Opinion ID: 2763493
Heading Depth: 2
Heading Rank: 1

Heading: Two-Pronged Test for Liability Under 26 U.S.C.

Text: § 6901 Section 6901 of the Internal Revenue Code allows the IRS to assess tax liability against the transferee of assets of a taxpayer who owes income tax. 26 U.S.C. § 6901(a)(1)(A)(I). Transferee liability is “subject to the same provisions and limitations” as the original tax liability, id. § 6901(a), and includes liability of a “transferee of a transferee.” Id. § 6901(c)(2). A “transferee” includes a “donee, heir, legatee, devisee, [or] distributee.” Id. § 6901(h). Treasury regulations further provide that “the term ‘transferee’ includes . . . the shareholder of a dissolved corporation, . . . the successor of a corporation, . . . and all other classes of distributees.” 26 C.F.R. § 301.6901-1(b). In 1958, the Supreme Court held that this section “neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes.” Comm’r v. Stern, 357 U.S. 39,42 (1958). Because the section is “purely a procedural statute,” the Supreme Court looked to state law to define “the existence and extent” of “substantive liability.” Id. at 44–45. The result is a twopronged inquiry for assessment of transferee liability: (1) is the party a “transferee” under § 6901 and federal tax law?; and (2) is the party substantively liable for the transferor’s unpaid taxes under state law? See Diebold, 736 F.3d at 184–85; Frank Sawyer Trust of May 1992 v. Comm’r, 712 F.3d 597, 605 (1st Cir. 2013); Starnes v. Comm’r, 16 SALUS MUNDI FOUNDATION V. CIR 680 F.3d 417, 428 (4th Cir. 2012). Salus Mundi and the IRS agree on the applicability of this two-pronged test but dispute the relationship between the two prongs and the proper outcome in the case. The IRS argues that the two prongs are not independent. Rather, a court must first undertake the inquiry under § 6901 and federal tax law to determine transferee status and, if necessary, recharacterize transactions under the “substance over form” doctrine. The IRS argues that the series of transactions between the Double-D shareholders, Shap, Toplands Farm, and Morgan Stanley should be recharacterized and Double-D deemed to have sold its assets and distributed the proceeds to its shareholders. Under the IRS’s interpretation, the federal law recharacterization is antecedent to the state law liability prong, and a court should apply state substantive law to the recharacterized transaction. Salus Mundi counters that the inquiries are independent so the failure to satisfy either prong prevents the assessment of liability. In Salus Mundi’s view, the state law inquiry is separate from the determination of transferee status under § 6901 and any recharacterization of the transactions must rely on state law. The Tax Court agreed with Salus Mundi’s interpretation and stated that “[t]he law of the State where the transfer occurred (in these cases, New York) controls the characterization of the transaction.” “Under the [New York Uniform Fraudulent Conveyance Act], a party seeking to recharacterize a transaction must show that the transferee had ‘actual or constructive knowledge of the entire scheme that renders [its] exchange with the debtor fraudulent.’” Diebold, 736 F.3d at 184–85 (quoting HBE Leasing Corp. v. Frank, SALUS MUNDI FOUNDATION V. CIR 17 48 F.3d 623, 635 (2d Cir. 1995)). The Tax Court found that the Double-D shareholders lacked actual or constructive knowledge of Shap’s tax avoidance scheme and therefore refused to recharacterize the transactions under New York law. The IRS’s argument that “state law liability is assessed based upon the transaction as recharacterized by federal tax law” has recently been considered and rejected by three circuits. See Diebold, 736 F.3d at 184–85; Frank Sawyer Trust, 712 F.3d at 605; Starnes, 680 F.3d at 428. The IRS relies on the dissent in the Fourth Circuit’s decision in Starnes as well as an older case from the Second Circuit, Rowen, as support for its position. See Starnes, 680 F.3d at 440–46 (Wynn, J., dissenting); Rowen v. Comm’r, 215 F.2d 641, 643 (2d Cir. 1954). The IRS cites to a passage in Rowen that uses the transferee determination under § 6901 as the starting point for the state law inquiry. Id. But this decision predated the Supreme Court’s decision in Stern; when the Second Circuit revisited this issue in Diebold, it squarely rejected the IRS’s argument. 736 F.3d at 185. The Second Circuit held that “the position urged by the IRS imports federal law into the substantive determination of liability, in contravention of long settled law that § 6901is only a procedural statute, creating no new liability.” Id. (citing Stern, 357 U.S. at 42). The IRS, citing the dissent in Starnes, contends that the Supreme Court in Stern did not foreclose its interpretation of the two-pronged inquiry under § 6901. The IRS points out that the Kentucky law at issue in Stern precluded tax liability regardless of transferee status so the Supreme Court did not address whether determination of transferee status under 18 SALUS MUNDI FOUNDATION V. CIR § 6901 is a threshold inquiry. The dissent in Starnes argued that the analysis is different when presented with a transaction where “[state] law may indeed impose liability on the former shareholders, but only if there was a fraudulent transfer and they are transferees under federal law.” Starnes, 680 F.3d at 441 (citation omitted). The Starnes dissent also argued that holding the two prongs to be independent “would allow state substantive law to redefine” potential transferees “in clear contravention” of the specific definition provided in § 6901(h). Id. at 442 n.3. The IRS and the Starnes dissent present a plausible characterization of Stern. And there are plausible policy rationales for using the federal doctrine of substance over form to provide for liability against “a transparent scam designed by the parties to fraudulently evade paying taxes.” Id. at 441. But every circuit to directly address the issue has found that Stern is best interpreted as establishing that the state law substantive liability inquiry is independent of the federal law procedural inquiry, and we agree. See, e.g., id. at 429 (“An alleged transferee’s substantive liability for another taxpayer’s unpaid taxes is purely a question of state law, without an antecedent federal-law recasting of the disputed transactions.”). The IRS’s arguments are not sufficiently persuasive to create an inter-circuit conflict. See Beecher v. Comm’r, 481 F.3d 717, 720 (9th Cir. 2007) (“As a general rule, the tax decisions of other circuits should be followed unless they are demonstrably erroneous or there appear cogent reasons for rejecting them.”). Therefore, we conclude that “the two prongs of § 6901 are ‘independent requirements, one procedural and governed by federal law, the other substantive SALUS MUNDI FOUNDATION V. CIR 19 and governed by state law.’” Diebold, 736 F.3d at 186 (quoting Starnes, 680 F.3d at 427).