In Norma L. Slone, the petitioners prevailed when the Tax Court refused to apply the substance-over-form doctrine to recast a sale of a company’s stock following an asset sale as a liquidating distribution. The court further found that the taxpayers were not liable as transferees under Sec. 6901 for taxes arising from the asset sale.
Substance over form and its related judicial doctrines are used to determine the true meaning of a transaction disguised by formalisms that exist solely to alter tax liabilities. In such instances, the substance of a transaction, rather than its form, will be given effect. Courts generally respect the form of a transaction but will apply the substance-over-form principles when warranted.
Sec. 6901(a) provides a procedure through which the IRS may collect from a transferee unpaid taxes owed by the transferor of assets if applicable state law or equity principles provide an independent basis for holding the transferee liable for the transferor’s debts.
In 2000, Slone Broadcasting Corp. (SBC), a Tucson, Ariz.-based, family-owned and -operated C corporation, sold its radio station assets to a larger competitor. Then, in 2001, Slone sold its stock to an affiliate of Fortrend International LLC, which had approached SBC with a strategy to offset taxable income from the asset sale with a loss on high-basis/low-value Treasury notes. Although advisers to SBC knew of the existence of a strategy, they were not told its details, with Fortrend saying only that they were “proprietary” and that they did not constitute any of the 16 listed transactions summarized in Notice 2001-51. As part of the sale, the affiliate assumed liability for $15 million in federal income taxes owed on the asset sale. Then Fortrend contributed the Treasury notes to the affiliate, with which SBC merged.
The IRS audited the successor corporation, Arizona Media, and determined an income tax deficiency of nearly $13.5 million and a penalty under Sec. 6662 of nearly $2.7 million. The IRS levied the amount, but Arizona Media made no payments and was administratively dissolved by the state of Arizona for failing to file an annual report.
The IRS issued transferee notices for the unpaid liability to SBC shareholders including the founding family members, James Slone and his wife. The notices stated that the stock sale was substantially similar to an “intermediary transaction” tax shelter as described in Notice 2001-16 and recharacterized the asset and stock sales as an asset sale followed by a liquidating transaction. The Slones petitioned the Tax Court.
Before trial, the IRS conceded that the stock sale was separate from the asset sale but argued it was still a liquidating distribution under the substance-over-form doctrine. However, the taxpayers successfully showed that the sales were distinct, that no tax strategies to offset potential gains were discussed, and due diligence was employed to investigate and negotiate the stock sale. There are legitimate tax planning strategies to defer or avoid paying taxes, so it was not unreasonable for the taxpayers to believe that Fortrend had a legitimate method of doing so. When SBC’s advisers were told that Fortrend’s methods were proprietary, they did not have a duty to inquire further and were not responsible for any tax strategies used after the closing of the stock sale, the court said. Consequently, the Tax Court refused to apply the substance-over-form doctrine and held for the petitioners.
By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.