When advising a client who is about to sell a corporation, it is important to be aware of transferee liability. Transferee liability could occur when a corporation incurs federal income tax liability, as in the case of a C corporation; or built-in gains tax or excess net passive income tax liability, as in the case of an S corporation.
For example, assume that during year one, a seller owns 100 percent of the stock in a corporation and is a calendar-year taxpayer. At the time of the sale, the corporation has accrued a federal income tax liability payable on or before March 15 of year two. Further assume that the seller sells all of his or her stock in the corporation to a purchaser during year one. After the sale, the purchaser receives all of the corporation’s assets – resulting in its inability to pay its liabilities, including the federal income taxes – and then dissolves the corporation.
The corporation’s creditors, including the Internal Revenue Service (IRS), cannot collect on their respective debts from the corporation because it no longer exists. The IRS’ alternatives for collecting the income tax debt depend upon state law. In the case of a corporation that is subject to New Jersey law, a creditor has options pursuant to the New Jersey Uniform Fraudulent Transfers Act. Pursuant to this act, a transfer is deemed fraudulent with respect to a creditor if the debtor engages in a transaction that is disadvantageous to a debtor, in other words, where the debtor does not receive the fair market value of assets in a sale or exchange. One example of a fraudulent transfer is when an insolvent corporation issues a dividend because, by definition, the debtor corporation receives nothing in the exchange.
In the aforementioned example, the creditor can then recover his/her claim against the corporation by seizing its assets which are now held by the shareholder. Accordingly, the IRS now becomes a creditor because of the corporation’s unpaid federal income tax liability. In general, the IRS has four years from the due date of the corporation’s income tax return, including extensions, to exercise this option, which is comprised of the normal three-year period for assessing income tax deficiencies plus one year.
Regarding the sale of a business, the seller has to be concerned about transferee liability if the seller sells his/her corporate stock and the sales proceeds are derived directly from the corporation. In this case, the seller would be the transferee and would thus have transferee liability if the corporation’s liabilities exceed its assets (i.e., if the corporation becomes insolvent) after the sale of the corporate stock.
Therefore, it is crucial that the seller performs due diligence regarding the purchaser before selling the business; it is not sufficient to merely know that the purchaser has the funds to buy the business. Among other things, the seller should, with the assistance of legal counsel, determine (1) whether the purchaser intends to continue the corporation’s business; (2) that the purchaser has the ability to pay the corporation’s liabilities; and (3) how the purchaser intends to fund the business purchase.
The seller should also be wary if the purchaser claims that he/she can reduce the corporation’s federal income tax liability with respect to the year of sale and, therefore, would be willing to purchase the corporation’s stock at a price greater than the fair market value of its equity. The seller should be especially skeptical if the corporation already sold its business assets in a prior sale, resulting in the corporation only holding cash. This is because the tax court has held that the seller was liable for a dissolved corporation’s unpaid federal income tax liability at the time of a sale when the seller knew, or should have known, that the liability would never be paid by the corporation. Therefore, it is crucial for the seller’s accountant to independently verify the purchaser’s income tax reduction claims.
Lowell S. Kirschner, CPA, LL.M., is a member of the New Jersey Society of CPAs Federal Taxation Interest Group. Contact him at [email protected].