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Dude Ranch Shareholders Liable for Unpaid Corporate Taxes after Liquidation Scheme Collapses.

(Parker Tax Publishing March 27, 2015)

The Seventh Circuit affirmed a Tax Court decision holding former dude ranch shareholders liable as transferees for unpaid taxes left over from participation in an intricate tax-avoidance scheme pitched to them as an alternative to a standard liquidation. Feldman v. Comm'r, 2015 PTC 58 (7th Cir. 2015).

Background

William Feldman founded Woodside Ranch in the 1920s and over time the ranch came to offer a wide array of outdoor recreational activities. The ranch was incorporated in 1952 as Woodside Ranch Resort, Inc. ("Woodside") and was owned and operated by the descendants of the founder until its sale in 2002.

By the late 1990s, the ranch was facing a number of challenges to its ongoing viability as due to competition from nearby casinos and water parks. The ten shareholders, all descendants of the founder, decided to sell the ranch to a third party who they hoped would continue to operate the ranch. Although the shareholders proposed a stock sale, the buyer insisted on an asset sale and the shareholders acquiesced. The asset sale netted the shareholders $2.3 million, resulting in a taxable capital gain of $1.8 million (on a basis of $510,000) and triggering tax liabilities of approximately $750,000.

While the asset sale was pending, Woodside's accountant and financial advisor introduced the shareholders to Honora Shapiro, a 50 percent owner of Midcoast Acquisition Corp. ("Midcoast"), a firm specializing in tax shelters. The shareholders jumped at the opportunity to reduce their tax liability, and in June of 2002 Midcoast sent a letter of intent offering to buy Woodside's stock for its liquidation value (about $1.4 million) plus a premium of about $225,000.

The closing involved a number of steps in quick succession, taking place in a single day in July of 2002. First, Woodside redeemed 20 percent of its stock directly from the shareholders, leaving it with $1.83 million in cash, and the still-unpaid tax liabilities. The parties then executed the share purchase agreement and the funds were then wired into and out of a trust account. At 12:09 p.m., Woodside's cash reserves of $1.83 million were transferred into the trust account. Then, at 1:34 p.m., Shapiro transferred $1.4 million into the trust account, purportedly as a loan to Midcoast to fund the transaction, although there was no promissory note or other writing evidencing a loan. At 3:35 p.m., $1,344,451 was wired to Woodsedge LLC, an entity set up to receive the proceeds of the stock sale, as payment to the shareholders. One minute later, at 3:36 p.m., $1.4 million was returned to Shapiro, repaying the undocumented "loan."

After the stock sale, Woodside had $452,729 cash on hand along with the tax liabilities from the initial asset sale. A few days later, Woodsedge LLC, which was holding the proceeds of the redemption and stock sale, disbursed approximately $1.2 million to the shareholders. Woodside never paid federal taxes on the capital gain from the asset sale; its 2003 tax return claimed a net operating loss carried back to 2002, reducing Woodside's 2002 federal tax liability to zero.

In 2008 the IRS sent notices to the former shareholders assessing transferee liability for Woodside's unpaid taxes and penalties under Code Sec. 6901.

At trial before the tax court, the shareholders conceded that the tax shelter was illegal, but contested transferee liability. In a comprehensive opinion, the tax court ruled in the IRS's favor, holding that the stock sale was in substance a liquidation with no purpose other than tax avoidance, making the shareholders liable for the unpaid tax debt as transferees of Woodside under Code Sec. 6901 and Wisconsin law. The shareholders then appealed to the Seventh Circuit.

Analysis

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must first establish that the target for collection is a "transferee" of the delinquent taxpayer within the meaning of Code Sec. 6901; next, the IRS must show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

The Circuit Court reviewed the Tax Court's decision for error. The tax court had found that the stock sale was structured to avoid the tax consequences of Woodside's asset sale, which the shareholders would have had to absorb had they pursued a standard liquidation. Formally, the shareholders sold their Woodside stock to Midcoast, which purported to fund the transaction via a loan from Honora Shapiro.

The tax court looked past these formalities to the substance of the transaction, recasting it as a liquidation, and found that Midcoast did not actually pay the shareholders for their stock; instead, each shareholder received a pro rata distribution of Woodside's cash on hand (which came from the proceeds of the asset sale) making them "transferees" under Code Sec. 6901(h). The circuit court found nothing wrong with this recharacterization by the tax court, noting it has long been established that courts may look past the form of a transaction to its substance to determine how the transaction should be treated for tax purposes.

Accordingly, the circuit court agreed with the tax court's conclusion that the transaction was a de facto liquidation. Woodside carried on no business activity, its only asset was cash from the initial asset sale, and the shareholders had planned to liquidate. The circuit court reasoned that the $1.4 million loan from Shapiro was a sham, because if it was removed from the transaction, nothing of consequence would change. What remained after disregarding the sham loan was a transfer of cash from Woodside to the trust account and then to an LLC owned by the shareholders established for the sole purpose of receiving the proceeds of the transaction. The circuit court noted that, in reality, the only money that changed hands was Woodside's cash reserves. On those facts the circuit court found it was entirely reasonable for the tax court to conclude that this was a liquidation cloaked in the trappings of a stock sale.

Having received Woodside's cash in a de facto liquidation, the circuit court agreed with the tax court, holding the shareholders were transferees under Code Sec. 6901. In addition, the circuit court found the shareholders were liable for Woodside's tax debts under Wisconsin state law, and sustained the tax court's determination of transferee liability under Code Sec. 6901.

For a discussion of transferee liability, see Parker Tax ¶262,530. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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