Eleventh Circuit Affirms Tax Court: Sale of Media Company Lacked Valid Business Purpose

(Parker Tax Publishing October 2017)

The Eleventh Circuit affirmed a Tax Court decision that former shareholders of a media company were liable as transferees for unpaid taxes on gains from the sale of the company's assets through a complex multistep transaction involving an intermediary and several other entities. The Eleventh Circuit concluded that the Tax Court correctly applied federal tax principles of substance over form in determining that the taxpayers were liable under state law for a fraudulent transfer. Shockley v. Comm'r, 2017 PTC 446 (11th Cir. 2017).

Background

Terry and Sandra Shockley, a married couple, are former shareholders of Shockley Communications Corporation (SCC). SCC owned five TV stations, a radio station, and a video production company in Wisconsin, as well as a TV station and several radio stations in Minnesota. The Shockleys each owned approximately 10 percent of the SCC's common stock and an entity owned by the couple, Shockley Holdings L.P., owned around 3.5 percent of the company. The couple served on the board of directors; Mr. Shockley served as president and treasurer, and Mrs. Shockley served as vice president and secretary.

In early 2000, the Shockleys decided to retire and began exploring alternatives for a sale of SCC, including a sale of the company's stock and a sale of the assets. The Shockleys were advised that the after-tax liquidation proceeds of a stock sale could be as high as $94 million while the proceeds of an asset sale might be only $75 million. However, they also learned that the general preference in the industry would be an asset sale. By May 2000, SCC had an offer from Quincy Newspapers, Inc., to purchase around 95 percent of SCC's assets for $160 million. No deal was reached and negotiations continued through summer 2000.

SCC eventually entered into an agreement with Integrated Capital Associates (ICA) for a buy stock/sell assets transaction. ICA would form a wholly owned subsidiary, NCAC, to purchase the Shockleys' stock for $117 million. An asset purchase agreement provided that NCAC would sell SCC's Wisconsin TV stations and production company to Quincy for $168 million. Under a separate asset purchase agreement, NCAC would sell the Minnesota TV station to a company owned by the Shockleys. In the sale negotiations, counsel for SCC and NCAC discussed the importance of minimizing any links between the stock purchase agreement and the asset purchase agreements.

In 2001, the IRS issued Notice 2001-16, which advised that participants in "intermediary transactions tax shelters," also known as "Midco transactions," would be required to disclose their participation. The Shockleys were advised by their accountant that their proposed transaction was similar to the transactions described in the notice.

The SCC transactions closed at the end of May 2001. The stock sale and the asset sales all took place in under three hours at the office of a law firm representing ICA. The transaction involved multiple steps and several entities including an Isle of Man limited partnership. The Shockleys each received around $11 million and Shockley Holdings received just over $4 million in exchange for their shares. The transaction resulted in the sale of SCC's highly appreciated assets without any tax liability to SCC, its shareholders, or anyone else. SCC's tax return for its short 2001 tax year reported that it had zero assets by the end of its 2001 tax year and zero tax due. It reported that SCC had merged into a wholly owned subsidiary of NCAC and had converted into a Delaware LLC in a tax free liquidation and distribution under Code Sec. 332.

In 2005, the IRS assessed a deficiency for SCC of over $41 million, penalties of approximately $10 million, and interest of almost $27 million. The IRS determined that the Shockleys were liable for SCC's taxes as transferees under Code Sec. 6901. The Shockleys filed Tax Court petitions contesting the transferee liability determination.

The Tax Court sided with the IRS, disregarding the form of the transaction and holding the Shockleys liable as transferees of SCC. Each was held liable for approximately $11 million plus interest, and Shockley Holdings was held liable for $4 million plus interest. The Shockleys appealed the Tax Court's decision to the Eleventh Circuit.

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. The IRS must establish that the target for collection is a transferee of the delinquent taxpayer under Code Sec. 6901. It must also show that the transferee is liable for the transferor's debts under state law. Code Sec. 6901(h) defines the term "transferee" broadly to include any donee, heir, legatee, devisee, or distributee.

The Shockleys challenged the Tax Court's findings with respect to both their transferee status under Code Sec. 6901 and their substantive liability under state law. They argued that the Tax Court improperly recast the SCC stock sale as an asset sale followed by a liquidating distribution. According to the Shockleys, SCC was a going concern at the time of the stock sale, and the legitimate nontax reason for the transaction was to avoid a piecemeal sale of SCC's assets. The Shockleys said they engaged in one transaction, the sale of SCC stock to NCAC for cash, and that NCAC undertook the asset sale without their involvement or knowledge. They also argued that the transaction was at arm's length because there was no affiliation between the stock purchaser and the shareholders.

With regard to their substantive liability under state law, the Shockleys said the Tax Court erroneously applied the Wisconsin fraudulent transfer law to their transaction. To be liable under the Wisconsin Uniform Fraudulent Transfer Act (WIUFTA), (1) the creditor's claim must arise before the transfer was made, (2) the debtor must make the transfer without receiving a reasonably equivalent value in exchange, and (3) the debtor must either be insolvent at the time of the transfer or become solvent as a result of the transfer. According to the Shockleys, the Tax Court erroneously recast the transaction to create the requirements for a fraudulent transfer, in effect expanding the definition of a transfer beyond the statutory intent. The Shockleys conceded that if the transaction was properly recast, the first two elements of the fraudulent liability test would be satisfied, but that the Tax Court erred in determining that SCC was insolvent as of the transaction closing date.

Analysis

The Eleventh Circuit held that there was no legitimate business purpose or any economic effects that justified using the Midco transaction form described in Notice 2001-16. The court rejected the Shockleys' argument that they wanted to avoid a piecemeal sale because the transaction resulted in SCC's radio assets being sold separately some four months after the sale of the TV assets and the assets were ultimately distributed to three different buyers. The Eleventh Circuit found the Shockleys' claim that they engaged in only one transaction, the stock sale, disingenuous at best given their awareness that the stock sale was just one piece of a complex puzzle. The Eleventh Circuit found that several facts, including the fact that NCAC had no assets or income producing purpose of its own, contradicted the Shockleys' position that the transaction was at arm's length. There was no adequate nontax justification for the numerous transactions between shell companies, the Eleventh Circuit said. The Tax Court therefore appropriately used the substance-over-form analysis and its related judicial doctrines to determine the true nature of the transaction, which existed solely to alter tax liabilities.

The Eleventh Circuit next determined that the Tax Court correctly applied the substance-over-form analysis in finding the Shockleys liable under the WIUFTA. The court reasoned that the substance-over-form analysis comported with the Wisconsin statute's purpose of protecting creditors and that this statutory intent would be frustrated if the court could not look through the form of a transaction to its substance. The Eleventh Circuit also found that the Tax Court correctly followed Feldman v. Comm'r, 2015 PTC 58 (7th Cir. 2015), which held that the substance over form analysis under Wisconsin law is substantially the same as under federal tax law. According to the Eleventh Circuit, the similarly broad definitions of a transfer under Code Sec. 6901 and the WIUFTA, the creditor protection goals of the WIUFTA, and the lack of any case law suggesting a meaningful difference between the analysis under Wisconsin and federal law showed that the Tax Court was correct in following Feldman. The Eleventh Circuit further found that in recasting the transaction, SCC was correctly determined to be insolvent at the time of the transfer as required under the WIUFTA.

The Eleventh Circuit concluded that the Shockleys qualified as transferees under the WIUFTA. SCC received nothing of reasonably equivalent value in exchange for the proceeds from the sale of its assets, given that the distributions essentially liquidating the company rendered its stock worthless. The IRS's claim against the Shockleys arose before the transfers were made. Finally, the court noted, the transfers caused SCC to become insolvent because its liabilities exceeded its assets. The Eleventh Circuit therefore upheld the Tax Court's determination that the Shockleys were substantively liable for the fraudulent transfer.

For a discussion of transferee liability under Code Sec. 6901, 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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