Kardash v. Commissioner, T.C. Memo. 2015-51 Reviewed by Momizat on . Assessing Solvency, Fraudulent Transfers, and Liability When Distributions are Made to Minority Shareholders The recent U.S. Tax Court case of Kardash v Commiss Assessing Solvency, Fraudulent Transfers, and Liability When Distributions are Made to Minority Shareholders The recent U.S. Tax Court case of Kardash v Commiss Rating: 0
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Kardash v. Commissioner, T.C. Memo. 2015-51

Assessing Solvency, Fraudulent Transfers, and Liability When Distributions are Made to Minority Shareholders

The recent U.S. Tax Court case of Kardash v Commissioner, T.C. Memo, 2015–51 provides guidance regarding transferee liability and underscores how valuations are used to determine when and if a subject company is insolvent. The case also summarizes a number of defenses used (and rejected) to counter a claim of transferee liability.

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The key issue in this March 18, 2015 U.S. Tax Court consolidated case is whether petitioner Kardash and Robb, minority shareholders, can be held liable for a portion of the $120 million owed in back taxes, penalties, and interest by the company now that the company cannot pay?  Judge Goeke held that petitioner was partially liable.

Background
Kardash and Robb were employed by Florida Construction Products Corp. (FECP), a company that made precast concrete products used primarily for residential construction.  They respectively owned 8.64 percent and 1.13 percent (Robb not until 2004).  The remainder of the company was owned by John Stanton, President, and Ralph Hughes, Chairman of the Board.  FECP’s revenues grew in the early 2000s. Its annual revenues peaked at more than $130 million in 2006.  During the time period 2003 through 2007 FECP paid no federal income taxes.  Its majority shareholders siphoned substantially all of the cash out of the company.

Messrs. Kardash and Robb were respectively involved in engineering/FECP operations and company sales.  They were not involved in the company’s financial matters.  While the IRS (Service) entered into an installment agreement with FECP and reached agreements with the estate of Hughes and Mr. Stanton, the Service sought to recover many of the transfers that petitioner’s received.  Specifically, the Service sought to recover from petitioners the following amounts:

                                                              Amounts
Year                 Mr. Kardash                 Mr. Robb
2003                $ 250,000                    $250,000
2004                  300,000                      200,000
2005                1,549,990                      199,890
2006                1,955,000                      255,000
2007                      57,500                         7,500
Total                 4,112,900                     912,390

Fraud at FECP

Until 2001 FECP was subject to a line of credit agreement that required it to produce audited financial statements each year.  Once FECP paid off the line of credit, the statements were not subsequently audited. At about this time Messrs. Hughes and Stanton began to systematically transfer all of the company’s pre-tax profits to themselves.  Mr. Stanton opened a bank account in FECP’s name that did not appear on its balance sheet. As FECP received payments for services, Mr. Stanton would transfer cash from the company’s operating account to this secret account. He would then transfer the money from the secret account to his and Mr. Hughes’ personal accounts or to the accounts of corporations he solely owned.  When accounting personnel asked Mr. Stanton how to characterize the transfers from the company’s operating account, he told them to mind their own business. The accounting staff recorded the amounts as loans receivables and eventually wrote them off as operating expenses.

Transfers to Petitioners: Advances and Dividends

Petitioners received several transfers during the years in which Messrs. Hughes and Stanton stripped FECP. The Service sought to recoup the “advances” and dividends.

FECP had a bonus program under which petitioners each earned significant compensation. FECP suspended the bonus program for 2003 and 2004. The advances would allow petitioners to continue their standards of living while the bonus program was suspended. When petitioners asked how they should report the advances in their returns, they were told they were loans and did not have to be reported.

In 2005, 2006, and 2007, FECP declared and paid dividends. FECP issued petitioners Forms 1099-DIV.

FECP’s Financial Condition

FECP’s revenue for the years at issue and the four preceding years were as follows:

                                      Revenue
Year                             (in millions)

1999                            $39.9
2000                              55.2
2001                              45.6
2002                              46.7
2003                              64.2
2004                             96.6
2005                            132.2
2006                            120.4
2007                              55.4

Because Messrs. Hughes and Stanton hid the transfers from FECP’s accounting personnel, FECP’s financial statements did not reliably indicate when FECP became insolvent.  Messrs. Hughes and Stanton left enough cash in the company to allow it to pay its usual creditors on time; however, FECP did not pay its federal or state income tax during the period and its tax liabilities continued to grow.  The following summarizes FECP’s liability for federal and state income tax, penalties, and interest during the period:

                                      Liability
Year                             (in millions)

2003                            $12.6
2004                              27.5
2005                              56.7
2006                            100.9
2007                            137.3
                       
Valuation of FECP: Solvency of FECP and Fraudulent Transfer Analysis

Petitioners and respondents presented expert witness testimony to try to establish when FECP became insolvent. 

Respondent’s expert evaluated FECP’s solvency during the years at issue.  This expert determined that the “asset accumulation approach” was the most appropriate method for valuing FECP’s assets.  Under this approach the expert valued FECP at the price at which a willing buyer would purchase the company’s tangible assets and land; no value was assigned to any intangible assets.

Respondent’s expert valued FECP’s assets using a 2006 appraisal of the assets the company then possessed. The appraisal indicated that the fair market value of FECP’s assets on the date of the appraisal represented 102 percent of the undepreciated book value of FECP’s property, plant, and equipment. He used this multiplier to estimate the fair market of FECP’s assets on other dates during the years at issue. Using this method, the expert determined FECP was insolvent at all times during the years at issue.

Respondent’s expert also valued FECP’s assets under the “market approach”.  The conclusion reached was similar.

Petitioner’s expert evaluated FECP’s solvency during the years at issue. This expert calculated the value for each year using three methods weighted evenly at 33.3 percent: 1) the discounted cash flow method; 2) the guideline public company method; and 3) the guideline company transaction method.

Using this approach, the expert opined that FECP became insolvent in 2007.

Court’s Analysis

Section 6901(a)(1) is a procedural statute authorizing assessment of transferee liability in the same manner and subject to the same provisions and limitations as in the case of taxes with respect to which the transferee liability was incurred. Section 6901(a) does not create or define a substantive liability but merely provides the commissioner a remedy for enforcing and collecting from transferee of the property the transferor’s existing liability.

Under section 6901(a) the commissioner may establish transferee liability if a basis exit under applicable state law or state equity principles for holding the transferee liable for the transferor’s debts.

Petitioners argued that they were not liable as transferees because respondent failed to exhaust collection efforts against more culpable parties.  First, they argue that respondent’s installment plan agreement with FECP cuts off their transferee liability. Secondly, they argue that respondent’s failure to exhaust collection actions against FECP precludes the Service from seeking to recover from them as transferees. Finally, they contend that the commissioner’s failure to exhaust efforts against more culpable transferee precludes him from collecting from them.  These arguments were rejected.

As for fraudulent transfers—the basis for transferee liability—the Service contends that petitioners were liable as transferees because the transfers they received were both actual and constructively fraudulent.  The court declined to group the transfers to petitioners with the transfers to Messrs. Hughes and Stanton for purposes of determining whether the transfers to petitioners were fraudulent.

Florida’s Uniform Fraudulent Transfer Act (FUFTA) does not require a creditor to pursue all reasonable collection efforts against the transferor. FUFTA provides three scenarios under which transfers may be constructively fraudulent. Each scenario requires the debtor to have received less than “reasonably equivalent value” for the transfer. If the debtor did not receive reasonable equivalent value, the transfer is fraudulent if: 1) the debtor was engaged or was about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; 2) the debtor intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due; and 3) the debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.

The court treated the 2003 and 2004 transfers separately from those for 2005 through 2007.  It found that FECP received reasonably equivalent value for the transfers then.  Accordingly, the transfers were not constructively fraudulent.

With respect to the 2005, 2006, and 2007 transfers, if these were dividends, FECP likely did not receive reasonably equivalent value for them, Under FUFTA, a distribution of dividends that is not compensation or salary for services rendered is not a transfer in exchange for reasonably equivalent value.  The court rejected petitioners’ argument that the dividends were compensation; FECP did not receive reasonably equivalent value for the 2005 through 2007 time frame.

As for insolvency, the analysis of the experts’ reports shows that FECP was insolvent for all transfers starting in 2005; FECP was insolvent once the dividends were transferred to the shareholders beginning in 2005, essentially stripping the company of its assets

Conclusion

The court held petitioners were liable as transferees under section 6901(a) for the years 2005, 2006, and 2007.  The case underscores that minority shareholders may be deemed liable as transferees if the company is insolvent or becomes insolvent and there was no reasonably equivalent transfer.  The case also illustrates how valuations are used to determine whether a subject company is insolvent.

 

Roberto H. Castro, Esq., MST, MBA, CVA, CPVA is managing member of Central Washington Appraisal, Economic & Forensics, LLC, Law Office of Roberto Castro, PLLC and business broker leading Murphy Business Central Washington.   Mr. Castro is also Technical Editor of QuickRead and a member of NACVA’s Around the Valuation World (AVW), and CTI’s MAFF Bankruptcy teaching staff.   As an attorney, Mr. Castro is admitted to the Bankruptcy Court of the Eastern and Western District of Washington State. In his law practice, he focuses on exit planning, estate and gift taxation, and bankruptcy law.  Mr. Castro can be contacted by either e-mail at either rcastro@rcastrolaw.com or rcastro@cwa-appraisal.com or at (509) 679-3668.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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