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The Tax Court held Minority Shareholders Liable as Transferees for Corporate Taxes.

(Parker Tax Publishing April 4, 2015)

The Tax Court held that, despite the fact two minority shareholders were unaware that majority shareholders had stripped away pre-tax profits from their company, the minority shareholders were partially liable as transferees for the unpaid corporate taxes as certain transfers to them were fraudulent. Kardash v. Comm'r, T.C. Memo. 2015-51.

Background

William Kardash and Charles Robb ("taxpayers") owned minority interests in Florida Engineered Construction Products Corp. (FECP), a Florida company making precast concrete products used in home construction. Kardash was an engineer for FECP's operations, and Robb managed the company's sales team. During the Florida housing boom in the early 2000s, FECP experienced a period of growth and profitability, and its annual revenues peaked in 2006 at more than $100 million. However, at the direction of the majority shareholders, FECP failed to report any income between 2003 and 2007.

During that time, the majority shareholders, John Stanton and Ralph Hughes, began to systematically transfer all of the company's pretax profits to themselves, unbeknownst to Kardash and Robb. The taxpayers received several transfers from the corporation for their services during these years, although they never had a hand in FECP's financial matters. After FECP suspended its bonus program for 2003 and 2004, the taxpayers were given "advances" of their bonuses for those years, characterized as "loans" that were never repaid and eventually forgiven. In 2005, 2006, and 2007 FECP declared and paid dividends to the shareholders based on their percentage of stock ownership.

The IRS eventually caught on to Hughes and Stanton's income stripping, audited FECP, and determined it owed over $120 million in unpaid tax, penalties, and interest. However, FECP was unable to pay the full amount, and entered into an agreement where it was to pay installments of $70,000 a month. Because at that rate it would take FECP more than 150 years to pay off its liability, the IRS looked to collect from the four shareholders.

The IRS reached agreements with Hughes and Stanton to recover some of the illicit transfers, and then sought to recover from Kardash and Robb, arguing the $5 million they received as dividends and bonus advances between 2003 and 2007 were fraudulent under Florida law, thus making the two taxpayers liable as transferees.

Analysis

Under Code Sec. 6901(a), the IRS may establish transferee liability for the transferor's debts if a basis exists under applicable state law (Comm'r v. Stern, 357 U.S. 39 (1958)).

The tax court looked to the Florida Uniform Fraudulent Transfer Act (FUFTA) to determine whether the bonus advances and dividends were fraudulent transfers. If the transfers were fraudulent, the IRS could hold Kardash and Robb liable as transferees and recoup those fraudulent transfers. The court found that under FUFTA, if the debtor did not receive reasonably equivalent value for a transfer, it was fraudulent if the debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.

The taxpayers argued that each transfer was compensation, and the work they performed for FECP constituted reasonably equivalent value. The IRS argued that FECP did not receive reasonably equivalent value because the 2003 and 2004 transfers were loans that were never repaid and the transfers in 2005, 2006, and 2007 were dividends.

The court noted that although Hughes told the taxpayers they would have to repay the bonus advances, they did not sign loan agreements or make interest payments, and the amounts were roughly what they would have received under the suspended bonus program. The court believed that these "advances" were really compensation received in lieu of bonuses, and that FECP never expected repayment. As such, the court found the taxpayers gave reasonably equivalent value for the 2003 and 2004 transfers, meaning they were not fraudulent under Florida law, and the IRS could not hold Kardash and Robb liable as transferees under Code Sec. 6901(a) with respect to those transfers.

However, the court noted that under the Uniform Fraudulent Transfer Act, a distribution of dividends is not a transfer in exchange for reasonably equivalent value. Although the taxpayers argued that the payments were compensation for their work, neither they nor FECP treated the payments as compensation. FECP issued Forms 1099-DIV for the payments, and the taxpayers reported the payments as dividends on their individual tax returns. Because the transfers were dividends, the court held that FECP did not receive reasonably equivalent value for the 2005, 2006, and 2007 transfers and consequently, the dividends would be fraudulent if FECP was insolvent at the time of the transfer or became insolvent as a result of the transfer.

The Tax Court determined that an analysis of the experts' reports showed that FECP was insolvent for all transfers starting in 2005. Accordingly, the dividend transfers Kardash and Robb received after those years were fraudulent under FUFTA, and the IRS could hold the taxpayers liable under Code Sec. 6901(a) as transferees for those portions, requiring them to disgorge the dividends to help pay off FECP's tax liability.

For a discussion of transferee liability, see Parker ¶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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