Shareholders of Closely Held Corporation Were Liable as Transferees

(Parker Tax Publishing June 2019)

The Sixth Circuit affirmed a Tax Court decision holding that a transaction entered into by shareholders of a closely held corporation was a sham transaction to avoid a tax liability and the shareholders were thus liable for the resulting tax deficiencies as transferees. Applying the test for transferee liability under Code Sec. 6901, the Sixth Circuit found that the corporation owed the taxes, the shareholders were transferees, and the shareholders were liable to the government under the applicable state fraudulent transfer statute. Hawk v. Comm'r, 2019 PTC 186 (6th Cir. 2019).

Background

After Billy Hawk died in 2000, his wife, Nancy, decided to sell the family's Tennessee bowling business, Holiday Bowl. Nancy owned almost a fifth of the company's stock and her husband's estate owned the remainder. The Hawks' two sons operated the two bowling alleys for a while, but by 2002 Nancy realized she needed to sell Holiday Bowl. With the help of lawyers and accountants, she made a deal with MidCoast, a company that claimed an interest in acquiring companies with corporate tax liabilities that it could set off against its net operating losses.

In 2002, Nancy sold Holiday Bowl's assets, leaving it with $4.2 million in cash and a federal tax liability of $1 million. Holiday Bowl also owned a horse farm that Nancy wanted to keep, valued at $777,000. Trying to lower the taxes triggered by the asset sale, the Hawks' broker approached their attorney with information about MidCoast. The broker said that if MidCoast bought Holiday Bowl, Holiday Bowl would not need to pay corporate taxes on the asset sale.

Under the purchase agreement, the Hawks sold some of their shares in exchange for the company's remaining property, the horse farm, leaving Holiday Bowl with nothing but $4.2 million in cash. MidCoast paid $3.4 million to Nancy and the estate plus expenses for Holiday Bowl's $4.2 million of cash. To finance the transaction, MidCoast claimed it would borrow money from a company called Sequoia Capital. According to MidCoast, Holiday Bowl would then enter the debt collection business in order to generate new losses that would offset Holiday Bowl's existing taxes. After the sale, MidCoast transferred Holiday Bowl to Sequoia in exchange for the cancellation of Sequoia's loan and $320,000 cash. No one ever paid Holiday Bowl's outstanding federal taxes, and the one-time bowling company dissolved in 2006.

After an audit, the IRS issued a notice of deficiency to Holiday Bowl for income tax deficiencies of almost $1 million. The IRS noted that Holiday Bowl had been dissolved and its assets had been transferred to the shareholders of Holiday Bowl. Citing Code Sec. 6901, the IRS said that, as shareholders of Holiday Bowl, Nancy and her husband's estate were liable as transferees for the tax deficiencies. The Tax Court agreed, concluding that the Sequoia's loan to MidCoast was a sham and that Holiday Bowl had simply distributed cash to the Hawks. The Hawks appealed to the Sixth Circuit.

Analysis

The Sixth Circuit affirmed the Tax Court's decision and held that, under Code Sec. 6901, (1) Holiday Bowl owed the taxes, (2) the Hawks were transferees of Holiday Bowl, and (3) the Hawks were liable to the government for the taxes under Tennessee's fraudulent transfer statute.

The Sixth Circuit found that, in light of the economic realities, the Hawks were transferees of the $3.4 million from Holiday Bowl. In the court's view, the Sequoia loan to MidCoast was a charade and, in reality, MidCoast paid for the transaction with Holiday Bowl's own funds. The court found that Sequoia had no risk because Holiday Bowl's own cash served as the collateral for the loan. The court also noted the parties did not sign most of the loan documents, and the loan would not incur interest unless MidCoast defaulted. The court found that while Sequoia stood to make around $17,000 when MidCoast paid back the loan, this translated to annual interest of $6.3 million, nearly double what MidCoast borrowed. The court concluded that in reality, Holiday Bowl distributed its money to the Hawks, making them the company's transferees.

The court also agreed with the Tax Court that the Hawks were liable under Tennessee law. The court noted that Tennessee has adopted the Uniform Fraudulent Transfer Act (UFTA), under which the Hawks were liable if (1) the transaction was a transfer, (2) Holiday Bowl did not receive reasonably equivalent value in exchange, and (3) Holiday Bowl became insolvent. The Sixth Circuit found that the transaction met all three requirements. According to the court, Tennessee courts would find an indirect transfer considering the economic realities of the transaction. The court also found that Holiday Bowl did not receive reasonably equivalent value because, when the Hawks exchanged stock for the horse farm, the transaction merely subtracted from Holiday Bowl's balance sheet and Holiday Bowl got nothing when the Hawks received their $3.4 million. Finally, Holiday Bowl became insolvent due to the transaction, according to the court, because after the Hawks received their cash back, Holiday Bowl had only about two-thirds of the money it needed to pay its outstanding taxes.

The court rejected all of the Hawks' arguments, including that they did not know about MidCoast's fraudulent scheme. According to the court, Tennessee courts look to the economic realities of the transaction regardless of whether the Hawks knew about the fraud, and that when it comes to constructive fraud, the UFTA does not require the transferee to know about the debtor's misconduct. According to the court, transferees who deal in good faith can offset their liability by whatever they paid the debtor for the transferred asset, but acting in good faith without more does not preclude transferee liability. The Hawks' emphasis on their due diligence and lack of knowledge of illegality did not shield them from the sham nature of the transaction, the court concluded.

Observation: The Sixth Circuit contrasted this decision with its decision in Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017) upholding a transaction involving a domestic international sales corporation and a Roth IRA. The court explained that, in that case, the plain terms of the relevant statutes permitted the transaction and the IRS could not recharacterize it using the substance-over-form doctrine. In this case, the government was enforcing the statutes as written, in the court's view.

For a discussion of transferee liability, see Parker Tax ¶262,530.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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