United States: MIDCO Transactions And The Expanding Universe Of Transferee Liability

The Internal Revenue Service's determination of transferee liability, essentially secondary liability, resulting from transactions involving the taxable sale and disposition of corporate stock, is being litigated with increasing frequency in the federal courts. The outcome of these disputes varies as they are highly fact determinative. Thus, not surprisingly, Taxpayers have experienced mixed results in court. Although there are lower courts that have held in favor of the putative transferee, selling shareholders, three recent Tax Court decisions have been reversed on appeal.1 In fact, to date only one taxpayer victory has been affirmed on appeal.2

The IRS's recent successes have emboldened it to utilize transferee liability more frequently as a tax collection mechanism, most notably against corporate shareholders who engaged in so-called Midco or middle-company transactions,3 primarily during the late 1990s to early 2000s.

Generally, a Midco transaction is one in which the seller engages in a stock sale (thus avoiding the triggering of built-in gain in appreciated assets) while the buyer engages in an asset purchase (thus allowing a purchase price basis in the assets), through use of an intermediary company. Taxpayers involved in these Midco transactions, and taxpayers who may be contemplating transactions that could be construed as Midcos, should be cognizant of their potential exposure as transferees under Code section 6901.4 They could potentially be subject to liability for their counterparty's unpaid taxes, interest and potential penalties related to the disposition of the property. Generally, the salient issue in these Midco transferee cases is whether the selling shareholder knew or should have known that the Midco intermediary would incur a tax liability that it could not and would not pay and thus would not be collected. Practitioners should be forewarned consequently that it would be prudent to give appropriate consideration to Section 6901 and evaluate their client's potential exposure to transferee liability before the transaction is completed. Part I of this paper evaluates Section 6901 on several fronts, with particular emphasis on recent decisions involving Midco transactions. Part II of this paper considers whether there are any limitations or defenses to the statute's reach. Since transferee liability of a taxpayer is derived from statutory authority, it is proper to begin by looking at the Code.

Legislative History of Section 6901 and Transferee Liability

In 1926, as part of an effort to assist in the collection of taxes, Congress enacted a provision that enabled the United States for the first time to proceed against those secondarily liable in the same manner as against those primarily liable.5 The purpose of Section 280 was to provide a summary and expeditious method of collecting income taxes in situations in which a taxpayer disposed of his assets, leaving himself unable to meet his tax liability. Prior thereto, the only avenue of redress open to the Government in such a case was to proceed against the transferee in equity upon a trust fund theory or at law if the debts of the transferor had been assumed. However, in practice, this was difficult and expensive, and was seldom attempted. Consequently, Congress established the alternative summary method of collection by notice to the transferee and extended to the taxpayer the opportunity either to pay and sue for a refund, or else to proceed before the Tax Court.6 No new obligation was created by the statute against the transferee, but merely a new procedure for enforcing the existing tax liability.7 Section 280 followed the enactment of Section 209 of Act of Congress in 1916, which created a liability at law for certain transferees of estates.8 A similar provision was subsequently enacted in 1932 for gift taxes.9

Section 311 of the Internal Revenue Code of 1939 followed as the successor to Section 280.10 The courts also recognized that Section 311 neither created nor defined a substantive  liability but provided merely a new procedure by which the Government may collect taxes.11 The U.S. Supreme Court has long since confirmed that this section "neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes."12

In 1954, the collection provisions for transferee liability in the areas of income, estate and gift taxes were collapsed into the current version of Section 6901.13 Section 6901(a) provides that the liability of a transferee of a taxpayer's property may 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 in the case of income, estate and gift taxes.14 In other words, "Section 6901 allows the IRS to assess and collect from the transferee the tax liability of the transferor as though the transferee was the taxpayer."15 A "transferee" includes a "donee, heir, legatee, devisee, [or] distributee."16 Transferee liability under Section 6901 does not create a separate or new liability – it merely provides the IRS with a secondary method for collecting the transferor's tax liability.17

Although the language adopted in Section 6901 differs from that used in the earlier versions, the intent and purpose of the underlying collection provision of transferee liability remained unchanged. The legislative history that accompanied the progeny of Section 6901 indicated that the new collection procedure was intended to be a "substitute for" the trust fund equitable proceedings.18 But some courts interpreted the provision as providing an alternate method of enforcing a transferee's obligation.19 Regardless of which interpretation is correct, the enactment of Section 6901 did not change the extent of the transferee's liability under existing law.20 The Conference Report to Section 280 stated that "(w)ithout in any way changing the extent of such liability of the transferee under existing law, the amendment enforces such liability . . . in the same manner as the liability for a tax deficiency is enforced."21 It is also important to note that Section 6901 is strictly procedural in nature, it does not grant the Government any substantial rights.22

For nearly thirty years following the passage of Section 280, courts and taxpayers struggled with the issue whether the transferee liability Code provision should be determined by reference to federal law or state fraudulent conveyance law. In 1958, the Supreme Court settled the debate in Commissioner v. Stern.23 In Stern, the Supreme Court ruled that transferee liability must be determined by reference to state law. The Supreme Court recognized that the procedures in place prior to the enactment of Section 6901's predecessor statute "proved unduly cumbersome."24 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.25 The statute was not enacted to expand the Government's reach as creditor in collecting taxes. Rather, the Supreme Court recognized that "[t]he Government's substantive rights in this case are precisely those which other creditors would have under [state] law."26 As such, Section 6901 was never intended to place the Government in a better position than any other creditor under state law. Thus, the existence and extent of the transferee's liability are determined by the law of the State in which the transfer occurred.27

In Tax Court, the Commissioner bears the burden of proving that a taxpayer is liable as a transferee.28 To successfully assert transferee liability, the IRS must both identify a substantive basis (state law) beyond Section 6901 and assert liability via the procedures mandated by Section 6901. The IRS may assess transferee liability under Section 6901 against a party only if two distinct prongs are met: (1) the party must be a transferee under Section 6901; and (2) the party must be subject to liability at law or in equity.29 Under the first prong of Section 6901, the court will look to federal tax law to determine whether the party in question is a transferee.30 The second prong, whether the party is subject to liability at law or in equity, is determined by the applicable state law.31 If there is no "conveyance" under state law, then there is no need to determine whether the taxpayer is a transferee under federal law.32 Because transferee liability rests on the principle of equity, nexus to the transaction is paramount to secondary collection against a transferee. A transferee can also be liable for interest33 and penalties.34

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1 See Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2d Cir. 2013); Frank Sawyer Trust v. Commissioner, 712 F.3d 597 (1st Cir. 2013); Slone v. Commissioner, 778 F.3d 1049, modified 116 AFTR2d 2015- 5962 (9th Cir. 2015).

2 See Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2013).

3 See Notice 2001-16.

4 Unless otherwise indicated, all references in this article to "Section" and "Sections" are to the Internal Revenue Code of 1986, as amended (the "Code"), and all references to "Treas. Reg. §" are to regulations issued thereunder (the "Treasury Regulations" or "Regulations"). Reference to the "IRS" or "Service" are to the Internal Revenue Service.

5 See Section 280 of the Revenue Act of 1926.

6 The summary transferee liability procedures of Section 6901 do not replace the trust fund doctrine or other federal statutes, such as the Federal Debt Collection Procedures Act of 1990.

7 See Hatch v. Morosco, 50 F.2d 138 (2d Cir. 1931).

8 See Ch. 463, S 209, 39 stat. 756, 780 (1916). The provisions of Section 280 of the Revenue Act of 1926, providing the new remedy for collection of income taxes, are almost identical to the provisions applicable to estates. See Section 6324. In the context of estate taxes, a transferee's personal liability is derived from Section 6324(a)(2) which provides, "(i)f the estate tax imposed by chapter 11 is not paid when due, then the . . . transferee . . . or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042, inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax." The "value" of the property is its fair market value.

9 See Ch. 209, S 510, 47 stat. 245, 249-501 (1932). In the context of gift taxes, if a donor fails to pay his annual gift tax liability the second sentence of Section 6324(b) provides that "the donee of any gift shall be personally liable for such tax to the extent of the value of such gift" as of the time the gift was completed. The "value" of a gift is the fair market value of the property received from the donor. In addition to the personal liability of the transferee, the liability is also secured by a lien on the property received.

10 Section 311 of the Internal Revenue Code of 1939 provided, in part:

(a) Method of collection. The amounts of the following liabilities shall, except as hereinafter in this section provided, be assessed, collected, and paid in the same manner and subject to the same provisions and limitations as in the case of a deficiency in a tax imposed by the chapter (including the provisions in case of delinquency in payment after notice and demand, the provisions authorizing distraint and proceedings in court for collection, and the provisions prohibiting claims and suits for refunds):

(1) Transferees. The liability, at law or in equity, of a transferee of property of a taxpayer, in respect of the tax (including interest, additional amounts, and additions to the tax provided by law) imposed upon the taxpayer by this chapter.

(f) Definition of 'transferee'. As used in this section, the term 'transferee' includes heir, legatee, devisee, and distributee.

11 See e.g., Phillips v. Commissioner, 283 U.S. 589 (1931); Hatch v. Morosco, 50 F.2d 138 (2d Cir. 1931); Weil v. Commissioner, 91 F.2d 944 (2d Cir. 1937); Tooley v. Commissioner, 121 F.2d 350 (9th Cir. 1941).

12 Commissioner v. Stern, 357 U.S. 39, 42 (1958) (discussing the predecessor transferee liability statute under the Internal Revenue Code of 1939, 26 U.S.C. § 311).

13 In 1954, legislative history indicates that the amalgamation of the three separate provisions into a single section was not intended to change existing law. See S. Rep. No. 1622, 83rd Cong., 2 Sess., reprinted in 1954 U.S.C.C.A.N. 4793, 5225.

14 Section 6901(a) provides:

(a) Method of Collection – The amounts of the forgoing liabilities shall, except as hereinafter in this section, 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:

a. (1) Income, Estate, and Gift Taxes – (A) Transferees – The liability, at law or in equity, of a transferee of property –

(i) of a taxpayer in the case of [income] tax.

(b) Liability – Any liability referred to in subsection (a) may be either as to the amount of tax shown on the return or as to any deficiency or underlayment of any tax.

15 See William W. Han, The Scope of Transferee Liability in Estate and Gift Tax Cases, TAXES (Jan. 1, 1996).

16 See Section 6901(h).

17 The trust fund doctrine is another legal theory utilized by the IRS to collect tax from a transferee. The doctrine has been sparingly invoked by the IRS since the enactment of Section 6901 and is beyond the scope of this article.

18 See H.R. Conf. Rep. No. 356, 69th Cong. 1st Sess. (1926), reprinted in 1939-1 C.B. (Part 2) 361, 372.

19 See Phillips v. Commissioner, 283 U.S. 589 (1931); United States v. Geniviva, 16 F.3d 522 (3d Cir. 1994).

20 See H.R. Rep. No. 356, 69th Cong., 1st Sess. (1926), reprinted in 1939-1 C.B. (Part 2), 361, 371.

21 Id.

22 See Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012).

23 357 U.S. 39 (1958)

24 Id. at 43.

25 Id. at 43; John Ownbey Co. v. Commissioner, 645 F.2d 540, 543 (6th Cir. 1981), citing Delia v. Commissioner, 362 F.2d. 400, 402 (6th Cir. 1966)

26 Id. at 47.

27 Id. at 45.

28 See Section 6902(a); Tax Court Rule 142(d). However, in a tax refund suit, the taxpayer bears the burden to show that plaintiff is not liable as a transferee. See e.g. Andrew v. United States, 91 F.Supp.3d 739 (D NC 2015).

29 See Rowen v. Commissioner, 215 F.2d 641, 643 (2d Cir. 1954) (discussing predecessor statute, 26 U.S.C. § 311).

30 Id. at 644.

31 See Stern, 357 U.S. at 45. In Stern, the Government argued, unsuccessfully, that the court reject the applicability of state law in favor of having the federal courts fashion a unified federal rule to determine transferee liability. Since Stern, the First and the Fourth Circuits have both addressed the relationship between the transferee prong and the liability prong of Section 6901. Both of these circuits concluded that the two prongs of Section 6901 are independent, and that the Tax Court did not err by only addressing the liability prong under state law. See Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597, 605 ( 1st Cir. 2013); Starnes v. Commissioner, 680 F.3d 417, 428 (4th Cir. 2012). The Second Circuit recently joined the First and Fourth Circuits in their interpretation of Section 6901. See Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2d. Cir. 2013).

32 See Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597, 605 (1st Cir. 2013)("if the Trust was not a transferee of the companies for purposes of Massachusetts fraudulent transfer law, then whether or not it was a 'transferee' for purposes of Section 6901 is irrelevant.")

33 In Stein v. Commissioner, the Tax Court stated that federal law governs the running of interest when the value of the transferred assets exceeds the transferor's total liability. 37 T.C. 945, 961 (1962). ("In cases where the transferred assets exceed the total liability of the transferor, the interest being charged is upon the deficiency, and is therefore a right created by the Internal Revenue Code.") The Code provides that the transferee is liable for interest from the date of the fraudulent transfer. See Section 6601; Lowy v. Commissioner, 35 T.C. 393, 395-96 (1960) ("[W]here the tax liability [is] greatly in excess of the amount received by the transferees in distribution . . . the transferee [is] liable to the full extent of the amounts received by them with interest from 'the fair average date of receiving' the sums distributed."). However, state law governs the running of interest when the value of the transferred assets is "insufficient to satisfy the transferor's tax liabilities." Stein, 37 T.C. at 961. Under New York law, "interest on a conveyance voidable because of constructive fraud runs from the date of demand by the creditor, but where actual fraud exists, interest runs from the date of fraudulent conveyance." Id. at 692 (citing MacIntyre v. State Bank of Albany, 307 N.Y. 630 (1954)).

34 The Code and Treasury Regulations do not explicitly state that transferees shall be liable for penalties. Nevertheless, courts have held that "the Internal Revenue Code . . . spells out the right of the Government to [collect] the so-called penalties" from transferees. Lowy v. Commissioner, 35 T.C. 393, 395 (1960). The courts have reached this conclusion summarily. See, e.g., Mizrahi v. Commissioner, T.C. Memo 1992-200; Swinks v. Commissioner, 51 T.C. 13, 17 (1968). Presumably, they do so by looking to the statutory structure of Section 6901, which provides that the transferee's liabilities "shall . . . be assessed, paid, and collected in the same manner . . . as in the cases of the taxes with respect to which the liabilities were incurred." Subsection (b) adds that "[a]ny liability . . . may be either as to the amount of tax shown on a return or as to any deficiency or underpayment of any tax." Together, these subsections provide that the amount of the transferee's liability is measured "as to any deficiency or underpayment" that created the transferor's liability. See Section 6902. In other words, the transferee steps into the shoes of the transferor. See Saltzman, IRS Practice & Procedure, pt. 17.05 ("Because the amounts of tax, penalty, and interest constitute the claim of the United States against the taxpayer/transferor, they also measure the claim against the transferred assets followed into the hands of the transferee."); see also I.R.M. pt. (stating that transferee liability should "include liability . . . for penalties").

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