On November 14, the Second Circuit ruled that an intermediary or "midco" transaction was a fraudulent conveyance under New York state law and remanded the case back to the Tax Court to determine transferee liability.1 The Second Circuit found that shareholders in the transaction had constructive knowledge of the fraud, contrary to the previous Tax Court holding.

Background

The case involves shareholders of a personal holding company taxed as a C corporation ("Double D") that held, among other things, $129 million in shares of appreciated stock that would have triggered a tax liability of approximately $81 million in a sale of the assets directly. Instead, the shareholders worked with an investment banking firm to set up a newly formed entity, Shap Acquisition Corporation II ("Shap II"), that purchased the shares of Double D with short-term financing, with a plan to immediately sell the securities portfolio portion of the assets to a third party.

The IRS issued a notice of deficiency against Double D resulting from the IRS's determination that the sale by the shareholders of Double D was, in substance, an asset sale followed by a liquidating distribution to the shareholders. The IRS was unable to find any Double D assets from which to collect the liability, so the IRS issued a notice of transferee liability against three foundations that were transferees of Double D shareholders, and thus, transferees of a transferee.

Section 6901 of the Code allows for the collection of a tax liability of a transferee of property of a taxpayer, and the IRS may assess transferee liability under section 6901 against a party if two prongs are met: (1) the party is a transferee under section 6901 and (2) the party must be subject to liability under the applicable state law. The applicable law in New York establishes liability for a transferee if the transferor makes a conveyance without fair consideration that renders the transferor insolvent.

The Tax Court found that the IRS failed to establish that a fraudulent conveyance occurred under New York state law and held that the three foundations were not liable as subsequent transferees under section 6901.

Second Circuit Decision

The Second Circuit held that because the sophistication of the parties' representatives and the details of the case pointed to an "active avoidance of the truth," the shareholders should have known the conveyance from Double D was fraudulent, even though Double D did not actually make the conveyance to the shareholders itself as a result of the midco transactions. Accordingly, the Court held it was proper to collapse the multilateral midco transactions into a single transaction whereby liability could be established under state law.

The Second Circuit also avoided a circuit split with the First Circuit and Fourth Circuit, holding that the two prongs of the transferee liability test – transferee status and liability – are separate and independent inquiries, one procedural and governed by federal law, and the other substantive and governed by state law.

The Second Circuit also held, as a preliminary matter, that the standard of review for Tax Court decisions involving mixed questions of law and fact is de novo to the extent the alleged error is in the misunderstanding of a legal standard and clear error to the extent the alleged error is in a factual determination

Footnotes

1 Diebold Foundation, Inc. v. Commissioner, No. 12-3225 (2d Cir. Nov. 14, 2013).

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