As a tax professional, few things horrify me more than appreciated assets inside a C corporation. That was at the root of a recent Eighth Circuit decision Stuart v Commissioner. William Stuart had been a shareholder in Little Salt Inc.
Little Salt Inc in Lincoln, Nebraska was formed in 1960 and apparently did not have much going on other than 160 acres of land suitable for duck hunting. I have to wonder whether there was any tax planning going on from 1986, when the Tax Reform Act of 1986 made appreciated assets in C corporations a really bad idea and 2003, when Little Salt sold the land to the city of Lincoln for $472,000. The corporation showed taxable income of $432,148 and corporate tax of $148,546 on its 2003 return. Liquidating distributions to shareholders would be subject to a second tax.
MidCoast To The Rescue
The shareholders of Little Salt were not alone in being caught by double taxation from a corporate asset sale. It seems that people not paying attention or thinking ahead in 1986 were legion. I shake my head and feel sad, but the people who founded MidCoast Investments, Inc. saw opportunity. They offered shareholders of companies a great deal. After the asset sale when all that was left in the company was money in the bank and an obligation to pay corporate income tax, they would buy the company from you.
In the case of of Little Salt they offered to pay cash in the corporate till less 64.92% of the projected corporate tax due. In other words, they were offering to, in effect, pay the corporate tax for you for roughly two thirds. They had a story about how they would re-engineer the company to engage in debt collection, but the Little Salt shareholders were not particularly interested in all that. They were interested in netting more from the sale than they would have from the liquidation. Here is how it went.
On August 7, 2003 Little Salt followed through on the agreement by wiring $467,721 in cash to a trust account maintained by counsel for MidCoast. MidCoast in turn wired the $358,826 purchase price for the shareholders’ stock to their counsel’s trust account. Counsel for the shareholders then distributed the purchase price to the shareholders pro rata.
Taxes Not Paid
I don’t know about you, but it seems to me like MidCoast bought $467,721 for $358,626. Note that they were wired the money before they paid for the stock. Just saying. But of course there was that corporate tax liability to worry about. Here is how that went.
In December 2003 Little Salt filed a corporate tax return that reported taxable income in the amount of $432,148 and tax due in the amount of $148,456. This 2003 return also noted that Little Salt had $278 in cash, an outstanding shareholder loan of $467,000, and no other assets. Little Salt did not include a payment with its return. Then, in 2004 MidCoast sold all of Little Salt’s shares to Wilder Capital Holdings, LLC. During that same year, Little Salt reported a bad debt deduction of $450,370. That 2004 bad debt deduction created a net operating loss which Little Salt carried back to its 2003 tax return.
In 2007 the IRS issued a statutory notice of deficiency with respect to Little Salt’s 2003 tax return. In the notice, the IRS disallowed the bad debt deduction reported on Little Salt’s 2004 tax return and the net operating loss carryback deduction on the 2003 tax return. As a result the IRS assessed taxes of $145,923 against Little Salt as well as an accuracy related penalty of $58,369.
Transferee Liability
Now if you were one of the former shareholders of Little Salt, you might be inclined to say “Not my circus. Not my monkeys” . The IRS has a different view. They call it “transferee liablity”. The argument is that the Little Salt shareholders effectively liquidated the company without paying the taxes, rather than actually selling it.
MidCoast and a similar outfit called Fortrend have resulted in a plethora of tax cases. The transferee liability is not a matter of federal law, but rather of state law, Nebraska in this case. The Little Salt shareholders went to Tax Court and mostly lost. The Tax Court held that they had to pay the amount that they had saved – $58,842. That is not a horrible result. I mean nothing ventured nothing gained.
IRS Wants More
That did not satisfy the IRS, which appealed to the Eighth Circuit, which is sending the matter back to the Tax Court.
Had the Tax Court considered the IRS’s state law recharacterization argument and determined that the stock sale should be recast as a liquidating distribution to the shareholders, the outcome of this case could well have been different. The Tax Court’s decision to limit the IRS’s recovery to $58,842 depends on the shareholders’ status as transfer beneficiaries and its conclusion that $58,842 is the amount by which the shareholders benefitted from Little Salt’s transfer of its cash to MidCoast. The rationale underlying this measure of recovery would have little application if the Tax Court had concluded that the stock sale should be recharacterized as a liquidating distribution directly to the former shareholders. If the transaction is recharacterized under Nebraska law, the IRS could be entitled to collect the full amount of its claim from the former shareholders.
The shareholders still have some hope.
Although we agree with the IRS that the Tax Court should have considered whether the stock sale should be recharacterized as a liquidating distribution to the shareholders under Nebraska law, we decline its invitation to resolve this question in the first instance. A remand will allow for “adequate vetting through the adversarial process and avoid having the appellate court ‘try the action de novo.’”
The Moral
Besides the lesson of nor just idly watching while an asset that will ultimately be sold appreciates inside a C corporation, there is another one here. It is an instance of Reilly’s Second Law of Tax Planning – “Sometimes it is better to just pay the taxes”. The Little Salt shareholders were only saving a bit more than a third of the tax and now there is a good chance they will be liable for 100%. Not to mention all the tsoris they have had over the last decade or so.
Other Coverage
Lew Taishoff had something on the decision – Little Salt In The Wounds.
While once again affirming that State voidable transfer law controls (and IRS doesn’t bother to fight this on appeal, as they’re 0-for-5 on the Circuits), Eighth Circuit gives Tax Court Judge James S. (“Big Jim”) Halpern the right-about-face.