On May 31, 2012 the Fourth Circuit Court of Appeals issued its opinion in the case of Starnes v. Commissioner, upholding a decision of the United States Tax Court which determined that the former shareholders of a corporation were not liable as transferees for unpaid corporate income taxes. The opinion is the first appellate level decision addressing the proper legal standard to be applied in order to determine if a person is liable as a transferee under § 6901 of the Internal Revenue Code.
The Starnes case involved what the IRS characterizes as an “intermediary transaction tax shelter.” The IRS first alerted the general public to intermediary transaction tax shelters in IRS Notice 2001-16. Generally, an intermediary transaction tax shelter is a transaction where shareholders of a C corporation sell their stock, at a time when the corporation has an accrued tax liability and few assets or only cash assets, to a third-party for an amount in excess of the liquidation value of the corporation (i.e. proceeds shareholders would receive if corporation paid its accrued tax liability and liquidated). The stock purchasers in many of these transactions claimed losses to offset the accrued tax liabilities and absconded with the corporation’s funds. The IRS has been unable to successfully collect the taxes from the corporate taxpayers and has pursued the selling shareholders, arguing that they are liable for the unpaid taxes as transferees of the corporation. Although the corporations did not directly distribute any funds to the selling shareholders (a prerequisite to a finding of transferee liability), the IRS argues that the stock sale should be disregarded under federal tax doctrines and the transaction should be viewed as a redemption of the former shareholders stock by the corporation or a liquidating distribution from the corporation to the former shareholders.
The United States Tax Court determined that state law controlled the determination of whether a person is liable as a transferee under I.R.C. § 6901 and that the IRS could not use federal tax doctrines to recast the transaction in Starnes. The United States Tax Court further determined that the IRS had not met its burden to show that the petitioners in Starnes were liable as transferees under the applicable state law. The Fourth Circuit Court of Appeals agreed with the United States Tax Court and affirmed its decision.
The decision in Starnes turned on its particular facts and the evidence presented at trial. A taxpayer can still be found to be liable as a transferee (at least one recent intermediary transaction tax shelter case has been decided by the United States Tax Court in favor of the IRS), however, the Fourth Circuit decision clarifies that the IRS cannot simply rely on federal tax doctrines to recast a transaction and instead must show that a taxpayer is liable as a transferee under applicable state law. The proof required to show that a taxpayer is liable as a transferee under state law is generally greater than the proof required to recast a transaction under federal tax principles.
The full impact of the Starnes decision is not yet known. The IRS may seek and be granted a rehearing in Starnes, or petition for writ of certiorari. Whether the IRS will follow Starnes in circuits other than the Fourth Circuit is also unknown.
The IRS has asserted transferee liability against many selling shareholders involved in intermediary tax shelter transactions, relying on federal tax doctrines to support its assertions. Taxpayers facing an IRS assertion of transferee liability based on federal tax doctrines should carefully consider their potential liability under applicable state law in light of the Starnes decision.