Another Circuit Finds Federal Substance over Form Doctrine Inapplicable in Transferee Liability Case

For a transferee of assets to be held liable under Section 6901 for the income taxes of the transferor, two elements must be met. First, the party must be a transferee under Section 6901. This is a federal law question, and state law concepts are not relevant. In the subject case, lower tier shareholders of a corporation that received proceeds relating to a sale of stock of the corporation, were deemed to receive proceeds from the sale of assets of the corporation when the IRS applied the substance over form doctrine to create a deemed sale of assets. Thus, they were transferees under this first element by reason of the federal substance over form doctrine. The IRS was seeking to impose transferee liability on the lower tier  shareholders for the corporate income tax imposed on the deemed sale of corporate assets.

The second requirement is that the transferee be subject to liability at law or in equity, applying state law (and not federal law). This often involves the question of whether state fraudulent conveyance law applies. In the subject case, the IRS argued that once the taxpayers were found to be transferees under federal law under the first element above, then they would be deemed to be transferees when testing liability under state fraudulent conveyance law. That is, the IRS was arguing that state law liability is assessed based upon the transaction as recharacterized by federal tax law.

The Ninth Circuit Court of Appeals held that the IRS position was wrong. That the taxpayers were "transferees" under federal substance over form law, did not make them "transferees" in determining state law transferee liability. This was based on the observation that allowing the federal determination to apply would put the IRS in a different status as creditor than other creditors seeking to collect under the applicable state law.

The subject case is not the first pronouncement of this principle. It had previously been enunciated by the Second Circuit Court of Appeals in a case involving the same facts, and by two other circuits.

Interestingly, the Circuit Court of Appeals nonetheless found that the taxpayers were "transferees" under state law anyway, without the assistance of the federal substance over form doctrine.

Salus Mundi Foundation, 114 AFTR 2d ¶2014-5556 (CA 9 12/22/2014)