Sixth Circuit Clarifies Substance Over Form Doctrine in “MidCo” Case

After the Summa Holdings case, the substance over form doctrine was left with a significant black eye by the Sixth Circuit.¹ On May 15, 2019, the Sixth Circuit, upheld a transferee liability claim against shareholders of a Tennessee corporation while also clarifying its holding is Summa Holdings.² While the Summa Holdings discussion is certainly interesting, the Hawk case offered a valuable and thorough analysis of the application of IRC § 6901 and its interplay with state law.

Background

Nancy Sue Hawk sold the substantially all assets of the family bowling business, Holiday Bowl, Inc., a Tennessee corporation (“Holiday Bowl”) within a few years following the passing of her husband, Billy Hawk. Shortly after selling the assets of the business, Nancy and the other shareholders (primarily her husband’s estate) sold the stock to a company called MidCoast in a tax-motivated transaction.

By the numbers, the sale was pretty straight forward. Aside from a few assets kept by the family, like a horse farm, Holiday Bowl sold its assets for $4.2 million, generating a $1 million federal tax liability (an almost $3.2 million net value). MidCoast came along with interest in buying the cash-rich, non-operating company. MidCoast apparently had an interest in buying companies with gains to use against its net operating loss carryforwards.³

MidCoast paid the shareholders of Holiday Bowling $3.4 million, approximately $200,000 more than the shareholders would have received in a straight liquidation (after accounting for the corporate income tax liability from the sale). This purchase price was financed with a company named Sequoia. The loan documents were not fully executed. There was no interest on the loan unless there was a default (only a loan fee of $17,250). Furthermore, Holiday Bowl, the cash-heavy corporation, was directly transferred to Sequoia by MidCoast in partial satisfaction of its loan along with about $320,000. Holiday Bowl’s federal income taxes stemming from the asset sale were never paid.

Following non-payment of those taxes, the government sought collection from the selling shareholders. Following the Tax Court decision assessing transferee liability against the shareholders, the Sixth circuit affirmed.⁴

Application of IRC § 6901

In certain circumstances, IRC § 6901 allows the government to collect a tax liability owed by the transferor of assets, including penalties and interest, from the transferee. In order to collect a taxpayer’s unpaid tax from another person under IRC § 6901, the IRS must satisfy the following three conditions:

1. The taxpayer must be liable for the unpaid tax;
2. The other person must be a “transferee” within the meaning of IRC § 6901; and
3. An independent basis must exist under applicable state law or state equity principles for holding the other person liable for the taxpayer’s unpaid tax.

Without meeting all three elements above, IRC § 6901 does not apply.⁵

Disposing of the first element above, there was no dispute as to the Holiday Bowl tax liability by any party.

Transferee? (Re-Empowerment of Substance Over Form)

To satisfy the second of the three elements needed to be secondarily liable for taxes, the Hawk-shareholders must fit the definition of “transferees” under IRC § 6901(h). One such definition is “distributee.” The Hawks would fit the definition of being a distributee of Holiday Bowl (the taxpayer and technical transferor) under IRC § 6901(h) if either (1) Holiday Bowl transferred the purchase price proceeds to its shareholders directly, or (2) such funds were transferred through an intermediary with no other real purpose other than to transfer funds of Holiday Bowl to the Hawk-shareholders.⁶

In the case at hand, MidCoast purchased Holiday Bowl (holding $4.2 million cash as its only asset coupled with a $1 million federal income tax liability) for $3.4 million. The purchase was loosely financed through Sequoia. In essence, cash was sold for cash. The Court agreed with the Tax Court that Holiday Bowl was purchased with Holiday Bowl funds before payment of taxes. Recasting the transaction under the substance over form doctrine while paying homage to Summa Holdings, the Sixth Circuit agreed with the Tax Court concluding that the loan was in essence a fiction and that Holiday Bowl effectively just distributed its own funds to its shareholders in a very roundabout manner.

Independent Basis Under State Law (Tennessee)

The third element looks to state law and/or state equity principles. Holliday Bowl was a Tennessee corporations so the Sixth Circuit looked to Tennessee law in determining whether the third element was satisfied.

Tennessee adopted the Uniform Fraudulent Transfer Act providing remedies to creditors when insolvent debtors fraudulently transfer assets to third parties.⁷ Under Tennessee law, there are the following three inquiries:

1. Was there a transfer?
2. Was there reasonably equivalent value in exchange?
3. Did the transferor become insolvent?⁸

First, as to the transfer, the Sixth Circuit agreed a transfer existed for many of the reasons discussed above in applying substance over form. Tennessee statute broadly defines transfer, contemplating indirect transfers such as the one at play here. Second, there was no exchange of reasonably equivalent value. The Court determined Holiday Bowl just distributed funds (albeit indirectly) to the Hawk-shareholders. Lastly, after the transfer, Holiday Bowl would have been unable to pay its tax bill. As such, all three elements under Tennessee law were met which completes the IRC § 6901 analysis. In turn, the Hawk-shareholders were on the hook for the tax liability.

Summa Holdings Revisited in Dicta

Before wrapping up, it is worth taking a trip back to Summa Holdings to remember the lashing delivered by the Sixth Circuit.

In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation—a “domestic international sales corporation” (DISC) to be exact—to transfer money from their family-owned company to their sons’ Roth Individual Retirement Accounts. When the family did just that, the Commissioner balked. He acknowledged that the family had complied with the relevant provisions. And he acknowledged that the purpose of the relevant provisions was to lower taxes. But he reasoned that the effect of these *782 transactions was to evade the contribution limits on Roth IRAs and applied the “substance-over-form doctrine,” Appellee’s Br. 41, to recharacterize the transactions as dividends from Summa Holdings to the Benensons followed by excess Roth IRA contributions. The Tax Court upheld the Commissioner’s determination.

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

As it turns out, the Commissioner does not have such sweeping authority. And neither do we. Because Summa Holdings used the DISC and Roth IRAs for their congressionally sanctioned purposes—tax avoidance—the Commissioner had no basis for recharacterizing the transactions and no basis for recharacterizing the law’s application to them. We reverse.

Summa Holdings, Inc., at 781–82.

Throughout Hawk it was almost as if the Court really wanted to clarify its extremely strongly worded opinion in a way that seems to significantly soften the potential effects of Summa Holdings with respect to application of the substance over form doctrine. The Court clarified by analogizing distinguishing issues contained in Summa Holdings with Hawk. Particularly, Summa Holdings involved a very tax-motivated usage of two creatures of federal tax law having no economic substance, the domestic international sales corporation (DISC) and the Roth IRA. This allowed avoidance taxpayers to benefit from the tax mitigated aspects of the DISC (dividend only treatment) with tax-free growth in a Roth IRA. While the IRS might not have liked the result of the DISC/Roth combination, the Sixth Circuit was not prepared to allow the executive branch of government overwrite statute where a taxpayer used the DISC and Roth IRA as drafted in the statute, albeit in tandem for enhanced results. In Hawk however, the Court distinguishes its prior position by saying that the government was not seeking to ignore the form of the Code, but instead honor the written word and economic realities of the transaction at hand. While unfortunate for the taxpayer at hand, the clarification is certainly appreciated.

Joshua W. Sage, J.D., LL.M.

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1. See Summa Holdings, Inc. v. Comm’r, 848 F.3d 779 (6^th Cir. 2017).
2. Hawk, Jr. v. Comm’r, 123 AFTR 2d 2019-XXXX, (6^th Cir. 2019).
3. Notwithstanding IRC § 384 limiting use of net operating losses in certain acquisition transactions.
4. See Hawk, T.C. Memo. 2017-217
5. Diebold Foundation, Inc. v. Comm’r, 112 AFTR 2d 2013-6901 (2^nd Cir. 2013).
6. See IRC § 6901(h) and Treas. Reg. § 301.6901-1(b).
7. See Tenn. Code Ann. § 66-3-301 et seq.
8. See Stoner v. Amburn, 2012 WL 4473306, at *10 (Tenn. Ct. App. Sept. 28, 2012); Stone v. Smile, 2009 WL 4893563, at *4 (Tenn. Ct. App. Dec. 18, 2009).