Not heeding the advice of both an attorney and CPA firm proved costly to the taxpayers in the case of the Estate of Richard L. Marshall et al. v. Commissioner, T.C. Memo. 2016-119. The case involved a situation where the taxpayers were shareholders in a corporation whose major business activity became the pursuit of a claim against the U.S. Bureau of Reclamation. The corporation had previously been involved in construction jobs, but that activity ended when one of key shareholders was permanently disabled following a stroke.

The good news for the shareholders was that they prevailed in their claim—but that created a tax problem. As the Court described matters:

On March 22, 2002, the Department of the Interior Board of Contract Appeals ruled in favor of MAC in the Stillwater appeal. On May 16, 2002, MAC received a $40,033,130 litigation award from US BOR, which represented contract damages and interest for the Stillwater appeal (Stillwater litigation award). On August 2 and October 9, 2002, MAC received additional interest payments on the Stillwater litigation award of $265,743 and $556,005, respectively. The total amount of MAC's Stillwater litigation award, with interest, was $40,854,878, all of which MAC received during its FYE March 31, 2003.

Obviously this income was going to create a major tax burden, so the shareholders sought ways to reduce that burden. Eventually they became involved in a transaction promoted to them by Fortrend where they were told that their stock would be purchased largely with the cash remaining in the corporation immediately after the transaction.

That, of course, might strike some advisers as a problematical strategy for many reasons and, in fact, the transaction seemed extremely close to the “Intermediary Transaction Tax Shelter” the IRS had designated as a listed transaction in Notice 2001-16, though in this case there was no buyer of the underlying assets (the only real asset was the cash of the corporation and estimated tax payments it had already made).

The shareholders did seek advice from both an attorney and an international accounting firm regarding the transaction—and both warned them that the transaction exposed the shareholders to a risk of a transferee liability for taxes due at the corporate level should, as the advisers suspected, the claimed “loss” would not offset the income on the Stillwater award. With the corporation drained of cash that had been removed to pay for the shares, there wouldn’t be sufficient assets remaining to pay the tax due.

Not surprisingly the promoters assured the shareholders that their program was not like the one described in Notice 2001-16 and, as well, their tax strategy would assure that there would be no tax due for the corporation whose stock they were selling.

The shareholders went ahead with the transaction, though they had the international firm in question prepare their returns—and that firm insisted on attaching the Form 8886 disclosing participation in a listed transaction.

The IRS did examine the corporation whose stock was sold and, despite what the promoter claimed, disallowed the loss that offset the gain at the corporate level. Since the corporation no longer had sufficient assets to pay the tax due the IRS argued the very position the attorney and the international firm had warned the shareholders was a major risk in this strategy—that they were liable for the amount of the tax under the transferee liability rules.

As the Court notes, the IRS bears the burden of showing that the liability of one taxpayer (the transferor) should be borne by another (the transferee) under this provision. The Court explained:

Once the transferor's own tax liability is established, the Commissioner may assess that liability against a transferee under section 6901 only if two distinct requirements are met. First, the transferee must be subject to liability under applicable State law, which includes State equity principles. Second, under principles of Federal tax law, that person must be a "transferee" within the meaning of section 6901. See Salus Mundi Found. v. Commissioner, 776 F.3d 1010, 1017-1019 (9th Cir. 2014), rev'g and remanding T.C. Memo. 2012-61; Diebold Found., Inc. v. Commissioner, 736 F.3d 172, 183-184 (2d Cir. 2013), vacating and remanding Salus Mundi Found. v. Commissioner, T.C. Memo. 2012-61; Starnes v. Commissioner, 680 F.3d 417, 427 (4th Cir. 2012), aff'g T.C. Memo. 2011-63; Swords Trust v. Commissioner, 142 T.C. 317, 336 (2014).

As the taxpayers and corporation were in Oregon, the Court first looked at whether they would be subject to liability generally under Oregon law. The IRS argued that the transactions needed to be collapsed into a single transaction where the corporation effectively transferred its cash out to the shareholders, leaving the corporation with no assets with which to pay a tax liability that the shareholders were looking to avoid.

The Tax Court found that, while Oregon courts had not explicitly ruled in this area, courts in other states with similar statutes had allowed the transactions to be collapsed into one if the transferees had effective knowledge that the overall effect of the transactions would be to evade the payment of a legitimate obligation. That can include “constructive knowledge” where the party became aware that additional inquiry should be made, but failed to do so.

The Court found that, in this case, that was what had occurred. The Court noted:

Our analysis focuses on what John knew because John assumed the responsibility of representing the Marshalls. In determining what the transferees knew, we have to focus on what they were advised and what they themselves appreciated. See id. at 188-189. The Marshalls, Schwabe, and PwC had constructive knowledge of the entire scheme. John knew that Essex was interested [*35] in buying MAC only for its tax liability; that Essex intended to use high-basis low-value assets to offset MAC's income; that Essex intended to obtain a refund of MAC's prepaid taxes, a plan he was leery about; and that Essex was splitting MAC's avoided taxes with the Marshalls.

PwC and Schwabe had a sophisticated understanding of the entire scheme. Notably, before the MAC transaction closed, each of the Marshalls was warned by Schwabe of the risks of transferee liability and John was warned by PwC that the stock sale was similar to a listed transaction and was advised by PwC not to engage in the stock sale. Petitioners knew that the Stillwater litigation award would be considered income to MAC and be subject to corporate income tax for 2003. This knowledge motivated petitioners to enter into a transaction to mitigate this tax liability.

...The Marshalls recognized the large tax liability arising from the Stillwater litigation award and entered into a series of transfers to minimize the liability. John and the Marshalls' advisers are analogous to the advisers in Diebold Found., Inc. and Richard, Patsy, and Karen are akin to the shareholders in that case. The Court of Appeals for the Second Circuit in Diebold Found., Inc. found that if the advisers knew or should have known then the transferee is deemed to have had the same knowledge and had a duty to inquire. See Salus Mundi Found. v. Commissioner, 776 F.3d at 1019-1020; Diebold Found., Inc. v. Commissioner, 736 F.3d at 188-190. The Marshalls had a duty to inquire, and they were advised that there was a significant risk of transferee liability. Cf. Slone v. Commissioner, T.C. Memo. 2016-115, at *14-*17 (distinguishable on factual grounds) ("Petitioners and their advisers had no reason to believe that Fortrend's strategies were other than legitimate tax planning methods."). Accordingly, petitioners are transferees of MAC, as MAC sold its assets and MA LLC received noncash assets and the Marshalls received liquidating distributions in exchange for their shares.

The Court found that Oregon law would impose liability for both the tax and penalties that would be imposed on the corporation. The Court did not accept the taxpayer’s contention that they shouldn’t be held liable for the penalties (which would end up causing this to be much more costly to the taxpayers than if they had simply undertaken a “straight” liquidation and paid the taxes), finding that the penalties were a natural and totally foreseeable consequence of the transaction—and thus should be treated as one part of the collapsed transaction.

Obviously the results weren’t good for the taxpayers here—but the reality in this case is that two different advisers, not involved in promotion of the transaction, had both advised the taxpayers either not to engage in this transaction or that there was a significant risk that the transaction would have adverse results.