Listen to this post

What Corporate Shield?

Would you be surprised to learn that most shareholders of closely held corporations, and especially those with minority or merely passive interests, believe they cannot be held responsible for the tax obligations of their corporations?

I, for one, would not. Over the years, I have both experienced and read about many situations in which shareholders realized too late that the “limited liability” protection the corporate shield affords them under a state’s business corporation law goes only so far, even in cases where the corporation is respected as a separate legal entity.[i]

Among the scenarios in which the shareholders of a corporation may have to account personally for a corporate-level tax obligation are those involving the corporation’s failure to collect certain taxes on behalf of, or its failure to remit such taxes to, a taxing authority. This category of taxes includes employment taxes and sales taxes.[ii]

However, a shareholder of a closely held business is most likely to be taken aback if they are held liable for their corporation’s own income tax liability, notwithstanding the corporation is a C corporation[iii] – itself a separate income tax-paying entity[iv] – and regardless of the fact the shareholder is a non-controlling owner.

The U.S. Tax Court recently considered a situation in which the IRS sought to collect a C corporation’s income tax from its former shareholders.[v]

The Corporation

Corp was in the business of buying and selling marketable securities. Taxpayer inherited 25 percent of Corp’s stock at the death of their parent. The other three shareholders (each with a 25 percent interest) likewise inherited their stock upon the death of a parent. Thus, each shareholder held their 25 percent interest in the Corporation with an adjusted basis that was derived from the fair market value of the Corporation at the time of their parent’s death.[vi]

It should come as no surprise then, when the shareholders were considering how to dispose of Corp’s business, they decided to sell their shares of Corp stock,[vii] thereby taking advantage of the stepped-up stock basis which reduced the gain from the sale of their stock.[viii]

Although their stock basis was certainly an important factor in the shareholders’ deliberations, it is also likely they wanted to avoid the two levels of tax that attend the sale of a C corporation’s assets: first the corporation is taxed on the gain recognized from the sale of its assets;[ix] and second, if the amount distributed by the corporation to each of its shareholders (the net after-tax proceeds remaining from the asset sale) in liquidation of their stock exceeds such shareholder’s stock basis, the shareholder will be taxed on the resulting gain.[x]

Conversely, most buyers would prefer to acquire a target corporation’s assets while assuming only certain identified business liabilities. By purchasing the assets, the buyer obtains what is presumably an increased (cost) basis for such assets, which the buyer may then expense, depreciate, or amortize (depending upon the asset), thereby recovering its investment (the purchase price for the assets) much faster than if the buyer had acquired the corporation’s stock from its shareholders.[xi]

In any case, Corp’s shareholders retained an adviser to assist them in identifying potential purchasers for their stock.

Stock Sale + Tax Shelter

Not long after, the shareholders received an unsolicited offer from Acquirer to purchase all of Corp’s outstanding stock for a price equal to 100 percent of Corp’s cash on hand plus 93 percent of the fair market value of the securities owned by Corp at the time of closing.

The shareholders agreed to the stock purchase.[xii] To facilitate the transaction, Acquirer organized Sub.

That’s when things got interesting. Or should I say hairy?

“Midco” Transaction[xiii]

The shareholders entered into a Stock Purchase Agreement (SPA) with Sub.[xiv] As required by the SPA, Sub purchased from the shareholders all of Corp’s outstanding stock for $49.29 million and wired the funds to an account held by Corp’s president, who in turn transferred approximately $12.32 million each to Taxpayer and the other three shareholders.[xv]

Sub financed the stock purchase by obtaining a $55 million loan from Bank. To receive this loan, Sub was required (1) to enter into an agreement with Brokerage Firm (BF) by which the latter would buy certain securities from Corp, and (2) to agree to pay back the loan by a specified time. To satisfy these requirements, Sub and Corp engaged in a series of transactions that was completed in the same tax year as the shareholders’ sale of the Corp stock to Sub (the “Tax Year”).

“Son-of-BOSS” Transaction

Following the Midco transaction, Corp undertook a series of transactions during the Tax Year – involving Corp’s contribution of a purchased option to a partnership – intending to generate a purported capital loss.[xvi]

Corp used the loss from these transactions to offset the entire gain from the sale of Corp’s securities portfolio to BF in connection with the Midco transaction. As result, Corp reported a net loss of more than $2.2 million on its tax return for the Taxable Year.

Thus, Corp was able to realize the gain inherent in its assets, offset such gain and not incur an income tax liability, make a liquidating distribution to Sub, which would be absorbed by Sub’s cost basis for the Corp stock, and that Sub would use to satisfy its obligation to Bank.

Notice of Transferee Liability

The IRS determined that the Son-of-Boss transaction was a sham and should be disregarded. It then issued a notice of deficiency predicated on the adjustments that followed from this determination.

The IRS subsequently issued to Taxpayer a Notice of Transferee Liability, determining that Taxpayer was liable for a quarter of Corp’s income tax liability for the Tax Year. In the Notice informed Taxpayer that a portion of Corp’s liability was being assessed against him because it was determined that Corp transferred assets to Taxpayer, or alternatively, that Corp made transfers from which Taxpayer benefited, with either determination making Taxpayer a transferee of Corp. The Notice went on to state:

The transfers to you are voidable under state law. The transferor made the transfers with actual intent to hinder, delay or defraud a creditor. They were also constructively fraudulent. [Corp] did not receive reasonably equivalent value or fair consideration in exchange for the transfers. [Corp] was engaged or about to engage in a transaction for which its remaining assets were unreasonably small. [Corp] intended or believed or reasonably should have believed it would incur liabilities beyond its ability to pay as they became due. These and related transfers rendered [Corp] insolvent.

The IRS’s determination that Taxpayer was a transferee as to Corp was premised on the IRS’s assertion that the Midco transaction should be recast as an asset sale followed by a liquidating distribution from Corp to its shareholders, including Taxpayer.

Taxpayer filed a Petition with the Tax Court challenging the IRS’s transferee liability determination. The Petition alleged that Taxpayer was not a transferee of Corp or Sub and that the period of limitation for the IRS to make either determination expired before Taxpayer was issued the Notice of Transferee Liability.

Taxpayer then filed a Motion for Summary Judgment[xvii] asking the Court to find as a matter of law that Taxpayer was not a transferee of Corp because (1) the period of limitation to recast the MidCo transaction expired before the Notice of Transferee Liability was issued; (2) the IRS was collaterally estopped from relitigating facts that the Court had already decided in connection with the Son-of-Boss transaction; and (3) the IRS was judicially estopped from taking a position in this case that was contrary to a position advanced in connection with the Son-of-Boss transaction.

Court’s Discussion

The Court observed that each of Taxpayer’s three arguments was based on the premise that the IRS was precluded from recasting the MidCo transaction for purposes of determining that Taxpayer was liable as a transferee of Corp for the Tax Year.


According to the Court, the Code provides that the IRS may assess tax against the transferee of property of a taxpayer that owes income tax.[xviii] It specifically provides that the “liability, at law or in equity, of a transferee of property” shall be “assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.” 

The Court then explained that, for the IRS to assess transferee liability, two requirements must be met: first, a court must determine whether “the party [is] a ‘transferee’ under [the Code] and second whether “the party [is] substantively liable for the transferor’s unpaid taxes under state law.” 

Because Taxpayer directed its arguments only to the first prong – i.e., whether the IRS was precluded from characterizing Taxpayer as a transferee under the Code – the Court stated that it would address only those arguments, and would not determine whether Taxpayer was a transferee under state law.

Taxpayer’s Arguments

Taxpayer asserted that the IRS could not recast the Midco transaction as an asset sale followed by a liquidating distribution of the proceeds to its shareholders for the purpose of deeming Taxpayer to be a transferee for purposes of the Code, and put forth three arguments to support its position, including that the period of limitation to recast the transaction had expired.[xix]

Of course, the IRS disagreed, asserting that Taxpayer’s summary judgement motion should be denied because there was an issue of material fact as to whether Taxpayer was a transferee. The IRS also claimed that the Notice of Transferee Liability was issued timely and that the agency was not otherwise barred from recasting the Midco transaction.

Court’s Decision

The Court noted that the “expiration of the period of limitation on assessment is an affirmative defense, and the party raising it must specifically plead it and carry the burden of proving its applicability.”[xx]  To establish a limitations defense, the Court continued, the taxpayer must make a prima facie case establishing the filing of the return, the expiration of the statutory period, and the receipt or mailing of the notice after the running of the period. Where the taxpayer makes such a showing, the burden going forward with the evidence shifts to the IRS, which must then introduce evidence to show that the bar of the statute is not applicable.

Applicable Statutes of Limitations

The Code provides that the IRS must generally assess tax within three years after a return is filed.[xxi]

However, the Code also provides a separate period of limitation for assessing income tax with respect to a taxpayer that is attributable to any partnership item.[xxii] .  It provides that the assessment period generally “shall not expire before the date which is 3 years after the later of (1) the date on which the partnership return for such taxable year was filed, or (2) the last day for filing such return for such year (determined without regard to extensions).”[xxiii] Thus, the Code provides a minimum period within which the IRS may adjust partnership items.[xxiv] 

In addition. the Code specifies the period of limitation for assessing the tax of a transferor against a transferee. It provides that the period of limitation for assessment of any such tax liability of a transferee must be assessed “within 1 year after the expiration of the period of limitation for assessment against the transferor.”[xxv]

Court’s Analysis

The issue before the Court was whether the period of limitation for the IRS to assess transferee liability against Taxpayer expired before the IRS issued the Notice of Transferee Liability.

Relying upon the general 3-year statute of limitations, without regard to the special provision for partnership items, Taxpayer argued that the period of limitation to assert that he was a transferee of Corp on account of the recast of the Midco transaction expired before the IRS issued the Notice, and the period of limitation to assess any transferee liability on account of the recast expired one year later which, Taxpayer stated, would make the Notice is untimely.

The Court began by establishing there is only one period of limitation for the assessment of transferee liability, and that this limitation period does not distinguish between partnership items and non-partnership items.

Next, the Court determined that the period of limitation on assessment of tax attributable to partnership items relating to the Son-of-Boss transaction remained open from the time of the filing of the relevant partnership return until the IRS issued the Notice of Transferee Liability to Taxpayer because the partnership had agreed several times to

extend the applicable period of limitation. In addition, Taxpayer had agreed to extend the deadline for assessment of transferee liability.

On the basis of these extensions, the Court concluded that the IRS had issued the Notice of Transferee Liability to Taxpayer within the period of limitation.

Parting Thoughts

The transaction described above sought to achieve the best of both worlds: a sale of all the shares of a corporation’s stock with reduced long term capital gain for its shareholders, followed by a sale of the corporation’s assets without incurring a corporate-level income tax liability.

Unfortunately for the parties to the transaction, their arrangement was, in the end, a tax avoidance scheme, and the Court was obviously correct in recasting the transaction as an asset sale followed by a liquidating distribution to Taxpayer and the other shareholders of Corp.

Buyer borrowed the funds needed to acquire Corp’s stock and, as part of a plan, it sold Corp’s assets immediately after the stock sale to generate the liquidity required to satisfy the loan. In other words, Buyer was never really at economic risk with respect to the loan. It then used a tax shelter arrangement to generate a tax loss – again without economic consequences – to offset the gain from the asset sale.

In short, the cash for the purchase of the shareholders’ Corp stock came from the sale of Corp’s assets – thus, the shareholders’ transferee liability for Corp’s income taxes from the asset sale.

Transferee Liability

It is worth noting that a shareholder’s transferee liability for a corporation’s tax obligation may arise in many other settings. Thus, it would behoove a shareholder to familiarize themselves with the elements that must be present before the IRS may pursue them for their corporation’s income taxes: (i) the corporation must transfer its property to the shareholder without receiving equivalent value in exchange, and (ii) the corporation must be liable for tax both at the time of the transfer and when the IRS asserts transferee liability against the shareholder. If, under the circumstances, state law imposes substantive liability on the shareholder for the unpaid tax owed by the corporation, then the IRS may use the tools available under the Code to collect such tax from the transferee-shareholder.

Sign up to receive my blog at
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] It is not disregarded as a sham entity. 

[ii] At least where the taxing authority or court determines that the shareholder in question was a “responsible person” or was “under a duty to act” as to such taxes. See IRC Sec. 6672 as to federal employment taxes.

[iii] IRC Sec. 11: “A tax is hereby imposed for each taxable year on the taxable income of every corporation.”

[iv] As distinguished from a pass-through like an S corporation, which is generally not subject to income tax. IRC Sec. 1363(a): “Except as otherwise provided in this subchapter, an S corporation shall not be subject to the taxes imposed by this chapter.”

[v] Meyer v. Commissioner, T.C. Memo. 2024-15. Actually, the Court considered a motion for summary judgement filed by a former shareholder in which the latter asked the Court to conclude the former shareholder was not a transferee of their corporation.

[vi] The basis step-up under IRC Sec. 1014. It is important to note that a decedent’s shares of stock in a closely held corporation will usually be valued using a discount for lack of marketability and, depending upon the size of their interest, a discount for lack of control. See Rev. Rul. 59-60. Query whether the appraisers accounted for the appreciation of Corp’s assets and the potential tax liability inherent therein.

As a general rule, a shareholder’s basis in C corporation stock is equal to their original capital contribution in exchange for which they acquired the stock from the Corporation, plus any additional paid-in capital.

It should also be noted that a beneficiary who inherits property from a decedent is treated as having a long-term holding period in such property, regardless of how soon after such inheritance the beneficiary sells the property.

[vii] Mind you, a buyer is likely to pay less for the stock of a corporation because they will not be able to recover their investment in such stock until the stock is resold or the corporation is liquidated. The buyer is also more likely to insist on a more substantial and longer-lived escrow or other purchase price deferral mechanism to protect against any unexpected corporate liabilities that may arise.

[viii] IRC Sec. 1001. The individual shareholder’s gain would be subject to federal income at 20% (for long-term capital gain) plus the federal surtax on net investment income at 3.8%. IRC Sec. 1(h) and Sec. 1411.

It should also be noted that the stock sale, with nothing more, would avoid recognition of the gain inherent in Corp’s assets because the corporation would continue to own such assets.  

[ix] This will include federal, state and local income taxes that will be imposed on the corporation. In the case of a corporation doing business in New York City, the applicable tax rates (before accounting for these taxes in determining the corporation’s taxable income) are 21% federal, 7.25% NY State, and 8.85% City.

[x] IRC Sec. 331.

[xi] In some cases, a basis step-up may be achieved with a stock purchase. See IRC Sec. 338(h)(10) and Sec. 336(e).

[xii] After the shareholders accepted Acquirer’s offer, Corp terminated its agreement with the adviser and the latter agreed to refund the advance it had received.

[xiii] This transaction is sometimes peddled to shareholders of C corporations. As you’ll soon see, it is coupled with a loss-generating transaction that artificially eliminates the gain inherent in the C corporation’s assets.

[xiv] Sub was the Midco.

[xv] On that same date, Corp’s shareholders entered into a separate agreement with Sub regarding the receivables they were due pursuant to the SPA. This separate agreement required Sub to remit to the former Corp shareholders amounts received in connection with those receivables; specifically: (1) the advance to be refunded from Adviser and (2) a federal tax refund claim. Both amounts were to be split four ways and later remitted to each shareholder.

[xvi] The Son of Boss transaction involves the contribution of a purchased option to a partnership and the assumption by the partnership of a separate written option which the taxpayer incurred. A taxpayer engaged in a Son of Boss transaction claims that the basis in the taxpayer’s partnership interest is increased by the cost of the purchased call option but is not reduced under IRC Sec. 752 for the assumption of the obligation under the written call option. Subsequently, taxpayer claims a loss on the disposition of the partnership interest even though taxpayer has incurred no corresponding economic loss. See IRS Notice 2000-44.

[xvii] The Court explained that it may grant summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(a)(2). The moving party bears the burden of showing that there is no genuine dispute as to any material fact. When a motion for summary judgment is properly made and supported, an opposing party may not rest on mere allegations or denials. Rule 121(d). Rather, the party’s response, by affidavits or declarations, or as otherwise provided in Rule 121, must set forth specific facts showing there is a genuine factual dispute for trial. Rule 121(c) and (d). In deciding whether to grant summary judgment, the Court view the facts and make inferences in the light most favorable to the nonmoving party. 

[xviii] IRC Sec. 6901(a)(1)(A)(i).

[xix] Taxpayer’s other arguments, not addressed in this post, were as follows: the IRS was collaterally estopped from recasting the transaction, and the IRS should be judicially estopped from recasting the transaction.

[xx] See Tax Court Rule 39.

[xxi] IRC Serc. 6501.

[xxii] IRC Sec. 6501(n)(2) and Sec. 6229.

[xxiii] IRC Sec. 6229(a).

[xxiv] Where IRC Sec. 6501(a) and Sec. 6229(a) both apply, the longer of the two periods controls. 

[xxv] This is in the case of an initial transferee. In the case of a transferee of a transferee, the tax must generally be assessed “within 1 year after the expiration of the period of limitation for assessment against the preceding transferee, but not more than 3 years after the expiration of the period of limitation for assessment against the initial transferor.” IRC Sec. 6901(c)(1) and (2).