See yesterday’s post for the background on the liability of the minority shareholders discussed today.

Transferee Liability

Taxpayers argued that the IRS’s installment agreement with Corp cut off their transferee liability, and that the IRS’s failure to exhaust its collection options against Corp precluded the IRS from seeking to recover from them as transferees. They also argued that they were not liable as transferees because the IRS failed to exhaust collection efforts against more culpable parties.

According to the Court, although payments under the installment plan may eliminate or reduce the amount that may be collected from a transferee, the IRS may still take action to collect from any person who is not named in the installment plan agreement but is liable for the tax which relates to it. Thus, the installment plan between Corp and the IRS did not preclude Taxpayers from facing transferee liability.

Next, the Court determined that under State law the IRS does not have an obligation to pursue all reasonable collection efforts against a transferor before proceeding against a transferee. Therefore, the IRS was not required to exhaust collection efforts against Corp, and Taxpayers may be held liable.

Taxpayers argued that the IRS may not collect from them because it did not exhaust collection efforts against Insiders. The Court held that the IRS may proceed against any or all transferees in no particular order. Therefore, the IRS was permitted to pursue Taxpayers without first exhausting collection efforts against Insiders.

Fraudulent Transfer

The IRS asserted that Taxpayers were liable as transferees because the transfers they received were fraudulent. In doing so, it grouped together both the transfers Taxpayers received and the transfers Insiders received because, the IRS claimed, Corp made all of the transfers as part of a comprehensive scheme to defraud the IRS.

Although the facts established that Insiders organized a scheme to defraud the IRS, they did not establish that the payments Taxpayers received were part of this scheme, and the Court refused to impute that intent to the distributions to Taxpayers.

During the years at issue,  Taxpayers’ hard work was instrumental in Corp’s success and, according to the Court, they likely would have become suspicious if they had not been compensated fairly. Insiders wanted to take money for themselves; they devised a scheme from which Taxpayers incidentally benefited, but the payments they received were not made with the same intent as those Insiders received.

State Law

The Court next examined whether the transfers to Taxpayers were fraudulent as a matter of State law. According to the Court, if the debtor did not receive “reasonably equivalent value,” the transfer would be fraudulent if:

  1. The debtor was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction;
  2. The debtor intended to incur, or believed or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due; and
  3. The debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.

The Court considered whether Corp received reasonably equivalent value from Taxpayers for the transfers at issue. To resolve this issue, the Court first determined what Corp received in return for the transfers at issue.

2003 and 2004 Transfers

Corp suspended its bonus program after 2002. To offset the financial hardship resulting from the suspension of the bonus program, Insiders made advances to Taxpayers, which they were told were loans that did not have to be reported as compensation.

Taxpayers argued that each transfer was compensation and that the work they performed for Corp constituted reasonably equivalent value. The IRS contended that the payments were not compensation but, rather, that they were dividends.

The Court agreed with Taxpayers, finding that the “advances” were compensation that Taxpayers  received in lieu of bonuses, and Corp never expected repayment.

Because taxpayers gave reasonably equivalent value for the 2003 and 2004 transfers, they were not fraudulent.

2005, 2006, and 2007 Transfers

Taxpayers argued that the transfers they received in 2005, 2006, and 2007 were compensation for services performed and that they gave reasonably equivalent value for them. The IRS argued that the transfers were dividends and that, consequently, Taxpayers did not give reasonably equivalent value for them.

If the 2005, 2006, and 2007 transfers were dividends, Corp did not receive reasonably equivalent value for them. Under State law, a distribution of dividends that is not compensation for services rendered is not a transfer in exchange for reasonably equivalent value.

The Court found that Corp did not benefit from the dividends it paid to Taxpayers, that the dividends were not compensation for their work, and that neither Corp nor

Taxpayers treated the payments as compensation. Accordingly, the Court held that Corp did not receive reasonably equivalent value for the 2005, 2006, and 2007 transfers at issue.

Consequently, the Court stated that it would find any of the transfers during these years fraudulent if Corp was insolvent at the time of the transfer or became insolvent as a result of the transfer.

After reviewing the facts and expert valuation reports, the Court noted that the parties agreed that the transfers to Insiders contributed in large part to Corp’s insolvency. They disagreed about when Corp became insolvent. The IRS argued that Corp was insolvent when each payment was made. Taxpayers argued that Corp did not become insolvent until 2007, after they had received the last of the transfers at issue.

The Court found that Corp was solvent for the years 2003 and 2004 and insolvent for the years 2005, 2006, and 2007. Thus, the transfers Taxpayers received in 2003 and 2004 were not fraudulent under State law because Taxpayers gave reasonably equivalent value for them. Taxpayers did not give reasonably equivalent value for the transfers they received in 2005, 2006, and 2007, and Corp was insolvent when it made those transfers. Accordingly, those transfers were constructively fraudulent under State law.

The Court next considered the IRS’s argument that Corp made the transfers to Taxpayers with actual intent to hinder, delay, or defraud the IRS. This argument, that the transfers at issue were actually fraudulent, depended on grouping these transfers together with the transfers to Insiders.

The Court declined to do so, finding that:

  • Taxpayers were not “insiders;”
  • Corp was not threatened with suit when the 2003 and 2004 transfers occurred;
  • The amounts distributed to Taxpayers did not constitute substantially all of the Corp’s assets;
  • The 2003 and 2004 transfers were not a removal of assets;
  • While the 2003 and 2004 transfers to Taxpayers were not properly disclosed, they were not concealed;
  • The transfers made to Taxpayers in 2003 and 2004 were reasonably equivalent to the value of the assets transferred;
  • Corp did not became insolvent shortly after the transfers were made in 2003 and 2004 but, instead, became insolvent because of the transfers starting in 2005;
  • and the transfers to Taxpayers did occur shortly after Corp incurred tax liabilities.

After weighing these factors, and recognizing that no one factor is dispositive,

the Court concluded that the IRS did not show that the 2003 and 2004 transfers were made with intent to hinder, delay, or defraud the IRS.

The Court concluded that Taxpayers were liable as transferees under State law for the years 2005, 2006, and 2007; thus, under the Code, the IRS could seek to collect Corp’s income tax liability from them.

Advice?

What is a minority shareholder to do? The foregoing discussion highlights the fact that the privilege of ownership also entails a number of burdens. A key employee who is eager to own equity in its employer would be well advised to consider these.

Under the above circumstances, the compensation received was not recoverable by the IRS, while the dividends received were. What if the minority shareholders had already spent that money, or invested it in an illiquid asset, or made a gift?

Alas, there are times when there is little that a minority shareholder can do to protect him or herself from the IRS. Hopefully, state law (or a shareholders agreement) affords them some relief in seeking reimbursement from the insiders who brought the corporation to this point. Alternatively, the minority shareholder may seek an installment payment arrangement with the IRS. None of these is optimal.