Argued: April 15, 2013.
[Copyrighted Material Omitted]
Arthur T. Catterall, Attorney (Kathryn Keneally, Assistant Attorney General, Tamara W. Ashford, Deputy Assistant Attorney General, Gilbert S. Rothenberg, Kenneth L. Greene, Attorneys), Tax Division, United States Department of Justice, Washington, DC, for Respondent-Appellant.
A. Duane Webber (Phillip J. Taylor, Summer M. Austin, Mireille R. Zuckerman, Baker & McKenzie LLP, Washington, DC, Jaclyn Pampel, Baker & McKenzie LLP, Chicago, IL, on the brief), Baker & McKenzie LLP, Washington, DC, for Petitioner-Appellee.
Before: POOLER, DRONEY, Circuit Judges, SEIBEL,[*] District Judge.
POOLER, Circuit Judge:
The Commissioner of Internal Revenue (" Commissioner" ) appeals the decision of the United States Tax Court (Joseph Robert Goeke, J. ) holding that the Diebold Foundation, Inc. (" Diebold" ), could not be held liable as a transferee of a transferee under 26 U.S.C. § 6901. As an initial matter, we conclude that the standard of review for mixed questions of law and fact in a case on review from the Tax Court is the same as that for a case on review after a bench trial from the district court: de novo to the extent that the alleged error is in the misunderstanding of a legal standard and clear error to the extent the alleged error is in a factual determination. See 26 U.S.C. § 7482(a). On the merits, we hold that the two requirements of 26 U.S.C. § 6901— transferee status and liability— are separate and independent inquiries, one procedural and governed by federal law, and the other substantive and governed by state law. We further hold that, under the New York Uniform Fraudulent
Conveyance Act, the applicable state statute, the series of transactions at issue collapse based upon the constructive knowledge of the parties involved. The case is remanded to the Tax Court to determine in the first instance whether Diebold is a transferee of a transferee under § 6901 and whether the three-year statute of limitations of 26 U.S.C. § 6901(c)(2), which applies transferee of transferee liability, or the six-year statute of limitations of 26 U.S.C. § 6501(e)(1)(A), which applies to collection when substantial omissions are made from the report of gross income, governs. We thus vacate the decision of the Tax Court and remand the case for further proceedings consistent with this opinion.
This case involves shareholders who owned stock in a C Corporation (" C Corp" ), which in turn held appreciated property. Upon the disposition of appreciated property, taxpayers generally owe tax on the property's built-in gain— that is, the difference between the amount realized from the disposition of the property and its adjusted basis. 26 U.S.C. §§ 1(h), 1001, 1221, 1222. A C Corp, a corporation governed by subchapter C of the Internal Revenue Code, Eisenberg v. Comm'r, 155 F.3d 50, 52 n. 3 (2d Cir.1998), is treated as a separate legal entity for tax purposes, 26 U.S.C. § 11. C Corps are also subject to tax on built-in gain. See 26 U.S.C. §§ 11, 1201.
When shareholders who own stock in a C Corp that in turn holds appreciated property wish to dispose of the C Corp, they can do so through one of two transactions: an asset sale or a stock sale. In an asset sale, the shareholders cause the C Corp to sell the appreciated property (triggering the built-in gain tax), and then distribute the remaining proceeds to the shareholders. In a stock sale, the shareholders sell the C Corp stock to a third party. The C Corp continues to own the appreciated assets and the built-in gain tax is not triggered. In other words, in an asset sale, because C Corps are treated as separate legal entities for tax purposes, subject to corporate tax (independent of any capital gain taxes assessed against the earning shareholders), a C Corp's sale of its assets imposes an additional tax liability. While the C Corp, and not the shareholders, pays this tax liability, such payment nonetheless reduces the amount of cash available for distribution to those shareholders.
In the case of a stock sale, the assets remain owned by the C Corp and the tax on the built-in gain is not triggered. Buyers would generally prefer to purchase the assets directly and receive a new basis equal to the purchase price, thus eliminating the built-in gain. Sellers generally disfavor the sale of assets because of the attendant tax liability and would prefer to sell the stock and move the tax liability on to the purchaser. However, the seller's preferred transaction merely pushes the tax liability down the line; at any point when the shareholders of the C Corp— including new owners who purchased the shares in a stock sale— wish to sell the assets, the built-in gain tax will be triggered. Because of this accompanying tax liability, a stock sale will generally merit a lower sale price than an asset sale.
" Midco transactions" or " intermediary transactions" are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a
transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or " Midco" ) at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco's willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, that allow it to absorb the built-in gain tax liability. See I.R.S. Notice 2001-16, 2001-1 C.B. 730. If these tax attributes of the Midco prove to be artificial, then the tax liability created by the built-in gain on the sold assets still needs to be paid. In many instances, the Midco is a newly formed entity created for the sole purpose of facilitating such a transaction, without other income or assets and thus likely to be judgment-proof. The IRS must then seek payment from the other parties involved in the transaction in order to satisfy the tax liability the transaction was created to avoid.
Double D Ranch, Inc., (" Double D" ), a personal holding company, taxed as a C Corp, 26 U.S.C. § 542, had two shareholders: the Dorothy R. Diebold Marital Trust (" Marital Trust" ) and The Diebold Foundation Inc. (" Diebold New York" ) (together, the " Shareholders" ). The trustees of the Marital Trust were the Bessemer Trust Company N.A. (" Bessemer" ), operating primarily through its Senior Vice President, Austin J. Power, Jr., Dorothy Diebold (" Mrs. Diebold" ), and Andrew W. Bisset, Mrs. Diebold's attorney and personal advisor. The directors of Diebold New York were Mrs. Diebold, Bisset, and the three adult Diebold children. Diebold New York held slightly more than one-third of the shares of Double D;  the rest were held by the Marital Trust. Double D owned assets worth approximately $319 million, including $21.2 million in cash, $6.3 million in real property, and $291.4 million in publicly traded securities. Included in these securities holdings were approximately $129 million in shares of American Home Products Corporation (" AHP" ) stock; the rest of the portfolio was made up of diversified holdings. The AHP stock, other securities, and the real property— a farm in Connecticut— all had substantial built-in gain, such that the sale of the assets would have triggered a tax liability of approximately $81 million.
By 1999, Mrs. Diebold and her three children were " anxious" for her to begin making cash gifts to them, but the Marital Trust was insufficiently liquid for her to make such gifts. The other trustees, Power of Bessemer and Bisset, explained to Mrs. Diebold that the best way to make such gifts would be to sell the shares of Double D. Power knew that liquidating the assets of Double D would incur the substantial tax consequences discussed above because of the low tax basis of the assets. Power discussed with " a whole network of people, for months," whether there " were potential purchase[r]s for a corporation like Double D." Power engaged senior staff members at Bessemer as well as lawyers in other trust companies, identifying the illiquidity of the trust and the attendant tax consequences as " a problem," and asking, " What's the possible solution? How do we sell this?" Among those with whom Power consulted was
Richard Leder, an attorney at Chadbourne & Parke and Bessemer's " principal outside tax counsel." Identifying the steep tax liability inherent in the assets held by Double D, Leder testified, " it was generally known ... in that profession that there were ... some people, who for whatever reason, whatever their tax activities are, were able to make very favorable offers to sellers with stock with appreciated assets ... with the corporation having appreciated assets." Leder directed Power to one of these " people" in the form of Harry Zelnick of River Run Financial Advisors, LLC (" River Run" ). Power also sought out Stephen A. Baxley, a managing director at Bessemer, who referred him to Craig Hoffman at Fortrend International LLC (" Fortrend" ).
The trustees of the Marital Trust and the Directors of Diebold New York each decided that their respective entity would sell all of its Double D stock. Power was primarily responsible for implementing the decision to sell Double D. On May 26, 1999, Power, Baxley, Leder, and two other attorneys, acting as representatives of the Shareholders, met with Zelnick of River Run and Ari Bergmann, a principal at Sentinel Advisors, LLC (" Sentinel" ), a small investment banking firm specializing in " structuring economic transactions to solve specific corporate or estate or accounting issues." At this meeting, the Shareholder representatives, Zelnick, and Bergmann discussed methods for valuing Double D's AHP stock and alternatives for dealing with the Connecticut farm property (whether to distribute that asset out of the corporation or to leave it in the corporation for the buyer to sell). They also discussed the possibility of leaving the shareholders with an " option to buy" the farm. Sentinel gave the Shareholders a slideshow presentation of the possibilities for selling and valuing Double D, which Bergmann subsequently sent to the Shareholder representatives for their reference. Shortly after this meeting, Dudley Diebold, one of Mrs. Diebold's adult children who was a Director of Diebold New York, founded Toplands Farm, LLC (" Toplands Farm" ) to purchase the Connecticut farm property from Double-D.
Several days after the meeting with River Run and Sentinel, the Shareholder representatives met with Craig Hoffman and Howard Teig of Fortrend to discuss the sale of Double D. According to Leder, tax attorney to the Bessemer Trust, he was familiar with Fortrend because he " had represented a seller of stock in another transaction where the buyer had arranged to have [Fortrend] participate in the purchase." Fortrend provided Bessemer with a firm profile that detailed its strategy entitled the " Buy Stock/Sell Assets Transaction." Identifying the tax liabilities endemic to selling a corporation with appreciated assets, Fortrend presented its expertise as follows: " We are working with various clients who may be willing to buy the stock from the seller and
then cause the target corporation to sell its net assets to the ultimate buyer. These clients have certain tax attributes that enable them to absorb the tax gain inherent in the assets."
The Shareholder representatives chose to pursue the transaction with Sentinel instead of with Fortrend, and Sentinel sent them an initial term sheet, laying out the preliminary details of the transaction, on June 8, 1999. Sentinel intended to use a newly formed entity, Shap Acquisition Corporation II (" Shap II" ), specifically created to carry out the transaction. Power informed the Shareholders that Sentinel would purchase all of the shares of Double D, from both the Marital Trust and from Diebold New York, for a price that " works out to 97% of the market value of the Corporation's assets." Had the Shareholders sold the assets directly, the tax liability would have caused the Shareholders to realize an amount that worked out to approximately 74.5% of the assets' market value, a clear reduction from that negotiated with Shap II. On June 10, 1999, Mrs. Diebold approved of the sale and directed Power to go forward with it. On June 17, 1999, Shap II and the Shareholders executed a letter of intent and term sheet specifying that Shap II would purchase all issued and outstanding Double D Stock for cash in an amount equal to the value of Double D's assets minus a discount of 4.5% of the built-in gain.
Sentinel intended to purchase the Double D stock through Shap II with financing from Rabobank. Even prior to taking ownership of the Double D stock, Sentinel planned on having Shap II immediately sell Double D's securities portfolio, as it intended to use the proceeds of that sale to repay the loan from Rabobank. Rabobank provided financing on the condition that Shap II enter into a fixed price contract to sell the securities, with the purchase price to be paid directly to Rabobank, pursuant to an irrevocable payment instruction. Rabobank understood that the loan would be outstanding for " not more" than five business days, as that was the " longest settlement period" for the securities to be liquidated. Sentinel determined that the securities would be sold to Morgan Stanley.
While it is not clear that the Shareholders knew the details behind Sentinel's financing plan, the Shareholder representatives did indeed have notice that Shap II planned to sell Double D's securities to Morgan Stanley, based upon the draft of the stock purchase agreement drawn up to execute the stock sale between the Marital Trust and Diebold New York, on the one hand, and Shap II, on the other, which (1) indicated that certain limitations within the agreement would not apply to sale arrangements Shap II already had with Morgan Stanley, (2) held the selling shareholders liable for any costs incurred upon termination in " connection with arrangements for the sale of the Securities by [Double D] following the Closing," and (3) indicated that the agreement's prohibition on assignments of rights would not apply to Shap II assigning its rights " ...