Aggressive Planning Results in Potential Income Tax Transferee Liability and More Proceedings in the Tax Court

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By Kathleen Ford Bay, Esq.  

Richards Rodriguez & Skeith LLP, Austin, TX

The Tax Court held that Diebold Foundation, Inc., a private
foundation, could not be held liable under §6901 as a transferee of
a transferee. Salus Mundi Foundation (which was consolidated
with two other cases - DieboldFoundation, Inc., Transferee, docket
No. 24742-08; and Ceres Foundation, Inc., Transferee, docket No.
, T.C. Memo 2012-61. The Commissioner appealed to the
Second Circuit.

In Diebold Foundation, Inc., Transferee v.
, No. 12-3225-cv (2d Cir. 2013), the Second
Circuit considered a sophisticated and aggressive planning
technique, involving a series of transactions used in an effort to
reduce capital gains taxes on the sale of assets owned by a C
Corporation. Ultimately, the Second Circuit held as follows:

(1) First, on the standard of review: when there are mixed
questions of law and fact, the standard of review that applies to a
Tax Court decision is the same as the standard of review that
applies to a bench trial from a federal district court - de
, when the alleged error is the misunderstanding of a
legal standard and clear error when the alleged error
is in a factual determination. §7482(a)(1).

(2) Second, on the merits: §6901 has two requirements that are
separate and independent, being transferee status and liability.
Transferee status is procedural and federal law governs it.
Liability is substantive and governed by state law. Here, per New
York's Uniform Fraudulent Conveyance Act, the series of
transactions at issue collapsed based upon the constructive
knowledge of the parties involved.

Because the Tax Court concluded there was no liability under
state law, it had not addressed the issue of who was a transferee
under §6901. Therefore, the Second Circuit vacated and remanded to
the Tax Court to determine (1) if the Diebold Foundation, Inc.
("Diebold") is a transferee of a transferee under §6901 and (2) if
the transferee-to-transferee three-year statute of limitations
under §6901(c)(2) applies or if the substantial omission from gross
income six-year statute under §6501(e)(1)(A) applies.

The background facts are as follows. Double D Ranch, Inc.
("Double D"), a personal holding company taxed as a C corporation
had two shareholders: the Dorothy R. Diebold Marital Trust (the
"Marital Trust") and Diebold. The trustees of the Marital Trust
were Bessemer Trust Company, the widow ("Mrs. Diebold"), and Mrs.
Diebold's attorney. Diebold had five directors: Mrs. Diebold, her
attorney, and three adult Diebold children. The Marital Trust had,
until 1999, owned all of Double D's stock, but it transferred
slightly more than one-third of the stock to Diebold. (The
circumstances of this transfer are not discussed in the case.)

Double D was worth about $319 million, consisting of $21.2
million in cash, $6.3 million of real property (a farm in
Connecticut), $291.4 million of publicly-traded stock. The bulk of
these assets where highly appreciated; so much so that a sale of
the assets would have triggered capital gains taxes of
approximately $81 million.

By 1999, the Diebold children were "anxious" and wanted assets
transferred to them. Apparently, they wanted cash, not stock;
however, the Marital Trust was illiquid. As indicated above,
selling assets to generate cash carried a heavy capital gains
burden. Thus, the search for a way to get cash to the Diebold
children without incurring burdensome capital gains taxes

After pursuing other options, the trustees of the Marital Trust
and the Directors of Diebold, having decided to sell the Double D
stock, engaged Sentinel Advisors, LLC ("Sentinel"), a "small
investment banking firm specializing in `structuring economic
transactions to solve specific corporate or estate or accounting
issues.'" The general structure of the transaction was that the
Marital Trust and Diebold would sell their Double D stock to an
intermediary entity without a discount for the built-in gains and
would not have to recognize the capital gains. Then, the
intermediary entity would sell Double D's assets to the ultimate
purchaser and the purchaser would get a basis in the assets equal
to the purchase price. The intermediary entity would recognize the
built-in gain. The plan was that the intermediary entity would have
losses to offset the gain or would claim tax-exempt status. In many
instances the intermediary entity was a newly-formed entity that
was judgment proof because it had no other assets.

The Double D transaction was implemented as follows:

  •   One of the Diebold children wished to purchase the
    Connecticut real property. He formed Topland Farms, LLC for this
    purpose, and Topland Farms, LLC purchased the real property.
  •   Sentinel formed a new entity, Shap Acquisition
    Corporation II ("Shap II"), to purchase the Double D stock from the
    Marital Trust and Diebold.
  •   Sentinel obtained financing from Rabobank to purchase the
    Double D stock for approximately 97% of the market value of Double
    D's assets. Had the assets been sold instead of the stock, Double D
    would have realized about 74.5% of the assets' value. Stated as a
    formula, the structured transaction was "Purchase Price = Value of
    Assets - 4.5% Built-In Gain." Comparatively, in a direct stock
    sale, the discount rate would generally be the amount of the tax
    liability, the tax rate times the built-in gain. The highest
    marginal corporate tax rate in 1999 was 35%, so the formula would
    be: "Purchase Price = Value of Assets - 35% Built-In Gain."
  •   Sentinel planned for Double D's stock portfolio to be
    sold to Morgan Stanley through Shap II and the proceeds immediately
    used to repay Rabobank. In fact, to secure financing, Shap II had
    to sign a fixed price contract to sell the stock portfolio and put
    in place irrevocable payment instructions that the sale proceeds
    would go directly to repay Rabobank.
  •   Though the agreement required Shap II to deliver
    equivalent stock or cash to Morgan Stanley if closing did not take
    place on the day set forth in the agreement, this provision was not
    enforced and, in fact, the agreement was amended to change the
    closing date after it had passed.
  •   Bessemer distributed the $309 million from the sale to
    Shap II to the Marital Trust and Diebold after closing and later
    distributed another $15.7 million from Double D to the
  •   Shap II received approximately $319 million from selling
    Double D's assets. It claimed losses sufficient to offset the gain
    and, therefore, paid no tax on this amount. After Shap II repaid
    the loan to Rabobank, it retained approximately $10 million in
  •   Approximately one and a half years later, Diebold
    dissolved and distributed assets equally (approximately $33 million
    each) to three foundations, each one headed by one of the adult
    Diebold children: Diebold Foundation, Salus Mundi Foundation, and
    Ceres Foundation.

The IRS sent a notice of deficiency to Double D for deficiency
of income taxes, penalties, and interest in the amount of about
$100 million based on its determination that the sale of Double D
stock by the Marital Trust and Diebold was, in substance, an asset
sale followed by liquidating distributions to the Marital Trust and
Diebold. Double D did not contest this notice of deficiency, but
the IRS could not find assets of Double D from which to collect the
liability and decided it was futile to try to collect from the
corporation itself.

The IRS attempted to collect from the Marital Trust and Diebold.
It first tried to collect against Mrs. Diebold, but the Tax Court
held she was not liable because the Marital Trust was the actual
Double D shareholder, not her, and the court saw no reason to
ignore its separate existence. Diebold v. Commissioner,
T.C. Memo 2010-238. The IRS then issued separate notices of
transferee liability against each of the three succeeding
foundations to the original Diebold Foundation.

As indicated above, the Tax Court had concluded Diebold was not
liable under state law. However, the Commissioner had appealed. In
addressing the liability and transferee prongs of §6901, the Second
Circuit cited, discussed, and adopted recent opinions in the First
and Fourth Circuits: Frank Sawyer Trust of May 1992 v.
, 712 F.3d 597, 605 (1st Cir. 2013), and
Starnes v. Commissioner, 680 F.3d 417, 428 (4th Cir.
2012), both of which concluded that the two prongs of §6901 are
independent and that the Tax Court did not err by only addressing
the liability prong.

The Second Circuit determined, if there was not a "conveyance"
under the New York Uniform Fraudulent Conveyance Act, there would
be no need to determine whether or not the selling shareholders
were transferees under §6901. The Second Circuit ultimately held
that there was a conveyance because the trustees of the Marital
Trust and the directors of Diebold had "constructive knowledge" of
the entire transaction.

In holding that the taxpayers did have constructive knowledge of
the transactions, the Second Circuit held: The Tax Court did not
sufficiently address the totality of the circumstances from all of
the facts, which that court had already laid out itself. The
constructive knowledge inquiry does not begin, in this instance,
solely with the agreement between Shap II and Double D. Rather, it
is of great import that the [s]hareholders recognized the "problem"
of the tax liability arising from the built-in gains on the assets
held by Double D. The [s]hareholders specifically sought out
parties that could help them avoid the tax liability inherent in a
C Corp holding appreciated assets. They viewed slideshow[s] and
other presentations from three different firms … that purported to
deal with such problems. … Considering their sophistication, their
negotiations with multiple partners to structure the deal, their
recognition of the fact that the amount of money they would
ultimately receive for an asset or stock sale would be reduced
based on the need to pay the C Corp tax liability, and the huge
amount of money involved, among other things, it is obvious that
the parties knew, or at least should have known but for active
avoidance, that the entire scheme was fraudulent and would have
left Double D unable to pay its tax liability.

After holding that there was liability under the NYUFCA, the
Second Circuit remanded the case to the Tax Court to determine if
Diebold is a transferee of a transferee under §6901. There is also
the issue of which statute of limitation applies: the three-year
transferee-to-transferee year statute of limitation under
§6901(c)(2) or the six-year substantial omission from gross income
statute under §6501(e)(1)(A).

Caution: Cutting edge techniques are
always double-edged. If they work, taxpayers may avoid paying lots
of taxes. If they do not work, taxes, penalties, interest, and
attorney and accountant fees for rebutting IRS attacks, can be
large, and the taxpayer will likely spend a great deal of time and
energy dealing with the IRS. In this case, the IRS issued its first
notice of deficiency in March 2006. In August 2007, the IRS issued
a notice of deficiency against Mrs. Diebold as a transferee. The
Tax Court issued its opinion that the Marital Trust, not Mrs.
Diebold, was the transferee in October 2010. [Note: The
Commissioner did not argue that Mrs. Diebold was the transferee of
a transferee.] In July 2008, the IRS issued notices of deficiency
against the three successor private foundations. In March 2012, the
Tax Court issued its opinion regarding the foundations' transferee
liability, which the Commissioner then appealed. In mid-November
2013, the Second Circuit vacated the Tax Court's ruling and
remanded. There will be yet another Tax Court hearing and opinion,
unless a settlement is reached. Since the initial planning to
reduce capital gains taxes in 1999, over 14 years has passed. Since
the initial notice of deficiency in 2006, over seven years has
passed. Did Mrs. Diebold and her children have any inkling at the
time of the implementation of planning techniques that the IRS
might refuse to recognize the effectiveness of such techniques and
that they might be dealing with the IRS as a result for over 14
years, and counting?

For more information, in the Tax Management Portfolios, see
Peyser, 628 T.M.
, Transferee Liability,  and in Tax
Practice Series, see ¶3880, Tax Court Litigation.