Starnes v. Commissioner of Internal Revenue, Nos. 11-1636, 11-1706, 11-1712, 11-1714

Decided: May 31, 2012

Starnes, Morelli, Naples, and Stroupe (the “Former Shareholders”) worked at Tarcon, Inc.  In 1972, they purchased the company, each with a 25 percent stake.  In 2003, they decided to sell their interests.  Tarcon’s sole asset, a warehouse, was sold to ProLogis and the stock was sold to MidCoast Investments and its affiliates.  MidCoast agreed to operate Tarcon and pay $880,000 in federal and state corporate income taxes Tarcon owed.  MidCoast quickly sold Tarcon to another company, which then transferred Tarcon’s cash to an offshore account.  Tarcon’s 2003 tax returns claimed losses that purported to offset its entire tax liability.  When the IRS audited the federal return, it disallowed those losses and imposed tax liabilities, but Tarcon never paid.  The IRS asserted the Former Shareholders were liable as transferees for Tarcon’s unpaid taxes.

The Tax Court adhered to the Supreme Court’s decision in Commissioner v. Stern, 357 U.S. 39 (1958), which held that state law determines the “existence and extent” of a transferee’s liability for unpaid taxes the taxpayer owed prior to the transfer of assets.  The Tax Court applied North Carolina law and held that the Commissioner had not made the requisite showing to hold the Former Shareholders liable as transferees. Questions of law regarding Tax Court decisions are reviewed de novo, while findings of fact are reviewed for clear error.

In 1926, Congress authorized the Commissioner to collect taxes from transferees pursuant to 26 U.S.C. § 6901, which defines a “transferee” as including “shareholder[s] of a dissolved corporation.”  In Stern, the Court held that a transferee’s substantive liability for another’s tax deficiency was not rooted in § 6901 nor any other federal law.  The Erie doctrine thus required the application of state law until Congress stated that federal law governs transferee liability.  Stern also states that whether there has been a “transfer” within the meaning of § 6901 is a question of federal law.  The burden of proving both that a transfer has occurred and that state law allows for transferee liability rests with the Commissioner pursuant to 26 U.S.C. § 6902(a).

The Tax Court assumed that the Former Shareholders were transferees within the meaning of § 6901, but rejected each of the proferred bases for imposing substantive liability.

First, the Commissioner argued that the Tax Court committed legal error by treating the question of the Shareholders’ liability under state law as independent of whether they were transferees pursuant to § 6901.  The Commissioner argued that the “facts” to which state law is applied depend on whether someone is a transferee pursuant to § 6901.  Stern, however, precludes this argument, because the Court “assumed without deciding that Stern was ‘a transferee,’” an inquiry completely independent from assessing liability.  Because the questions are independent and because the Commissioner failed to prove the Shareholders were liable under state law, the Fourth Circuit declined to decide whether they were “transferees” as defined by § 6901.  The Commissioner then alleged four potential bases for imposing substantive liability.

First, NCUFTA § 39-23.5 provides that a “transfer” is fraudulent as to a creditor whose claim arose before the transfer was made if the debtor did not receive reasonably equivalent value in exchange and was insolvent or became insolvent.  The Tax Court considered only the transfer of Tarcon’s cash to MidCoast’s attorneys and the transfer of cash from MidCoast to the Former Shareholders, occurring on November 13 and 14, 2003.  Tarcon received reasonably equivalent value in these transfers and was not rendered insolvent as a result.  The Commissioner argued that later transactions should be considered, but there was no evidence that the Former Shareholders had actual or constructive knowledge of those transactions.

On appeal, the Commissioner argued that the Tax Court erred in choosing the shorter time frame and in finding the Former Shareholders lacked the requisite knowledge of the entire scheme.  The Fourth Circuit held that the Tax Court properly inquired as to whether the Former Shareholders knew or should have known that Tarcon would become delinquent in fact.  Further, the Tax Court applied the proper standard, assessing whether the Former Shareholders had actual or inquiry notice, finding that they had inquiry notice, but did not have constructive notice, as no reasonably diligent inquiry would have disclosed that Tarcon would become insolvent.

The Commissioner further argued that these factual findings were clearly erroneous, as the Shareholders should have known of MidCoast’s intent to create a tax shelter with Tarcon’s funds.  While the evidence supports the Commissioners arguments, the Tax Court relied on sufficient countervailing evidence, thus it did not clearly err.  Given that, the Commissioner failed to prove that later transfers should be collapsed with earlier transfers to assess whether Tarcon received “reasonably equivalent value.”  Accordingly, the transactions were not fraudulent, therefore § 39-23.5 does not provide a basis for substantive liability.

Second, NCUFTA§ 39-23.4(a)(2) provides that a “transfer” is fraudulent as to a creditor if the debtor made the transfer without receiving a reasonably equivalent value in exchange and was engaged in a transactions for which its remaining assets were unreasonably small or intended to incur debts beyond the debtor’s ability to pay.  As explained above, transfers after the November 13 and 14 transfers were not considered for NCUFTA purposes.  The Commissioner failed to prove Tarcon did not receive reasonably equivalent value for its cash, therefore § 39-23.4(a)(2) does not provide a basis for substantive transferee liability.

Third, under NCUFTA § 39.23.4(a)(1), a transfer made by a debtor is fraudulent as to a creditor if the debtor made the transfer with intent to hinder, delay, or defraud any creditor.  The statute provides non-exclusive factors for determining whether a debtor had the requisite fraudulent intent.  The Tax Court considered seven of these factors and held that the Commissioner failed to show that the Shareholders intended to hinder, delay, or defraud the IRS, Tarcon’s only creditor at the time.  The Commissioner argued on appeal that the Tax Court erred in applying these factors, but the Fourth Circuit found that the Tax Court did not commit legal error.  Accordingly, § 39-23.4(a)(1) does not provide a basis for substantive transferee liability.

Finally, the Commissioner argued that the common law trust fund doctrine provided a basis for imposing substantive liability on the Former Shareholders.  The doctrine treats the assets of a corporation essentially as a trust fund and treats the officers and directors as occupying a fiduciary position in respect to stockholders and creditors.  Additionally, debts must be paid before officers and directors can appropriate assets and officers (and stockholders) are liable to the corporation and its creditors for any loss arising out of fraud or negligence. The Tax Court rejected this argument because the trust fund doctrine only applies where the circumstances suggest a winding up or dissolution of the corporation and the Commissioner failed to present evidence that amounted to winding up or dissolution.

On appeal, the Commissioner argued that the finding that Tarcon was not in dissolution was clearly erroneous.  The Fourth Circuit disagreed.  MidCoast assured the Former Shareholders that Tarcon would remain a going concern and would be absorbed into MidCoast, thus the transaction did not amount to a winding up or dissolution of the company.

The Commissioner’s arguments essentially amount to an argument that, as a policy matter, requiring that he prove actual or constructive knowledge is an impossible burden in tax shelter cases.  For the foregoing reasons, the Fourth Circuit found that this policy argument is foreclosed by existing state law.  The Commissioner failed to show that the Former Shareholders should be held substantively liable as transferees.  The Fourth Circuit affirmed the Tax Court’s judgment.

Circuit Judge Wynn dissented from the opinion, noting that the transactions actually resulted in a $410,711 windfall to the Former Shareholders, which was a cut from Tarcon’s $88,627 tax liability.  This amount to a scam aimed at fraudulently evading paying taxes.  Furthermore, the majority incorrectly concluded that it did not need to address whether the Former Shareholders were transferees as defined by § 6901, touching upon the fact that this case is materially different from Stern.  In Stern, the transferee would not have been liable for her deceased husband’s unpaid tax deficiencies.  Here, however, the Former Shareholders would be liable only if there was a fraudulent transfer and they were transferees under § 6901.  This inevitably involves consideration of which transactions are under review.  Because of the distinction between this case andStern, the majority’s reliance on Stern is erroneous.

According to the dissent, the Tax Court and the Fourth Circuit must first assess which transactions are under review, which turns on the determination of whether the Former Shareholders are transferees.  Fourth Circuit precedent requires looking at substance over form and the objective characteristics of a transaction.  In this case, the “objective economic realities” indicate that the Shareholders wound up Tarcon and received cash, a transaction with no apparent plan to use the cash to continue business activities.  The sale to MidCoast was not a true sale of stock, but rather was a purported sale that was no more than a cash-for-cash swap.  This type of cash-for-cash exchange serves no purpose other than avoiding paying taxes.

Because the relevant transaction is actually the effective liquidation of Tarcon, the Fourth Circuit should have assessed whether the Former Shareholders were transferees.  Circuit Judge Wynn believes that the Former Shareholders satisfy the definition of transferees in § 6901.  The Former Shareholders are liable as “transferees of transferees” because Tarcon transferred liabilities to MidCoast, which in turn transferred cash to the Former Shareholders.

Finally, the Former Shareholders did not understand what MidCoast actually planned to do with Tarcon, but made no inquiries because they did not want to understand what was going on.  Willful blindness of this sort cannot be permitted to stand because it will encourage federal tax avoidance as a regular business practice.  For the foregoing reasons, Circuit Judge Wynn dissented from the Court’s opinion.

Full Opinion

-Michelle Theret

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