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Tax Court Fails to Properly Apply "Stern Test", Must Consider Economic Substance in Analyzing Stock Sale.

(Parker Tax Publishing July 16, 2015)

The Ninth Circuit held that by focusing on whether shareholders were transferees before addressing the substance of a series of transactions, the tax court applied the wrong legal standard to characterize a stock sale. The case was sent back to the tax court to consider the economic substance of the transactions in order to correctly apply the Stern Test. Slone v Comm'r, 2015 PTC 187 (9th Cir. 2015).


James Slone began his career in the radio industry in 1955 and, by 2000, owned Slone Broadcasting, a C corporation. In 2000, Slone Broadcasting entered into an asset sale agreement with Citadel Broadcasting. As a result of the asset sale, Slone Broadcasting realized a capital gain of $38.6 million, and incurred federal and state tax liabilities of $15.3 million. The corporation made its first income tax payment of $3.1 million for the 2002 tax year.

Before the closing of the asset sale, a representative of Fortrend International, LLC sent an unsolicited letter to Slone Broadcasting's lawyer, offering to buy the corporation's stock. The lawyer knew that Fortrend had a strategy to reduce the income taxes due as a result of the asset sale, but when he asked how the tax savings would be achieved, he was told the information was proprietary but that the transaction would not be deemed a listed transaction. The reputations of Fortrend and its various advisers were good, and the taxpayer's lawyer and accountant had no reason to suspect any impropriety.

As a result of negotiations between Slone Broadcasting and Fortrend, Berlinetta, Inc., an affiliate of Fortrend, purchased the stock of Slone Broadcasting for $35.7 million and assumed all of Slone Broadcasting's taxes owed as of the closing date. Following the closing, cash distributions were made in the amounts of $30,819,544 and $2,550,456 to the former Slone Broadcasting shareholders.

Shortly after the stock sale, Slone Broadcasting merged with Berlinetta to create Arizona Media Holdings, Inc. (Arizona Media). In 2001, a shareholder contributed Treasury bills with a basis of $38.1 million to the new company, and a month later Arizona Media sold the bills for $108,731. On its 2002 tax return, Arizona Media reported a $37.9 million gain from the asset sale and an offsetting loss of $38 million from the Treasury bill sale. Arizona Media claimed it had no income tax liability, and requested a refund for the $3.1 million tax payment made by Slone Broadcasting, which the IRS granted.

The IRS began investigating Arizona Media in March 2005. The IRS assessed a deficiency for taxes due on Slone Broadcasting's sale of assets to Citadel in the amount of $13.5 million in 2008, along with a penalty of $2.7 million and interest of $7.3 million. In 2009, after Arizona Media's failure to file an annual report, the state administratively dissolved the company. Unable to collect the tax deficiency from Arizona Media, the IRS sent notices of liability to the taxpayers as former shareholders of Slone Broadcasting and as transferees of Arizona Media.

Before the Tax Court, the taxpayers argued that the sale of stock was separate from the prior sale of assets, that there was no ulterior motive in the way the liquidation had been structured and, therefore, the form of the stock sale transaction to Berlinetta should be respected. The court found that Slone Broadcasting's sale of assets to Citadel was independent from the sale of stock to Berlinetta, and that there was no evidence the taxpayers conducted the liquidation process as a tax-avoidance scheme. The court also found that the taxpayers neither knew, nor should have known, that Fortrend and Berlinetta were involved in an illegitimate tax evasion scheme. Based on these findings, the court rejected the IRS's theory that the taxpayers were liable as transferees for the unpaid liabilities and respected the form of the stock sale.


Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must apply the two-prongs of the "Stern test" to (1) establish that the target for collection is a transferee of the delinquent taxpayer within the meaning of Code Sec. 6901, and (2) show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

In determining whether to disregard the form of a transaction, courts will look to the subjective aspect of whether the taxpayer intended to do anything other than acquire tax benefits, and the objective aspect of whether the transaction had any economic substance other than creation of tax benefits. Reddam v. Comm'r, 755 F.3d 1051 (9th Cir. 2014).

The Ninth Circuit stated it could not resolve whether the taxpayers were liable for the unpaid taxes because the Tax Court failed to apply the correct legal standard for characterizing the stock sale transaction for the purpose of transferee liability. The circuit court found the tax court did not address either the subjective intent of the taxpayers or the objective economic realities of the transaction, because it failed to address whether taxpayers had a legitimate business purpose for selling the stock, or whether the transaction had economic substance other than shielding the former Slone Broadcasting shareholders from tax liability.

The Ninth Circuit noted the tax court focused its factual inquiry and analysis on factors relevant to the second prong of the Stern test: assessing whether the taxpayers were substantively liable for the transferor's unpaid taxes as a matter of state law. The tax court's findings that taxpayers had not orchestrated the asset sale and the stock sale as a single scheme for tax evasion purposes, that Fortrend and its third-party service provider were legitimate players in the debt collection industry, that taxpayers had no reason to believe that Fortrend was using illegitimate tax evasion methods and had no duty to inquire further, all related to whether the taxpayers had actual or constructive knowledge of the entire tax evasion scheme that rendered their dealings with Fortrend fraudulent under state law.

The Ninth Circuit stated that the tax court did not use these factual findings to analyze the shareholders' liability under the applicable state law, but instead concluded from those findings that, under the first prong of the Stern test, the form of the stock sale should be respected for the shareholders' transferee status. The Ninth Circuit determined that was a reversible error.

The Ninth Circuit held that the tax court applied the wrong legal standard to the question of transferee liability because it failed to make findings relating to whether the IRS could properly disregard the form of the transaction in order to impose tax liability on the taxpayers as transferees. The Ninth Circuit remanded the case, instructing the tax court to make the findings necessary to correctly apply the Stern test.

For a discussion of transferee liability, see Parker Tax ¶262,530. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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