On October 14, 2005, the United States Tax Court in Tricarichi v. Commissioner22 held that the sole shareholder of a corporation was liable as a transferee under Section 6901 and Ohio law for the corporation's unpaid tax liability after he sold his stock to an "intermediary company" involved in a "Midco" transaction. In addition to the underlying tax liabilities, the taxpayer was found liable for penalties under Section 6662(a) and (h) for $6,012,777. An appeal, if taken, will lie to the US Court of Appeals for the Ninth Circuit.
Facts
In September 2003, Petitioner sold his cellular telephone business, West Side, a C corporation incorporated in Ohio, to Nob Hill, Inc., a Cayman Islands company and affiliate of Fortrend, for $35 million dollars. At the time of the sale, West Side had a net asset value of only $23.7 million, which reflected an aggregate tax liability for 2003 of $16 million. In 2003, West Side obtained total settlement proceeds of $65 million from litigation against major cellular service providers. As part of the settlement, West Side agreed to end all service to its cell phone customers as of June 2003.
Before the sale, Petitioner met with PwC to investigate alternatives to maximize after tax proceeds from the anticipated settlement. Petitioner expressed desire to eliminate the two-level tax on the settlement proceeds. Petitioner ultimately met with representatives of Midcoast and Fortrend to discuss the sale of West Side. Midcoast's representatives explained to petitioner that it was in the "debt collection" business and that, as part of its business model, it purchased companies that "had large tax obligations."23 Petitioner later met with Fortrend. Petitioner understood that Fortrend and Midcoast were both involved with "distressed debt receivables" and had basically the same business model. Fortrend told petitioner that it would purchase West Side and would offset the taxable gain with losses, thereby eliminating West Side's corporate income tax liability. Petitioner ultimately chose to sell West Side to Fortrend.
PwC reviewed the proposed transaction and characterized it as a "very aggressive, tax-motivated strategy" and indicated that the IRS would likely challenge the deductibility of the bad debt loss expected to be reported by West Side after the stock sale.24 The memorandum noted that PwC had provided no formal written advice to petitioner, but had discussed its conclusions orally with him.
Fortrend agreed to pay a "premium" for West Side. Fortrend offered to pay petitioner the amount of cash remaining (after the sale of all operation assets) in West Side, less 31.875% of West Side's total Federal and State tax liability for 2003. This left petitioner with a premium, above and beyond West Side's closing net asset value, equal to 68.125% of its accrued 2003 tax liability. In preparation for the stock sale, Millennium Recovery Fund, LLC, a Fortrend affiliate, created Nob Hill, Inc., a shell company to be the "intermediary company" that would purchase the West Side stock.
Petitioner's lawyers negotiated with Fortrend the technical details of the stock purchase agreement. Nob Hill provided covenants aimed at mitigating the risk that the transaction would be characterized as a "liquidation" of West Side. Nob Hill represented that West Side would remain in existence for at least five years after the closing, would "at all times be engaged in an active trade or business," and would "maintain a net worth of no less than $1 million" during this five-year period.25 (None of these representations were substantially honored.)
Nob Hill also provided purported tax warranties. The agreement represented that Nob Hill would "cause * * * [West Side] to satisfy fully all United States * * * taxes, penalties and interest required to be paid by * * * [West Side] attributable to income earned during the [2003] tax year."26 The agreement did not specify how Nob Hill would "cause" West Side to satisfy its 2003 tax liabilities or explain the strategy it would use to offset West Side's gain from the $65 million settlement. Nob Hill agreed to indemnify petitioner in the event of liability arising from breach of its representation to "satisfy fully" West Side's 2003 tax liability.27
Petitioner's lawyers attempted to include in the stock purchase agreement a provision prohibiting West Side from engaging in a "listed transaction" after Fortrend acquired West Side. Fortrend refused to agree to this provision. Instead, the parties negotiated a statement that Nob Hill "has no intention" of causing West Side to engage in a listed transaction.28
Petitioner agreed to sell West Side to Fortrend for $35 million, which represented a premium of $11.2 million above West Side's net asset value. In exchange, Petitioner agreed to pay Fortrend a fee in excess of $5 million. The stock purchase transaction was carefully structured to ensure that Fortrend made no real outlay of cash.
Following the closing, in November 2003, Millennium contributed to West Side a portion of a Japanese debt portfolio, consisting of defaulted loans that had a purported tax basis of $43 million, but a fair market value of less than $1 million. West Side wrote off the loans as worthless, and on its 2003 corporate income tax return, claimed a bad debt deduction of $42 million on account of that write-off. Following an audit, the IRS disallowed West Side's bad debt deduction. West Side did not challenge the deficiency notice, and in July 2009, the IRS assessed the tax deficiency of $15 million and penalties of $6 million under Section 6662(a) and (h). In 2012, the IRS timely mailed to petitioner a notice of liability as a transferee.
Legal Analysis
To impose transferee liability, a Court must first determine whether "the party [is] substantively liable for the transferor's unpaid taxes under State law."29 The Tax Court looked to Ohio law, the state of West Side incorporation and local for negotiating the sales contract. To determine petitioner's substantive liability under Ohio law, the Tax Court considered two questions: (1) did petitioner qualify as a transferee under Ohio law; and (2) was petitioner's transfer of West Side a fraudulent transfer under Ohio law.30 As to the first issue, petitioner argued that he was not a transferee of West Side because the cash he received from Nob Hill and the sources of that cash were "loans" from Rabobank and Moffat. For this reason, petitioner argued that he received no West Side assets. The Tax Court rejected petitioner's claim finding that the "loans" from Rabobank and Moffat were shams, and West Side was the true source of the cash petitioner received.31 Second, under Ohio law, the stock sale would be recharacterized as a defacto liquidation of West Side, with petitioner receiving in exchange for his stock a $35 million liquidating distribution.
Fraudulent Transfer
The Tax Court looked to Ohio law, which provides that a transfer is fraudulent with respect to a creditor where: (1) the creditor's claim arose before the transfer; (2) the transferor did not receive "a reasonably equivalent value in exchange for the transfer;" and (3) the transferor became insolvent as a result of the transfer.32 The Tax Court found that all three of these elements were satisfied.
In Tricarichi, there was no legitimate dispute that the IRS had a "claim" against West Side before the stock sale. West Side's federal tax liability had accrued in May 2003, four months before the transfer of assets. In addition, petitioner did not seriously dispute that West Side received "a reasonably equivalent value in exchange for the transfer."33 The Tax Court found that West Side consisted of nothing but cash and tax liabilities. The value of petitioner's stock thus equalled West Side's net asset value, which was approximately $23.7 million (cash equivalents of $40.6 million minus accrued tax liabilities of $16.9 million). West Side transferred $35.2 million to petitioner in exchange for his shares. Since his shares were worth only $23.7 million, West Side did not receive "a reasonably equivalent value in exchange for the transfer."34
As to the last element, the debtor making the transfer must have been "insolvent at that time or . . . become insolvent as a result of the transfer."35 Under Ohio law, solvency is measured at the time of the transfer. Here, West Side became insolvent as a result of the transfer. Following the transfer of $35.2 million to petitioner, West Side was left with tax liabilities of $16.9 million and assets of $5.1 million. Accordingly, the Tax Court found that West Side became insolvent as a result of the transfer and a fraudulent transfer had taken place.
Penalties
Petitioner argued that he should not be liable for any penalties because the distressed debt transaction claimed by West Side, giving rise to those penalties, was not entered into until after petitioner sold his stock and petitioner had nothing to do with the distressed debt transaction. The Tax Court rejected petitioner's argument and refused to follow Stanko v. Commissioner36 because, according to the Tax Court, that case related to Nebraska law in effect before 1989, which was different than Ohio law. Ohio law defined "claim" expansively to include any "right to payment" even if it is "unliquidated" and "unmatured." Thus, the Court found that the IRS may have a claim for the penalties whether or not they are thought to have been "existing at the time of the transfer."37
Footnotes
22 T.C. Memo 2015-201, 2015 WL 5973214.
23 Id. at *3.
24 Id. at *12.
25 Id. at *17.
26 Id.
27 Id.
28 Id. at *18.
29 Sloan v. Commissioner, __ F3d __, 2015 WL 5061315 (9th Cir. 2015).
30 Id. at *31.
31 Id. at *44.
32 Id. at *58-60.
33 Id.
34 Id.
35 Id.
36 209 F.3d 1082 (8th Cir. 2000).
37 Id. at *62.
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