The Tax Court in Brief February 7 – February 11, 2022
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Tax Litigation: The Week of February 7 – February 11, 2022
Slone v. Comm’r, T.C. Memo 2022-6 | February 7, 2022 | Lauber, J. | Dkt. Nos. 6629-10, 6630-10, 6631-10, 6632-10 (Consolidated)
Short Summary: These four “sister” and consolidated Slone opinions stem from a stock-sale transaction commonly known as an “intermediary company” or “Midco” transaction which ultimately resulted in a $13,494,884 federal income tax deficiency and a $2,698,997 accuracy-related penalty, plus accrued interest, against a judgment-proof corporation. Thus, the Commissioner pursued the tax liability (including penalties and interest) against transferees of the corporation’s assets.
Key Issues:
- Under the computation rules for entry of a decision, i.e., Tax Court Rule 155, did the Commissioner properly compute Petitioners’ transferee liability to include penalties and interest assessed against a transferor corporation before Petitioners received notice of liability from the IRS?
- Whether Petitioners were entitled to reductions for “equitable recoupment” when they recomputed past tax liabilities by reducing reported capital gains by the transferee liability imposed on them?
Short Answers:
- Yes.
- No.
Primary Holdings:
- A transferee may be liable for penalties assessed against a transferor even when claims for those penalties against the transferor did not come into existence until long after the transfers at issue took place. The analysis depends in part on state law, and in the case at hand, the applicable state law permitted the Commissioner, a creditor, to apply a transferor’s liability for penalties to the Petitioners.
- Where the transferee receives assets with a value exceeding the transferor’s liability (which was the case as to one of the Petitioners), the Internal Revenue Code determines pre-notice interest, and the availability of interest under state law is irrelevant. Sections 6601 and 6621 of the Code permit recovery of pre-notice interest from that transferee.
- Equitable recoupment is an equitable remedy available where the government has taxed a single transaction under inconsistent theories. To pursue equitable recoupment, there must be an inadequate remedy at law. In Slone, the computation of tax rules set forth in Section 1341 provided an adequate legal remedy for the alleged inconsistency presented by Petitioners.
Key Points of Law:
- An “intermediary company” or “Midco” transaction is a type of tax shelter that was promoted in the late 1990s and early 2000s. The basic premise behind the shelter was to use an intermediary company (a “Midco”) to purchase shares of a target company, together with embedded corporate tax liability, and, through a series of sham transactions and accountings, attempt to avoid corporate-level tax, thus benefitting the shareholders of the target company. Generally, the promoter and the shareholders would agree to split the dollar value of the corporate tax avoided by the transaction, and the Midco would ultimately distribute its cash to the shareholders of the target company, resulting in an asset-less and judgment-proof Midco entity from whom no tax could be collected. In 2001, the IRS listed Midco transactions as reportable transactions for federal income tax purposes, and the IRS warned that it may impose penalties on participants, preparers, and promoters of these transactions. See Notice 2001-16, 2001-1 C.B. 730, clarified by Notice 2008-111, 2008-51 I.R.B. 1299.
- The Slone cases presented to the Tax Court with all substantive issues being resolved. In such situations, the Tax Court normally directs that decisions be entered under Rule 155 so as to ascertain the bottom-line tax effect of the determinations made in the Court’s opinion.
- Rule 155(a) provides, in part: “Where the Court has filed . . . its opinion . . . determining the issues in a case, it may withhold entry of its decision for the purpose of permitting the parties to submit computations . . . showing the correct amount to be included in the decision.” Rule 155 sets forth procedural rules for the Court to address matters where all substantive issues are determined but the parties’ respective computations do not agree. New issues may not be raised in a Rule 155 computation proceeding. See Rule 155(c).
- The Commissioner is permitted to assess a tax liability against a person who is the transferee of assets of a taxpayer who owes income tax, estate tax, or gift tax. See 26 U.S.C. § 6901(a)-(a)(1)(A)(iii). The tax liability of a transferor may be collected only once. However, transferee liability is several under section 6901, and each applicable transferee is severally liable for a transferor’s tax debt up to the value of the assets that each transferee received. The determination of such transferee liability depends on whether the person is substantively liable for the transferor’s unpaid taxes under state law and whether that party is a “transferee” within the meaning of section 6901.
- In the case of Slone, the substantive state law in issue was the Arizona Uniform Fraudulent Transfer Act, which, generally speaking, is a law that allows a creditor (here, the IRS) with the means to reach assets a debtor (here, a Midco) has transferred to another person (here, Petitioners and parties to a Midco transaction) to keep them from being used to satisfy a debt. See Rev. Stat. Ann. § 44-1001, et. seq. (2021).
- The Court of Appeals for the Ninth Circuit (in one of the appeals in the Slone cases) held that the Petitioners were transferees of the target corporation involved in the Midco transaction and thus were subject to transferee liability for the income tax obligations of the Midco, up to the limit of the amount transferred to Petitioners. Upon remand to the Tax Court, it found that a transferee may be liable for penalties assessed against a transferor even when claims for those penalties against the transferor did not come into existence until long after the transfers at issue took place. The Court noted that the Arizona UFTA defines “claim” very broadly to include even future penalties that the IRS, as a creditor, might assess against the Midco in issue. See Rev. Stat. Ann. § 44-1001.2 (2021) (defining “claim”). Thus, the computation of the Commissioner to include those penalties against the transferees was proper.
- The Commissioner does not bear the burden of production with respect to penalties in a corporate- or partnership-level proceeding. In Slone, the tax liability in issue was that of a corporation, albeit to be assessed against individual transferees; thus, the burden of proof for liability of an individual for a penalty was inapplicable. See 26 U.S.C. § 7491(c) (“Notwithstanding any other provision of this title, the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”) (emphasis added).
- In a fraudulent transfer matter, “if the transferred assets are insufficient to satisfy the IRS’s claim against the transferor, the IRS may have a further right to collect pre-notice interest from the transferee, based on the transferee’s wrongful use of the transferred assets.” Where, however, the transferee receives assets with a value exceeding the transferor’s liability, the Internal Revenue Code determines pre-notice interest, and the availability of interest under state law is irrelevant. See 26 U.S.C. § 6601. Because one of the Petitioners received assets with a value that exceeded the transferor’s total tax liability (including pre-notice interest), that Petitioner’s liability for interest is governed by federal law (Code sections 6601 and 6621), not Arizona law.
- Equitable recoupment is an equitable remedy designed to prevent injustice where the government has taxed a single transaction event under multiple inconsistent theories. The basic requirement for equitable relief has always been the inadequacy of the remedy at law. The Court in Slone found that the computation of tax rules set forth in Section 1341 provided an adequate legal remedy for the problem that Petitioners identified. In addition: “‘[W]here a taxpayer has in [one] year received an amount from a corporation under a claim of right and paid a tax upon the receipt, he is not entitled to recover the tax paid in the prior year under a doctrine of equitable recoupment when it is later determined that he is liable as transferee for tax of the corporation making the distribution to him.’” Slone, at pg. 14 (quoting Maynard Hosp., Inc. v. Comm’r, 54 T.C. 1675, 1676 (1970)).
Insights: Under Section 6901, the Commissioner has wide statutory latitude to pursue tax liability against a person who is the transferee of assets of a taxpayer who owes income tax, estate tax, or gift tax. Transferee liability depends on a blend of state law and federal law. Tax shelters, such as Midco transactions, that are designed to inappropriately avoid corporate-level taxation place benefitting (and perhaps unknowing) shareholders in jeopardy for transferee liability, including for penalties and interest assessed against the corporation years before the shareholders are notified of the potential transferee liability.
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