Last week the Tax Court issued an opinion involving proposed transferee liability assessments in excess of $10.7 million in which it rejected the IRS’s proposed application of federal law to recast a transaction under the substance over form doctrine. Swords Trust v. Commissioner, 142 T.C. No. 19. The court held that the trusts were not liable as transferees under I.R.C. sec. 6901.

The initial liability had been incurred by a personal holding company, Davreyn Corporation, pursuant to an IRS income tax examination in which the IRS recharacterized a sale of stock to a sale of assets followed by a distribution to the corporation’s shareholders. That recharacterization resulted in an increase of $13.4 million in long-term capital gain and a $4.6 income tax deficiency.

The IRS sought to hold several trusts liable for transferee assessments pursuant to I.R.C. sec. 6901 by virtue of funds that the trusts had received from a stock redemption and stock sale involving Davreyn. The IRS sent notices of liability to the trusts with respect to a Davreyn’s unpaid income tax liability.

I.R.C. sec. 6901 authorizes the IRS to make transferee assessments, which assessments provide the IRS with a procedure to collect the transferor’s tax liability from transferees. Transferees can include shareholders of a dissolved corporation. However, the IRS is required to rely upon an independent basis under applicable state law or state equity principles which provide for holding a transferee liable. The IRS has the burden of proof to show that a person is liable as a transferee.

In Swords Trust, the Court held that the IRS failed to establish that an independent basis existed under applicable state law or state equity principles for holding the trusts liable for Davreyn’s unpaid tax liability. The Court rejected the IRS’s attempt to apply federal substance over form doctrine, instead holding that the IRS was required to show that state law would provide for such a recharacterization. The Court found that the IRS failed to establish that Supreme Court of Virginia would apply a substance over form analysis under the facts of this case. Nor did the IRS prove that the trusts were liable under Virginia’s fraudulent conveyance statutes or trust fund doctrine.