Salus Mundi Foundation v. Commissioner

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
SALUS MUNDI FOUNDATION, No. 12-72527
Transferee,
Petitioner-Appellee, Tax Ct. No.
24741-08
v.
COMMISSIONER OF INTERNAL OPINION
REVENUE,
Respondent-Appellant.
Appeal from a Decision of the
United States Tax Court
Argued and Submitted
November 21, 2014—San Francisco, California
Filed December 22, 2014
Before: John T. Noonan and Sandra S. Ikuta, Circuit
Judges, and William H. Albritton, Senior District Judge.*
Opinion by Judge Noonan
*
The Honorable William H. Albritton III, Senior District Judge for the
U.S. District Court for the Middle District of Alabama, sitting by
designation.
2 SALUS MUNDI FOUNDATION V. CIR
SUMMARY**
Tax
The panel reversed the United States Tax Court’s decision
that the Salus Mundi Foundation was not liable under 26
U.S.C. § 6901 for unpaid tax liability arising from the sale of
appreciated assets held by Double-D Ranch, Inc., and
remanded.
The panel concluded that the two requirements of section
6901, transferee status under federal law and substantive
liability under state law, are separate inquiries. Adopting the
reasoning of Diebold Foundation, Inc. v. Comm’r, 736 F.3d
172 (2d Cir. 2013), the panel held that the state law
substantive liability requirement was satisfied because the
Double-D shareholders made a fraudulent conveyance under
the New York Uniform Fraudulent Conveyance Act. The
panel remanded to the Tax Court to determine: (1) Salus
Mundi’s status as a transferee of a transferee under the
federal law inquiry of section 6901; and (2) whether the IRS
assessed liability within the applicable limitations period.
COUNSEL
Arthur T. Catterall (argued), Kenneth L. Greene, and Gilbert
S. Rothenberg, Attorneys, Tax Division, Department of
Justice, Washington, D.C., for Respondent-Appellant.
**
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
SALUS MUNDI FOUNDATION V. CIR 3
A. Duane Webber (argued), Phillip J. Taylor, Summer M.
Austin, and Mireille R. Zuckerman, Baker & McKenzie,
LLP, Washington, D.C.; Jaclyn Pampel, Baker & McKenzie,
Chicago, Illinois, for Petitioner-Appellee.
OPINION
NOONAN, Circuit Judge:
OVERVIEW
The IRS appeals the United States Tax Court’s decision
that the Salus Mundi Foundation was not liable under
26 U.S.C. § 6901 for the unpaid tax liability arising from the
sale of appreciated assets held by Double-D Ranch, Inc.
We conclude that the two requirements of 26 U.S.C.
§ 6901 — transferee status under federal law and substantive
liability under state law — are separate and independent
inquiries. Therefore, the IRS cannot rely on federal law to
recharacterize the series of transactions for purposes of the
state law inquiry.
The Second Circuit addressed the same factual and legal
issues in Diebold Foundation, Inc. v. Comm’r, 736 F.3d 172
(2d Cir. 2013). We adopt the reasoning of that opinion on the
state law inquiry and conclude that the Double-D
shareholders had constructive knowledge of the fraudulent
tax avoidance scheme at issue. Accordingly, we collapse the
series of transactions and conclude that the shareholders made
a fraudulent conveyance under the New York Uniform
Fraudulent Conveyance Act and that the state law liability
prong of 26 U.S.C. § 6901 was therefore satisfied.
4 SALUS MUNDI FOUNDATION V. CIR
We remand to the Tax Court to determine in the first
instance: (1) Salus Mundi’s status as a transferee of a
transferee under the federal law inquiry of 26 U.S.C. § 6901;
and (2) whether the IRS assessed liability within the
applicable limitations period.
FACTUAL AND PROCEDURAL HISTORY
A. Background on the Diebold Family and Double-D
Ranch, Inc.
Richard Diebold was a major shareholder of American
Home Products Corporation (AHP), a publicly traded
corporation. In 1980, he formed Double-D Ranch, Inc. as a
personal holding company for investment assets, including
shares of AHP, other marketable securities, and real estate.
Richard Diebold was married to Dorothy Diebold, and they
had three children.
When Richard Diebold died in 1996, ownership of all the
stock of Double-D was transferred to the Dorothy R. Diebold
Marital Trust. The marital trust had three cotrustees: Dorothy
Diebold; the Bessemer Trust Co.; and Andrew Bisset,
Dorothy Diebold’s personal attorney. Austin Power, Jr. was
a senior vice president at Bessemer Trust who served as
counsel and primary account manager for the marital trust.
In 1999 Dorothy Diebold was 94 years old and “anxious”
to make cash gifts to her children. Power explained to her
that the marital trust was insufficiently liquid to make such
gifts, but she would be able to make cash gifts if she were to
sell the shares of Double-D. After this explanation, “she was
anxious for [Bessemer] to proceed with the sale of the Double
D Ranch,” and the other trustees agreed.
SALUS MUNDI FOUNDATION V. CIR 5
As part of the decision to sell Double-D, the marital trust
transferred one-third of the Double-D shares to the Diebold
Foundation, a charitable foundation incorporated by Richard
Diebold in 1963 in New York. In 1999 its directors were
Dorothy Diebold, Bisset, and Dorothy Diebold’s three adult
children. Each of the three adult children intended to
organize their own foundations, one of which became the
Salus Mundi Foundation. The directors of the Diebold
Foundation planned to sell the shares of Double-D and
distribute the money to the children’s foundations.
Power was given primary responsibility by the Double-D
shareholders to sell the shares of Double-D.
B. Double-D’s Built-In Gain Tax Liability and the
Use of Intermediary Transactions
In 1999, Double-D’s assets were valued at approximately
$319 million, including approximately $129 million of AHP
stock, $162 million of other marketable securities, and $6
million of real estate in a Connecticut farm; the adjusted tax
bases of these assets were nominal or low. If Double-D
simply sold its assets, it would be taxed on the built-in gain
of those assets, i.e. the difference between the selling price of
the assets and their adjusted tax bases. See 26 U.S.C. §§ 1(h),
1001, 1221, 1222. Sale of Double-D’s assets would have
triggered tax liability of approximately $81 million.
Another option was to sell shares of Double-D. In that
case, Double-D would continue to own the appreciated assets,
and the built-in gain tax would not be triggered. See Diebold
Found., Inc. v. Comm’r, 736 F.3d 172, 175–76 (2d Cir. 2013)
(discussing generally the issue of appreciated assets and the
use of intermediary transactions to avoid tax liability). But
6 SALUS MUNDI FOUNDATION V. CIR
with a stock sale, the assets would retain their low tax bases,
and the built-in gain tax liability would be triggered if
Double-D’s new owners ever sold the assets. Id. For this
reason, a potential buyer of Double-D’s shares would demand
a substantially lower price to account for the built-in gain tax
liability. Id.
An intermediary transaction tax shelter, also known as a
Midco transaction, is a financial arrangement designed to
allow a seller to have the benefits of a stock sale and the
buyer to have the benefits of an asset purchase with both
seller and buyer avoiding the built-in gain tax liability. Id.
The shareholders sell their shares in a corporation to an
intermediary entity at a purchase price that does not discount
for the built-in gain tax liability; the intermediary then sells
the assets of the corporation to the buyer, who gets a purchase
price basis in the assets. Id. The intermediary keeps the
difference between the asset sale price and the stock purchase
price as its fee. Id.
The intermediary attempts to avoid the built-in gain tax
liability by claiming tax attributes, such as losses, that if
legitimate would allow the intermediary to absorb the
liability. Id.; see also I.R.S. Notice 2001–16, 2001–1 C.B.
730; I.R.S. Notice 2008-111, 2008-51 I.R.B. 1299. If the
intermediary’s tax attributes turn out to be artificial, then the
built-in gain tax liability of the sold assets remains
outstanding. Diebold, 736 F.3d at 176. The IRS may seek to
collect from the intermediary, but the intermediary is often a
newly formed entity without other assets and is thus likely to
be judgement-proof. Id. The IRS may then seek payment
from the other parties to the transaction. Id.
SALUS MUNDI FOUNDATION V. CIR 7
C. Double-D’s Meetings with Potential Purchasers
Power recognized Double-D’s built-in gain tax liability as
a “problem” and reached out to “a whole network of people,
for months” to try to find a solution that maximized the
purchase price for Double-D. Power consulted Richard
Leder, Bessemer’s “principal outside tax counsel.” Leder
testified that “it was generally known to – in that profession
that there were . . . some people, who for whatever reason,
whatever their tax activities are, were able to make very
favorable offers to sellers with stock with appreciated assets
. . . with the corporation having appreciated assets.” Leder
directed Power to one of these “people,” Harry Zelnick of
River Run Financial Advisors, LLC, as a potential purchaser
for Double-D. Another managing director at Bessemer
referred Power to Fortrend International LLC.
On May 26, 1999, Power, Leder, and other
representatives of the Double-D shareholders met and
discussed the potential sale of Double-D with Zelnick and Ari
Bergman, a principal at Sentinel Advisors LLC, “a small
investment banking firm that specialized in structuring
economic transactions to solve specific corporate and estate
or accounting issues.” On May 28, Bessemer received the
written summaries of the strategies discussed, including an
Executive Summary that discussed “efficiently liquidating the
portfolio” and indicated that “Sentinel Advisors has
performed comprehensive portfolio and liquidity analysis on
your holdings and would like to present several different
benchmark alternatives for evaluating the liquidation of a
large equity portfolio.”
On June 1, Power and other Double-D representatives met
with Fortrend. Fortrend representatives presented a strategy
8 SALUS MUNDI FOUNDATION V. CIR
entitled “Buy Stock/Sell Assets Transaction,” described as
“working with various clients who may be willing to buy the
stock from the seller and then cause the target corporation to
sell its net assets to the ultimate buyer. These clients have
certain tax attributes that enable them to absorb the tax gain
inherent in the assets.”
D. Stock Purchase Agreement between Double-D and
Sentinel
The Double-D representatives decided to sell to Sentinel.
Sentinel agreed to a cash purchase of all shares of Double-D
at a price equal to the fair market value of Double-D’s assets
minus a discount of 4.25% of the built-in gain. Power sent
Dorothy Diebold a letter seeking her approval in which he
stated that the arrangement “works out to 97% of the market
value” of Double-D’s assets. If Double-D had sold its assets
directly, the built-in gain tax liability would have resulted in
the shareholders realizing only about 74.5% of the market
value.
In the initial term sheet that Sentinel sent to Bessemer, the
Purchaser of Double-D was listed as “XYZ Corporation, a
special purpose entity.” This placeholder eventually became
Shap Acquisition Corporation II (Shap), a new entity which
Sentinel created specifically to facilitate the liquidation of
Double-D’s assets.
Rabobank, a bank based in the Netherlands, provided a
30-day loan to Shap on the condition that Shap enter into a
fixed price contract to sell the marketable securities, with the
purchase price to be paid directly to Rabobank pursuant to an
irrevocable payment instruction. Rabobank anticipated the
loan to Shap “to be outstanding for not more than 5 business
SALUS MUNDI FOUNDATION V. CIR 9
days” because five days was the “longest settlement period
for these securities that will be liquidated.” Shap entered into
a fixed price contract to sell the securities to Morgan Stanley.
On June 24, a draft stock purchase agreement was sent to
Power and other Double-D representatives. The draft
contained several references to Shap’s arrangements with
Morgan Stanley, including a section entitled “Parties in
Interest” which provided that “Purchaser [Shap] may assign
its rights and interests under this Agreement to Morgan
Stanley as collateral security for [Shap’s] obligation to
deliver the Securities to Morgan Stanley following the
Closing for purposes of resale. . . .” “Securities” was defined
to mean the securities owned by Double-D as of the closing
date.
One of the lawyers for the Double-D shareholders deleted
all references to Morgan Stanley in the draft stock purchase
agreement. The lawyers also added language specifically
disclaiming the shareholders’ responsibility for any tax
liabilities arising from the sale of Double-D’s assets:
“Purchasers [Shap], not Sellers [Double-D’s shareholders],
shall be responsible for all Taxes . . . regardless of taxable
period, arising from any sale or disposition of any of the
Securities or the Farm.” Another added provision provided
that “any sale or other disposition by [Double-D] that is
consummated after the acquisition of the Shares by [Shap]
shall be treated as occurring after the period ending on the
Closing Date.”
Following these negotiations, the Double-D shareholders
and Shap executed the stock purchase agreement on June 25,
1999, with a closing date of July 1, 1999. Also on June 25,
Shap and Morgan Stanley entered into a contract for Shap to
10 SALUS MUNDI FOUNDATION V. CIR
sell the securities held by Double-D to Morgan Stanley on
July 1, 1999. The agreement between Shap and Morgan
Stanley referenced the agreement between Shap and the
Double-D shareholders and mandated the use of the same
valuation method for the securities.
The stock purchase agreement also required Shap to cause
Double-D to execute an option agreement on the Connecticut
farm “immediately” after the closing, giving Toplands Farm,
a LLC created by Dudley Diebold, one of the adult Diebold
children, the option to purchase the farm for $6.3 million.
The option agreement was signed by Dudley Diebold on June
30, 1999. On June 30, Dudley Diebold also executed an
occupancy agreement that set forth the terms for Toplands to
take possession of the property on July 1, 1999.
E. Closing of the Stock Purchase Agreement and Sale
of Double-D’s Assets
The closing of the stock sale between the Double-D
shareholders and Shap was delayed from July 1 to July 2,
1999. Power testified that the delay was due to Morgan
Stanley “[seeking] custody and/or control over some of the
Double-D Ranch assets prior to the closing.” Power further
testified that “[t]here was no way we [the Double-D
shareholders] were going to part with any of the Double-D
Ranch assets prior to the closing, prior to basically delivering
the shares against the cash purchase price.”
Because of the delay, Shap was unable to deliver the
securities held by Double-D to Morgan Stanley on July 1 as
mandated by their agreement. The terms of that agreement
provided that Shap “irrevocably agree[s] that, in the event
that the Stock Purchase Agreement Closing does not occur on
SALUS MUNDI FOUNDATION V. CIR 11
the Stock Purchase Agreement Closing Date, [Shap]
remain[s] obligated to deliver to Morgan Stanley (I) shares
fungible with, in all respects, the Shares; or (ii) the amount of
cash equivalent . . . .” But Morgan Stanley did not require
Shap to comply with this provision; instead “Morgan Stanley
backed down” after Bessemer intervened. Power testified
that:
I spoke with Tim Morris who was the head of
the Bessemer investment department, and I
said, somehow or other Morgan Stanley is
trying to throw a monkey wrench into our
Double-D Ranch closing. And it’s my
understanding that Mr. Morris made a call to
one of the persons, the senior people he knew
at Morgan Stanley, and at some point shortly
after that, they backed off and we closed as
we were planning to do, but a day delayed.
After Bessemer’s intervention, the two agreements were
amended: the closing date of the stock purchase agreement
between the Double-D shareholders and Shap was changed to
July 2, and the settlement date of the agreement between
Shap and Morgan Stanley to deliver Double-D’s securities
was changed to July 6.
The planned transactions then went forward. On July 2,
the Double-D shareholders sold their shares to Shap.
Immediately after the closing on July 2, the new president of
Double-D countersigned the option and occupancy
agreements with Toplands Farm. On July 6, Double-D’s
securities were transferred to Morgan Stanley. Morgan
Stanley recorded a trade date of July 2 and a settlement date
of July 6 (or July 8 for one security). Later in July and
12 SALUS MUNDI FOUNDATION V. CIR
August, Toplands Farm exercised its option and paid Shap
$6.3 million for the Connecticut farm.
Shap ultimately paid the Double-D shareholders
approximately $309 million and received about $319 million
from its sale of Double-D’s assets. Because Shap claimed
losses sufficient to off-set the built-gain tax liability, it did not
pay any tax on its sale of Double-D’s assets. After repayment
of its Rabobank loan, Shap retained profits of about $10
million.
The $309 million paid to the Double-D shareholders was
distributed proportionally to the marital trust and the Diebold
Foundation. Pursuant to a plan of dissolution effective
January 29, 2001, the Diebold Foundation distributed all of
its assets in equal shares to the three foundations formed by
the Diebold children: the Salus Mundi Foundation, the Ceres
Foundation, and the Diebold Foundation. These transfers, of
approximately $33 million each, were not made in exchange
for any property or in satisfaction of any existing debt.
F. Tax Filings and IRS Collection Efforts
All of the parties to this intermediary transaction filed tax
returns. The Double-D shareholders filed returns that
reflected the sale of their shares to Shap on July 2, 1999. On
March 20, 2000, Double-D filed a corporate return for a short
taxable year of July 1–2, 1999, and indicated that it was filing
its final return. This return did not report the sale of
securities to Morgan Stanley or the sale of the Connecticut
farm to Toplands Farm. Shap filed a consolidated return with
Shap Holdings, Inc. (the new name for Double-D) for the
taxable year ending June 30, 2000. On this return, Shap
reported the sale of Double-D’s assets and the resulting built-
SALUS MUNDI FOUNDATION V. CIR 13
in gain, but Shap also claimed losses sufficient to offset the
gain and reported no net tax liability. The Tax Court later
determined that these losses were artificial losses resulting
from a tax shelter known as a Son-of-BOSS transaction. See
Desmet v. Comm’r, 581 F.3d 297, 299–300 (6th Cir. 2009)
(“A typical Son-of-BOSS scheme uses a series of contrived
steps in a partnership interest to generate artificial tax losses
designed to offset income from other transactions.” (internal
quotation marks omitted)).
On March 10, 2006, the IRS issued a notice of income tax
liability against Double-D for the July 1–2, 1999 taxable year,
assessing a deficiency of approximately $81 million plus
penalties and interest. The IRS determined that the sale of
Double-D stock on July 2 by the Double-D shareholders was,
in substance, actually a sale of Double-D’s assets followed by
a liquidating distribution to the shareholders. Double-D did
not contest this assessment, but the IRS was unable to find
any assets of Double-D from which to collect the liability.
Deciding that further efforts to collect from Double-D
would be futile, the IRS attempted to collect from the
Double-D shareholders as transferees of Double-D pursuant
to 26 U.S.C. § 6901.
G. Tax Court Proceedings
On August 7, 2007, the IRS issued a notice of transferee
liability against Dorothy Diebold as a transferee of Double-D.
Dorothy Diebold contested the assessment. After a trial, the
Tax Court determined that she was not liable because the
marital trust was the actual Double-D shareholder, and the
Tax Court chose not to disregard its separate existence.
Diebold v. Commissioner, 100 T.C.M. 370 (T.C.
14 SALUS MUNDI FOUNDATION V. CIR
2010), 2010 WL 4340535, at *8–10 (2010). The IRS failed
to assert and prove transferee of transferee liability. Id. at
*10. The IRS did not appeal that decision.
On July 11, 2008, the IRS issued notices of transferee
liability against each of the Diebold children’s foundations
for the $33 million that each foundation received from the
original Diebold Foundation. The IRS asserted that the
Diebold Foundation was a transferee of Double-D and that
the three successor foundations were in turn transferees of the
Diebold Foundation. The three foundations contested the
notices, and the Tax Court consolidated their petitions. The
parties agreed to use the same evidence, including trial
testimony, that was used in the earlier case against Dorothy
Diebold.
The Tax Court determined that the original Diebold
Foundation was not liable as a transferee of Double-D
because the Double-D shareholders lacked actual or
constructive knowledge under New York state law of Shap’s
fraudulent tax avoidance scheme. The Tax Court held that
because the Diebold Foundation was not liable as a transferee
of Double-D, the successor foundations could not be liable as
transferees of a transferee. The IRS now appeals the Tax
Court’s decision in favor of Salus Mundi.
STANDARD OF REVIEW
“The United States Courts of Appeals . . . shall have
exclusive jurisdiction to review the decisions of the Tax
Court . . . in the same manner and to the same extent as
decisions of the district courts in civil actions tried without a
jury . . . .” 26 U.S.C. § 7482(a)(1). “Thus, we review the tax
court’s conclusions of law de novo and its factual findings for
SALUS MUNDI FOUNDATION V. CIR 15
clear error.” DHL Corp. & Subsidiaries v. Comm’r, 285 F.3d
1210, 1216 (9th Cir. 2002).
DISCUSSION
A. Two-Pronged Test for Liability Under 26 U.S.C.
§ 6901
Section 6901 of the Internal Revenue Code allows the
IRS to assess tax liability against the transferee of assets of a
taxpayer who owes income tax. 26 U.S.C.
§ 6901(a)(1)(A)(I). Transferee liability is “subject to the
same provisions and limitations” as the original tax liability,
id. § 6901(a), and includes liability of a “transferee of a
transferee.” Id. § 6901(c)(2). A “transferee” includes a
“donee, heir, legatee, devisee, [or] distributee.” Id. § 6901(h).
Treasury regulations further provide that “the term
‘transferee’ includes . . . the shareholder of a dissolved
corporation, . . . the successor of a corporation, . . . and all
other classes of distributees.” 26 C.F.R. § 301.6901-1(b).
In 1958, the Supreme Court held that this section “neither
creates nor defines a substantive liability but provides merely
a new procedure by which the Government may collect
taxes.” Comm’r v. Stern, 357 U.S. 39,42 (1958). Because the
section is “purely a procedural statute,” the Supreme Court
looked to state law to define “the existence and extent” of
“substantive liability.” Id. at 44–45. The result is a two-
pronged inquiry for assessment of transferee liability: (1) is
the party a “transferee” under § 6901 and federal tax law?;
and (2) is the party substantively liable for the transferor’s
unpaid taxes under state law? See Diebold, 736 F.3d at
184–85; Frank Sawyer Trust of May 1992 v. Comm’r,
712 F.3d 597, 605 (1st Cir. 2013); Starnes v. Comm’r,
16 SALUS MUNDI FOUNDATION V. CIR
680 F.3d 417, 428 (4th Cir. 2012). Salus Mundi and the IRS
agree on the applicability of this two-pronged test but dispute
the relationship between the two prongs and the proper
outcome in the case.
The IRS argues that the two prongs are not independent.
Rather, a court must first undertake the inquiry under § 6901
and federal tax law to determine transferee status and, if
necessary, recharacterize transactions under the “substance
over form” doctrine. The IRS argues that the series of
transactions between the Double-D shareholders, Shap,
Toplands Farm, and Morgan Stanley should be
recharacterized and Double-D deemed to have sold its assets
and distributed the proceeds to its shareholders. Under the
IRS’s interpretation, the federal law recharacterization is
antecedent to the state law liability prong, and a court should
apply state substantive law to the recharacterized transaction.
Salus Mundi counters that the inquiries are independent
so the failure to satisfy either prong prevents the assessment
of liability. In Salus Mundi’s view, the state law inquiry is
separate from the determination of transferee status under
§ 6901 and any recharacterization of the transactions must
rely on state law.
The Tax Court agreed with Salus Mundi’s interpretation
and stated that “[t]he law of the State where the transfer
occurred (in these cases, New York) controls the
characterization of the transaction.” “Under the [New York
Uniform Fraudulent Conveyance Act], a party seeking to
recharacterize a transaction must show that the transferee had
‘actual or constructive knowledge of the entire scheme that
renders [its] exchange with the debtor fraudulent.’” Diebold,
736 F.3d at 184–85 (quoting HBE Leasing Corp. v. Frank,
SALUS MUNDI FOUNDATION V. CIR 17
48 F.3d 623, 635 (2d Cir. 1995)). The Tax Court found that
the Double-D shareholders lacked actual or constructive
knowledge of Shap’s tax avoidance scheme and therefore
refused to recharacterize the transactions under New York
law.
The IRS’s argument that “state law liability is assessed
based upon the transaction as recharacterized by federal tax
law” has recently been considered and rejected by three
circuits. See Diebold, 736 F.3d at 184–85; Frank Sawyer
Trust, 712 F.3d at 605; Starnes, 680 F.3d at 428.
The IRS relies on the dissent in the Fourth Circuit’s
decision in Starnes as well as an older case from the Second
Circuit, Rowen, as support for its position. See Starnes,
680 F.3d at 440–46 (Wynn, J., dissenting); Rowen v. Comm’r,
215 F.2d 641, 643 (2d Cir. 1954). The IRS cites to a passage
in Rowen that uses the transferee determination under § 6901
as the starting point for the state law inquiry. Id. But this
decision predated the Supreme Court’s decision in Stern;
when the Second Circuit revisited this issue in Diebold, it
squarely rejected the IRS’s argument. 736 F.3d at 185. The
Second Circuit held that “the position urged by the IRS
imports federal law into the substantive determination of
liability, in contravention of long settled law that § 6901is
only a procedural statute, creating no new liability.” Id.
(citing Stern, 357 U.S. at 42).
The IRS, citing the dissent in Starnes, contends that the
Supreme Court in Stern did not foreclose its interpretation of
the two-pronged inquiry under § 6901. The IRS points out
that the Kentucky law at issue in Stern precluded tax liability
regardless of transferee status so the Supreme Court did not
address whether determination of transferee status under
18 SALUS MUNDI FOUNDATION V. CIR
§ 6901 is a threshold inquiry. The dissent in Starnes argued
that the analysis is different when presented with a
transaction where “[state] law may indeed impose liability on
the former shareholders, but only if there was a fraudulent
transfer and they are transferees under federal law.” Starnes,
680 F.3d at 441 (citation omitted). The Starnes dissent also
argued that holding the two prongs to be independent “would
allow state substantive law to redefine” potential transferees
“in clear contravention” of the specific definition provided in
§ 6901(h). Id. at 442 n.3.
The IRS and the Starnes dissent present a plausible
characterization of Stern. And there are plausible policy
rationales for using the federal doctrine of substance over
form to provide for liability against “a transparent scam
designed by the parties to fraudulently evade paying taxes.”
Id. at 441. But every circuit to directly address the issue has
found that Stern is best interpreted as establishing that the
state law substantive liability inquiry is independent of the
federal law procedural inquiry, and we agree. See, e.g., id. at
429 (“An alleged transferee’s substantive liability for another
taxpayer’s unpaid taxes is purely a question of state law,
without an antecedent federal-law recasting of the disputed
transactions.”).
The IRS’s arguments are not sufficiently persuasive to
create an inter-circuit conflict. See Beecher v. Comm’r,
481 F.3d 717, 720 (9th Cir. 2007) (“As a general rule, the tax
decisions of other circuits should be followed unless they are
demonstrably erroneous or there appear cogent reasons for
rejecting them.”). Therefore, we conclude that “the two
prongs of § 6901 are ‘independent requirements, one
procedural and governed by federal law, the other substantive
SALUS MUNDI FOUNDATION V. CIR 19
and governed by state law.’” Diebold, 736 F.3d at 186
(quoting Starnes, 680 F.3d at 427).
B. The Second Circuit’s Decision in Diebold
Foundation v. Commissioner
Because the Diebold children’s foundations were
organized in Arizona, Connecticut, and South Carolina, the
Tax Court’s decisions in their favor were appealable to the
Ninth, Second, and Fourth Circuits, respectively. The IRS
did not appeal the decision in favor of the Ceres Foundation
to the Fourth Circuit. But the IRS did appeal the decision in
favor of the successor Diebold Foundation to the Second
Circuit. See Diebold, 736 F.3d at 172.
The Second Circuit concluded that under New York law,
the Double-D shareholders had constructive knowledge of the
tax avoidance scheme and were therefore liable under state
law; the Second Circuit vacated the Tax Court’s decision and
remanded to the Tax Court to determine transferee status
under federal law and the applicable statute of limitations. Id.
at 190. In reaching that conclusion, the court reasoned that
the following facts, among others, showed a failure of
ordinary diligence and active avoidance of the truth by the
shareholders: (1) the shareholders’ recognition of the
“problem” of the “tax liability arising from the built-in gains
on the assets held by Double-D”; (2) the shareholders’
“sophisticated understanding of the structure of the entire
transaction,” including Shap’s plans to immediately sell
Double-D’s assets; and (3) the shareholders’ knowledge that
Shap “had just come into existence for the purposes of the
transaction” and thus “did not have the assets to meet its
obligation to buy equivalent shares on the open market for
20 SALUS MUNDI FOUNDATION V. CIR
delivery to Morgan Stanley or pay Morgan Stanley an
equivalent sum in cash.” Id. at 187–89.
We have held that “absent a strong reason to do so, we
will not create a direct conflict with other circuits.” United
States v. Chavez-Vernaza, 844 F.2d 1368, 1374 (9th Cir.
1987). “As a general rule, the tax decisions of other circuits
should be followed unless they are demonstrably erroneous
or there appear cogent reasons for rejecting them.” Beecher,
481 F.3d at 720. The Second Circuit’s decision in Diebold
Foundation addressed the same facts, issues, and applicable
law at issue in this appeal. While the question of the
shareholders’ constructive knowledge is a difficult issue, we
conclude that the Second Circuit’s decision is not
demonstrably erroneous. Accordingly, we adopt the
reasoning of that opinion on the state law inquiry and
conclude that the shareholders had constructive knowledge of
the tax avoidance scheme and made a fraudulent conveyance
under New York law. See Diebold, 736 F.3d at 190; N.Y.
Debt. & Cred. Law § 273.
In short, we conclude that the two prongs of § 6901 are
separate and independent; an alleged transferee’s substantive
liability is determined solely with reference to state law,
without any threshold requirement that the disputed
transactions be recast under federal law. We also conclude
that the shareholders’ conduct shows that they had
constructive knowledge of the fraudulent scheme; we
therefore collapse the series of transactions and hold that the
state law liability prong of the 26 U.S.C. § 6901 inquiry was
satisfied in this case. We remand to the Tax Court to
determine in the first instance: (1) Salus Mundi’s status as a
transferee of a transferee under the federal law inquiry of
SALUS MUNDI FOUNDATION V. CIR 21
26 U.S.C. § 6901; and (2) whether the IRS assessed liability
within the applicable limitations period.
CONCLUSION
The Tax Court’s decision in favor of Salus Mundi is
hereby REVERSED, and the case is REMANDED to the
Tax Court for further proceedings consistent with this
opinion.