State law is applied to determine whether a transferee is liable for a transferor’s tax liability.
The Tax Court held that four trusts were not required to pay their former personal holding company’s tax liability. Virginia state law does not contain a corollary to the federal substance-over-form doctrine, and federal law has overridden state law only when the underlying transaction was clearly a sham.
Facts: In 1961, Davreyn Inc. was established as a Virginia corporation owning substantial shares in Reynolds Metal Co. (later Alcoa). Davreyn was owned as a personal holding company by four Reynolds family trusts. By 2000, Davreyn and the trusts were managed by three Reynolds family members and their longtime accountant. In 2001, the Reynolds trusts entered into and completed a sale transaction with a financial buyer for the Davreyn stock.
The Reynolds trusts reported long-term capital gains from the stock sale on their 2001 income tax returns and reported income tax liabilities totaling just over $2.7 million. The buyer, Alrey Trust, liquidated Davreyn on the date of purchase and dissolved it later that month. Alrey Trust then transferred the Alcoa stock to Deutsche Bank for $14.4 million. Alrey Trust’s income, deductions, and credits were reported on the return of its grantor, Alrey Acquisition, which reported a taxable loss and tax liability of zero, the Alcoa stock sale proceeds offset by “an artificial loss resulting from what appears to have been a Son-of-Boss transaction,” according to the Tax Court.
The IRS issued notices of deficiency to Alrey Acquisition disallowing its claimed losses. The IRS also recharacterized Davreyn’s stock sale to Alrey Trust as a sale of assets followed by a distribution of assets to its shareholders, resulting in a deficiency in Davreyn’s return of $4.6 million plus penalties and interest, for a total of $10.7 million. It also issued the Reynolds trusts notices of transferee liability for that amount, identifying Davreyn as the transferor and apportioning the liability to each trust on the basis of the amount received in the sale.
Issues: Sec. 6901 allows the IRS to collect taxes from a third party if three conditions are all met:
- The transferor taxpayer is liable for the unpaid tax;
- The other person is a transferee within the meaning of Sec. 6901; and
- An independent basis for holding the other person liable exists under applicable state law or state equity.
The IRS urged the Tax Court to apply a two-step approach to determining the Reynolds trusts’ liability under Sec. 6901: (1) under the federal substance-over-form doctrine, to recast or collapse the sales transactions as a sham, and (2) to apply state law to the resulting recast transactions.
Holding: The court rejected the IRS’s two-step analysis and concluded that state law should first determine whether the substance-over-form doctrine applied. The IRS identified no Virginia state case applying a substance-over-form doctrine similar to that of federal law; thus, the transaction could not be recast to support transferee liability, the court held. The court also held that evidence indicated the trusts and their representatives had no actual or constructive knowledge of Alrey Trust’s plans to sell the Alcoa stock and to illegitimately avoid any resulting tax liability. The Reynolds trustees were not trying to sell Davreyn; rather, a buyer came to them. The trustees had no reason to question the buyer’s intent or plans for Davreyn. The sale was negotiated at arm’s length and for fair market value. Since the court held Sec. 6901 did not apply, it did not determine Davreyn’s liability or the Reynolds trusts’ status as transferees.
- Julia R. Swords Trust, 142 T.C. No. 19 (2014)
By Sharon Burnett, CPA, Ph.D., associate
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.