The case of Salus Mundi Foundation et al v. Commissioner

Transferee LiabilityOn August 15, 2016, the Tax Court decided in Salus Mundi Foundation et al v. Commissioner, T.C. Memo. 2016-154, that two foundations were liable as transferees for a corporation’s unpaid federal tax liability after another foundation distributed to the foundations the proceeds of the sale of the corporation’s stock.

The history in this case involves a marital trust that initially owned all of the stock in a C corporation called Double-D Ranch.  Later, a portion of the stock was transferred to the Diebold Foundation in New York.  Subsequent to that, the Diebold Foundation in New York sold the stock and distributed the proceeds from the sale of Double-D Ranch stock to three foundations formed by the Diebold children, pursuant to a New York state-approved plan of dissolution.

The IRS determined an income tax deficiency of over $81 million existed and found that the sale of Double-D Ranch’s stock by the Double-D Ranch shareholders to an intermediary corporation, Shap II, should not be respected for tax purposes, and in substance was really a sale of Double-D Ranch’s assets followed by a liquidating distribution to its shareholders.  This transaction was characterized by one Forbes article as “Shap II, in effect, “buying” the corporate tax liability” otherwise known as a “Midco transaction” in the world of tax shelters.

Although shareholders are generally not liable for the debts of a corporation, shareholders may be liable for a corporation’s tax liability if they are considered “transferees” under a state’s fraudulent conveyance laws.  When such transferee liability is established under state law, Internal Revenue Code (“Code”) Section 6901 allows the Internal Revenue Service (“IRS”) to assess and collect the tax liability from a transferee.  The term “transferee” is defined for income tax purposes as a “donee, heir, legatee, devisee, and distributee,” which may include the shareholder of a dissolved corporation and the successor of a corporation.

Transferee liability may be asserted against a transferee of a transferee.”

When the IRS could not find any assets of Double-D Ranch, it issued a notice of liability to the three children’s foundations under Code Section 6901, citing precedent where “transferee liability may be asserted against a transferee of a transferee.”

The Tax Court initially held that the foundations were not liable as transferees because the Diebold Foundation in New York did not have actual or constructive knowledge of the entire fraudulent tax scheme.

The current decision involved two cases stemming from the original Tax Court case on remand from the Court of Appeals for the 9th and 2nd Circuits.  On appeal, the 9th Circuit clarified the two-prong test for liability under Code Section 6901, which requires two inquiries:

  1. Is the party a “transferee” under Section 6901 and federal tax law?
  2. Is the party substantively liable for the transferor’s unpaid taxes under state law?

In applying the two-prong test, the 9th Circuit found that the Diebold Foundation in New York did have constructive knowledge of the entire scheme and decided to follow the 2nd Circuit’s reasoning in vacating the Tax Court’s decision.

On remand, the Tax Court held that two of the foundations in this case – the Salus Mundi Foundation and the Diebold Foundation, Inc. in Connecticut– were in fact liable as transferees for the tax liabilities of the shareholding Diebold Foundation in New York.

The vast majority of nonprofit organizations do not need to be concerned that a gift they receive from an individual or an organization will later produce a hefty tax bill.  The facts of this case involve a tax shelter that was put in motion by an interlocking network of commercial interests.

However, it sends a clear message to family businesses and their related charitable organizations to use careful corporate tax planning and individual estate planning that serve purposes other than tax minimization.