability prong. See Frank Sawyer Trust of May 1992 v. Comm’r, 712 F.3d 597, 605 (1st Cir. 2013);Starnes v. Comm’r, 680 F.3d 417, 428 (4th Cir. 2012). The Court cited Commissioner v. Stern, 357 U.S. 39 (1958) where the Supreme Court recognized that the predecessor statute to § 6901 “neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes.” The statute was enacted in order to do away with the procedural differences between collecting taxes from one who was originally liable and from someone who received property from the original tax owner.
As for the second prong, the Second Circuit Court stated that the NYUFCA defines a “conveyance” as “every payment of money, assignment, release, transfer, lease, mortgage or pledge of tangible or intangible property, and also the creation of any lien or encumbrance.” N.Y. Debt. & Cred. Law § 270. Further, the NYUFCA establishes liability for a transferee if the transferor, without regard to his actual intent, (1) makes a conveyance, (2) without fair consideration, (3) that renders the transferor insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. If Double D had sold its assets and liquidated the proceeds to its shareholders without retaining sufficient funds to pay the tax liability on the assets’ built-in gains, this would be a clear case of a fraudulent conveyance under § 273. However, due to the Midco form of this transaction, Double D did not actually make a conveyance to the Shareholders. If the form of the transaction is respected, § 273 is inapplicable.
The Second Circuit Court relied on HBE Leasing Corp. v. Frank, 48 F.3d 623, 635 (2d Cir. 1995), where it had previously stated: “[i]t is well established that multilateral transactions may under appropriate circumstances be ‘collapsed’ and treated as phases of a single transaction for analysis under the UFCA.” HBE Leasing described a “paradigmatic scheme” under this collapsing doctrine as one in which one transferee gives fair value to the debtor in exchange for the debtor’s property, and the debtor then gratuitously transfers the proceeds of the first exchange to a second transferee. The first transferee thereby receives the debtor’s property, and the second transferee receives the consideration, while the debtor retains nothing. Such a transaction can be collapsed if two elements are met. “First, in accordance with the foregoing paradigm, the consideration received from the first transferee must be reconveyed by the [party owing the liability] for less than fair consideration or with an actual intent to defraud creditors … Second, . . . the transferee in the leg of the transaction sought to be voided must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent.”
The Second Circuit stated that in this case, it was clear that the first element was met. Although the transaction had an additional wrinkle—namely, an additional party serving as the conduit for the transfers—it is still the case that one transferee received Double D’s property, another transferee (the Shareholders) received the consideration for these assets, and Double D was left with neither its assets nor the value of them. Therefore, in order for there to be liability against the selling Shareholders (and their successor entities), the Shareholders “must have actual or constructive knowledge of the entire scheme that renders [the] exchange with [Double D] fraudulent.”
When applying § 273 to a single transaction, the intent of the parties is typically irrelevant; the knowledge and intent of the parties becomes relevant when, as here, a court is urged to treat multiple business deals as a single transaction. Therefore, the Court proceeded to assess whether the Shareholders had actual or constructive knowledge of the entire scheme. The facts in this case demonstrated both a failure of ordinary diligence and active avoidance of the truth. Specifically the Court noted that the Shareholders recognized the “problem” of the tax liability arising from the built-in gains on the assets held by Double D, and sought out parties to help them avoid the tax liability inherent in a C Corp holding appreciated assets. They viewed slideshow and other presentations from three different firms that purported to deal with such problems.
The Court also noted that the Shareholder representatives had a sophisticated understanding of the structure of the entire transaction, a fact that courts frequently consider when determining whether to collapse a transaction and impose liability on an entity. See HBE Leasing, 48 F.3d at 635- 36 (“The case law has been aptly summarized in the following terms: “In deciding whether to collapse the transaction and impose liability on particular defendants, the courts have looked frequently to the knowledge of the defendants of the structure of the entire transaction and to whether its components were part of a single scheme.”) quoting In re Best Products Co., 168 B.R. 35, 57-58 (Bankr. S.D.N.Y. 1994 (emphasis added).
The fact that there had been a delay of the original closing date by one day, and the Shareholders’ representatives’ corresponding intervention between Shap Acquisition Corporation II (“Shap II”), an entity created specifically to carry out the transaction and Morgan Stanley, the ultimate buyer of Double D securities, made the conclusion of their “active avoidance of the truth” inescapable. By asking Morgan Stanley to “back off” and give Shap II extra time to provide the Double D securities so that the transactions would not be upended, the Shareholders demonstrated not only their knowledge of the structure of the entire transaction, but their understanding that Shap II did not have the assets to meet its obligation to buy equivalent shares on the open market for delivery to Morgan Stanley or pay Morgan Stanley an equivalent sum in cash. This understanding, combined with the Shareholders’ knowledge that Shap II had just come into existence for the purposes of the transaction, was more than sufficient to demonstrate an awareness that Shap II was a shell that did not have legitimate offsetting losses or deductions to cancel out the huge built-in gain it would incur upon the sale of the Double D securities.
The Second Circuit Court concluded that the Shareholders’ conduct evinced constructive knowledge, and therefore collapsed the series of transactions and found that there was a conveyance under the NYUFCA. In collapsing the transactions, the Court stated that, in substance, Double D sold its assets and made a liquidating distribution to its Shareholders, which left Double D insolvent—that is, “the present fair salable value of [its] assets [wa]s less than the amount . . . required to pay [its] probable liability on [its] existing debts as they bec[a]me absolute and matured.” N.Y. Debt. & Cred. Law § 271. With the liquidating distribution, Double D did not receive anything from the Shareholders in exchange, and thus Double D certainly did not receive fair consideration. Consequently, all three prongs of § 273 were met: Double D (1) made a conveyance, (2) without fair consideration, (3) that rendered Double D insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. Because the Court determined that there was state law liability, an issue arose regarding whether Diebold New York was a transferee under I.R.C. § 6901, and subsequently, whether Diebold was a transferee of a transferee under the same statute. To answer these questions, the Second Circuit Court remanded the case to the Tax Court.