Diebold Case In Second Circuit Adds Some Clarity To Transferee Liability Issue
November 15, 2013
by Monte A. Jackel
In Diebold Foundation v. Comm’r, the Second Circuit Court of Appeals reviewed a Tax Court opinion which had held, in a so-called Midco transaction (see Appendix below for the text of the IRS notice describing this transaction), that transferee liability for the unpaid taxes of the selling corporation was not applicable to certain distributees of the corporation. In an opinion issued yesterday, the Second Circuit had a number of interesting things to say in terms of its standard of review of Tax Court cases and how the transferee liability statute under section 6901 of the Internal Revenue Code is to be interpreted and applied.
The key points to be derived from this case are succinctly described below.
1. The first question faced by the Second Circuit was the standard of its review of Tax Court cases. In interpreting section 7482 of the Internal Revenue Code, the Second Circuit held that the Tax Court’s findings of fact are reviewed by it for “clear error”, but that mixed questions of law and fact are reviewed by it on a de novo basis to the extent that the alleged error is in the misunderstanding of the legal standard to be applied. The Second Circuit thus held that its prior view that mixed law and fact questions are to be reviewed under a clearly erroneous standard was incorrect.
2. Under section 6901, both the government and the taxpayer agreed that there is a two-part test. The disagreement in this case revolved around how that two-part test was to be applied. Under the two-part test in section 6901, (1) a party must be a transferee under section 6901, which is a federal tax law question, and (2) a party must be liable at law or in equity, which is a state law question. The government argued in both the Tax Court and in the Second Circuit that the two prongs were interdependent, meaning that if federal tax law held that the party was a transferee under section 6901, then state law had to be applied to the transaction as recharacterized under the federal tax law. The view of the Tax Court and of the taxpayer was that the two requirements were independent and that the party must both (1) be liable at law or in equity applying state law characterization standards, and (2) if the party is so liable under state law, then the party must be treated as a transferee under section 6901 applying federal tax law. The Second Circuit rejected the government premise that state law liability is assessed based upon the transaction as recharacterized by federal tax law because that view would favor the IRS over other creditors under state law and would import federal law into a state law substantive liability determination. The Second Circuit reiterated that section 6901 is only a procedural statute and does not create any new liability under state law.
3. The Second Circuit then determined that, under New York fraudulent conveyance law, the issue came down to determining whether the parties at issue had either actual or constructive knowledge that the selling corporation, by engaging in the Midco transaction, was seeking to avoid paying the federal income tax liability that would otherwise arise on the sale of the corporate assets. The Second Circuit viewed this question as one of mixed law and fact and thus applied a de novo review standard of the Tax Court’s holding that the parties were not liable under New York law. The Court then held that either the shareholders had actual knowledge of this tax avoidance goal or should be imputed this knowledge due to how the transaction was papered, the knowledge of the shareholders of the intended goals of the Midco transaction, and the duty of the shareholders, on this set of facts, to inquire further into the overall objectives and goals of the transaction. The Second Circuit then remanded the case back to the Tax Court to determine the other prong of the two-part test-whether the parties were transferees under section 6901 applying federal tax law standards of characterization of the transaction at issue.
Intermediary Transactions Tax Shelter Notice 2001-16
The Internal Revenue Service and the Treasury Department have become aware of certain types of transactions, described below, that are being marketed to taxpayers for the avoidance of federal income taxes. The Service and Treasury are issuing this notice to alert taxpayers and their representatives of certain responsibilities that may arise from participation in these transactions.
These transactions generally involve four parties: seller (X) who desires to sell stock of a corporation (T), an intermediary corporation (M), and buyer (Y) who desires to purchase the assets (and not the stock) of T. Pursuant to a plan, the parties undertake the following steps. X purports to sell the stock of T to M. T then purports to sell some or all of its assets to Y. Y claims a basis in the T assets equal to Y’s purchase price. Under one version of this transaction, T is included as a member of the affiliated group that includes M, which files a consolidated return, and the group reports losses (or credits) to offset the gain (or tax) resulting from T’s sale of assets. In another form of the transaction, M may be an entity that is not subject to tax, and M liquidates T (in a transaction that is not covered by § 337(b)(2) of the Internal Revenue Code or § 1.337(d)-4) of the Income Tax Regulations, resulting in no reported gain on M’s sale of T’s assets.
Depending on the facts of the particular case, the Service may challenge the purported tax results of these transactions on several grounds, including but not limited to one of the following: (1) M is an agent for X, and consequently for tax purposes T has sold assets while T is still owned by X, (2) M is an agent for Y, and consequently for tax purposes Y has purchased the stock of T from X, or (3) the transaction is otherwise properly recharacterized (e.g., to treat X as having sold assets or to treat T as having sold assets while T is still owned by X). Alternatively, the Service may examine M’s consolidated group to determine whether it may properly offset losses (or credits) against the gain (or tax) from the sale of assets.
The Service may impose penalties on participants in these transactions, or, as applicable, on persons who participate in the promotion or reporting of these transactions, including the accuracy-related penalty under § 6662, the return preparer penalty under § 6694, the promoter penalty under § 6700, and the aiding and abetting penalty under § 6701.
Transactions that are the same as or substantially similar to those described in the Notice 2001-16 are identified as “listed transactions” for the purposes of § 1.6011-4T(b)(2) of the Temporary Income Tax Regulations and § 301.6111-2T(b)(2) of the Temporary Procedure and Administration Regulations. See also § 301.6112-1T, A-4. It should be noted that, independent of their classification as “listed transactions” for purposes of §§ 1.6011-4T(b)(2) and 301.6111-2T(b)(2), such transactions may already be subject to the tax shelter registration and list maintenance requirements of §§ 6111 and 6112 under the regulations issued in February 2000 (§§ 301.6111-2T and 301.6112-1T, A-4). Persons required to register these tax shelters who have failed to register the shelters may be subject to the penalty under § 6707(a) and to the penalty under § 6708(a) if the requirements of § 6112 are not satisfied.