Shareholder Liable as Transferee for Dividend Payments Leading to Company's Insolvency

(Parker Tax Publishing August 2017)

The Eleventh Circuit held that a minority shareholder who received dividends from a company that became insolvent was liable as a transferee for the company's unpaid taxes. The court held that Code Sec. 6901 did not require the IRS to first exhaust its remedies against the company before pursuing the shareholder. Kardash v. Comm'r, 2017 PTC 357 (11th Cir. 2017).

Background

William Kardash was a minority shareholder and employee of Florida Engineered Construction Products Corporation (FECP), a manufacturer of concrete lintels and sills for use in residential construction. FECP was formed in 1986 with Kardash as one its founding shareholders. Kardash was later promoted to president of manufacturing and operations, a position he held until he retired in 2014. FECP's controlling shareholders were Ralph Hughes and John Stanton, who served as FECP's chairman of the board and president, respectively. During the early 2000s, FECP's revenues rose with the booming housing market. The company went from $40 million in revenue in 1999 to $132 million in 2005. However, by 2007 when the housing market declined, the company's revenues decreased to $55 million. Throughout this period, FECP paid no federal income tax. Hughes and Stanton siphoned substantially all of the cash out of the company using hidden bank accounts and shell corporations. Kardash was not involved in the cash siphoning scheme.

In 2009, the IRS informed FECP of tax deficiencies, penalties and interest it accrued during 2001 to 2007. A three-year investigation revealed that FECP's assets had a fair market value of approximately $3 million. Kardash contested the valuation and argued that the company was worth around $8 million. The IRS never elected to levy FECP's bank accounts or seize its assets. Instead, FECP stipulated that it owed the IRS around $129 million and agreed to monthly payments. The IRS also pursued funds that it argued had been fraudulently transferred by FECP to its shareholders. Stanton was convicted of eight counts of federal tax crimes and ordered to pay restitution. An agreement was reached with the estate of Hughes, who died in 2008. Kardash contested in Tax Court the IRS's determination of his liability as a transferee.

The IRS said Kardash was liable as a transferee for advances and dividends he received between 2003 and 2007, including dividends of approximately $1.5 million in 2005, $1.9 million in 2006, and $57,000 in 2007. According to the IRS, these advances and dividends were fraudulent transfers under Florida law because FECP did not receive any value from Kardash in exchange for the payments and either FECP was insolvent or the transfers led to FECP's insolvency. Kardash argued that the advances and dividends could not be fraudulent because they were intended to replace his bonuses, which FECP had suspended in 2003. Kardash further argued that in any event, FECP was not insolvent until 2006, meaning any payments before that time could not satisfy the insolvency element of constructive fraud. He also asserted that, notwithstanding Florida law, the IRS was required under Code Sec. 6901 to exhaust all reasonable collection efforts against FECP before pursuing transferee liability against him and failed to do so.

The Tax Court rejected Kardash's Code Sec. 6901 exhaustion argument. It held that state law, not Code Sec. 6901, determined whether the IRS had to exhaust all of its remedies before pursuing Kardash, and that Florida law did not impose such a requirement. The Tax Court agreed with Kardash that the advance payments were compensation because they were designed to replace FECP's bonus program but found that Kardash's dividends were not compensation. The Tax Court held that FECP became insolvent in January 2006, and grouped Kardash's 2005 dividend with the dividends paid that year to Stanton and Hughes as part of a series of transactions that led to FECP's insolvency.

Eleventh Circuit's Decision

Kardash appealed to the Eleventh Circuit, again arguing that Code Sec. 6901 imposes an exhaustion requirement on the IRS. He also challenged the Tax Court's conclusion that his dividends resulted in constructive fraud under Florida law. Kardash argued that FECP received value from his services in exchange for the dividend payments. He also argued that his 2005 dividend should not have been grouped with the transfers to Stanton and Hughes in order to satisfy the insolvency requirement. Kardash reasoned that his 2005 dividend was insignificant compared to those paid to Stanton and Hughes, as well as to FECP's total assets.

The Eleventh Circuit, while sympathetic to Kardash, held that Code Sec. 6901 did not require the IRS to pursue all reasonable collection efforts against FECP before collecting from Kardash. Reviewing the legislative history, the court concluded that the statute was intended to give the IRS a procedure for enforcing transferee liability without changing the extent of such liability under existing law. According to the court, the statute's "at law or in equity" language means the IRS can pursue either an equitable remedy against a transferee, which would require the exhaustion of remedies against the transferor, or proceed under a state statute if one applies. Florida's transferee liability statute defines a creditor to include any government agency and does not require the creditor to prove that all remedies against the transferor have been exhausted. Thus, the IRS was permitted under Florida law to pursue Kardash as a transferee without having to first prove exhaustion.

The Eleventh Circuit then applied the Florida constructive fraud statute and found that the dividend payments to Kardash made him liable as a transferee for FECP's unpaid taxes. The court first concluded that the dividends were not compensation. The court noted that FECP reported the payments as dividends on Form 1099-DIV and that Kardash paid the qualified dividend rate on the payments. The court also noted that, like dividends, the payments were based on Kardash's percentage stock ownership in FECP. Next, the court found that the Tax Court properly grouped the 2005 dividend with the payments to Stanton and Hughes as part of a series of transactions that led to FECP's insolvency. The court found some merit in Kardash's argument that his $1.5 million dividend in 2005 was small compared to the $16 million and $21 million dividends paid to Stanton and Hughes that year. The court concluded, however, that the payments were part of the same series of transfers leading to FECP's insolvency because Kardash, Stanton, and Hughes were all issued the same class of shares and the dividends were paid on a per share basis. There was no indication that, for example, FECP issued different classes of shares and that Stanton and Hughes triggered special dividends only on their class of shares. To the contrary, the court found that any discrepancy in the amounts paid to Kardash, Hughes and Stanton was attributed to the different number of shares they owned.

Observation: The court did note that, by all accounts, Kardash was a victim of the fraud conducted by his friends and coworkers at FECP. However, the court said, in perpetrating that fraud, Hughes and Stanton transferred funds from FECP to Kardash that rightly belonged to the IRS, and the law of Florida required that he pay those funds back.

For a discussion of transferee liability under Code Sec. 6901, see Parker Tax ¶262,530.10.

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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