Douglas R. Griffin, TC Memo 2011-61
The Tax Court has held that an entrepreneur who sold a substantial portion of the assets of a wholly-owned business wasn't liable as a transferee for the business's taxes. He deposited a portion of the sale proceeds into an interest-bearing account in his own name, and provided a promissory note to the business in the same amount, then sold his stock in an unrelated transaction in which a portion of his promissory note to the business was extinguished in exchange for the redemption of a portion of his stock. The overall facts of the case showed that the transactions were entered into separately and that they weren't fraudulent.
Background. Code Sec. 6901(a) provides that the liability of a transferee of a taxpayer's property may be “assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.” It doesn't create or define a substantive liability, but merely provides IRS a procedure to assess and collect from the transferee of property the transferor's existing liability. The existence and extent of the transferee's liability are determined by the law of the State in which the transfer occurred (in this case, Florida).
Under the Florida Uniform Fraudulent Transfer Act (UFTA), a transferee may be liable for the debts of a transferor who fraudulently conveys assets to the transferee. “Transfer” means every disposition of or parting with an asset or an interest in an asset and includes payment of money, release, lease and creation of a lien or other encumbrance. A transfer is fraudulent as to a creditor under Florida law if the debtor made the transfer with the actual intent to hinder, delay or defraud the creditor, and a transfer is constructively fraudulent if the debtor does not receive reasonably equivalent value and the debtor was insolvent or became insolvent as a result of the transfer.
The Pentair transaction. Douglas Griffin is a lifelong entrepreneur. One of his most successful businesses was HydroTemp, a Florida-based business which manufactured, designed, and distributed swimming pool heat pump equipment and hot water generators. Pentair Corporation, HydroTemp's biggest customer, inquired on several occasions about purchasing HydroTemp's swimming pool heat pump business. Griffin initially wasn't interested in selling HydroTemp, but he become concerned that he would lose Pentair's significant business if he did not sell HydroTemp's swimming pool heat pump assets to it. He agreed to sell HydroTemp's heat pump assets and the rights to its name brand for $8.3 million, and the sale closed on Jan. 30, 2003. A CPA determined that HydroTemp's combined income tax liability from the sale was approximately $2.6 million.
After the sale, HydroTemp still had a good deal of unrelated equipment and inventory and was owed approximately $1.5 million in accounts receivable. It also retained several employees to sell hot water generators and perform accounting work.
Griffin deposited the $8.3 million into HydroTemp's non-interest-bearing checking account and used approximately $2 million to repay loans and award bonuses to employees. Griffin wanted to transfer the remaining funds to an interest-bearing account, but he wasn't immediately able to open an account in HydroTemp's name due to a paperwork problem. So Griffin had the corporation lend him $5 million to place in an interest-bearing account in his own name, which was evidenced by a $5 million interest-bearing promissory demand note that Griffin pledged to pay within six months. HydroTemp also transferred an additional $300,000 to Griffin, which he treated as an interest-free loan to compensate him for past services.
The MidCoast transaction. Following the Pentair sale, Griffin was contacted by a number of individuals and businesses offering investment or similar opportunities. One contact was an individual from MidCoast Investments (MCI) who told Griffin that MidCoast Credit (MCC), a parent corporation specializing in asset recovery business, was interested in acquiring HydroTemp. After performing extensive research about MCC, Griffin decided to sell MCC his HydroTemp stock and signed a Letter of Intent. However, he began questioning that decision shortly thereafter due to various “unprofessional and unscrupulous” behavior on MCC's part. MCC threatened to sue if he didn't go forward with the sale, and both Griffin's attorney and accountant advised him to do so.
As part of the transaction, on June 13, 2003, Griffin's shares in HydroTemp were redeemed in exchange for HydroTemp extinguishing $3.8 million of the $5 million note. MCC received 75% of the HydroTemp stock, and MidCoast Acquisitions (MCA) received the remaining 25%. Griffin held no ownership interest in or authority over HydroTemp after this transaction.
HydroTemp timely filed a return for the tax year ending June 30, 2003, reporting a $7,524,153 long-term capital gain from the asset sale to Pentair and a $7 million short-term capital loss from the sale of binary options (i.e., options in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money or nothing at all if the option expires out of the money). Rather than reporting the approximate $2.6 million tax liability from the Pentair sale, HydroTemp reported a $508,322 loss with no tax due because of the short-term capital loss from the binary options. The return listed Griffin as the 100% stockholder of HydroTemp even though he had no interest in or involvement with HydroTemp after June 13, 2003.
IRS's position. IRS disallowed HydroTemp's losses from its claimed binary options sale and determined a tax deficiency and 40% accuracy-related penalty under Code Sec. 6662(a). IRS purported to have sent deficiency notices to HydroTemp at its two last known addresses provided by a MidCoast affiliate, but HydroTemp didn't respond. IRS assessed $3,878,294 against HydroTemp. The revenue officer who was assigned to collect on HydroTemp's assessment determined that it could not pay the assessed amount, so he issued a Notice of Transferee Liability to Griffin in March of 2008.
Griffin, who had been uninvolved with HydroTemp and wasn't aware of this liability until he received the transferee notice, learned that MCI and MCC sold all of their HydroTemp stock less than two weeks after the transaction with Griffin. MCC continued to operate HydroTemp (on the buyer's behalf) as an asset recovery business for approximately one year, then it was administratively dissolved. Griffin demanded that MCC pay the liability, but MCC refused. Griffin then obtained a declaratory judgment against MCC, which was subsequently affirmed by the Florida Circuit Court of Appeals. However, MCC still hadn't paid the judgment, so IRS sought to collect against Griffin as a transferee.
IRS argued that Griffin's sale to Pentair and the MidCoast transaction were part of an integrated plan entered into solely to lower Griffin's tax liability. Accordingly, applying the doctrine of substance over form, the transactions should be collapsed and viewed as a single transaction consisting of HydroTemp's asset sale to Pentair followed by a liquidating distribution of the sale proceeds. In the alternative, IRS argued that even if the transactions are treated as separate, Griffin should be liable as transferee of HydroTemp because they were actually or constructively fraudulent.
Conclusion. The Tax Court declined to apply the substance over form doctrine, finding that each transaction was separately arranged and had independent legal significance. Griffin was unaware of the MidCoast companies at the time of the Pentair sale and had no preconceived plan to sell HydroTemp's stock to anyone, as shown by the fact that he continued operating it following the Pentair sale. The Court also found it significant that Griffin took actions to ensure that HydroTemp's taxes would be paid, including obtaining a tax agreement and indemnity clause from MidCoast that he later litigated and sought to enforce.
The Tax Court then rejected IRS's argument to hold Griffin liable because the transactions were actually fraudulent. IRS's claim that Griffin transferred substantially all of HydroTemp's assets to himself, rendering HydroTemp insolvent after HydroTemp incurred a substantial debt, ignored the facts the HydroTemp held Griffin's promissory note (which was payable on demand) and that HydroTemp still had other cash and assets following both transactions.
IRS's attempt to hold Griffin liable based on constructive fraud similarly failed. The Tax Court found that neither transaction left HydroTemp insolvent. It further determined that IRS failed to show that Griffin's note was not of “reasonably equivalent value” to the sale proceeds transferred to the interest-bearing account or that his assets were insufficient to cover the note.
References: For transferee liability, see FTC 2d/FIN ¶V-9001 et seq.; United States Tax Reporter ¶69,014 et seq.; TG ¶72061 et seq.