Starnes v. Commissioner

PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

ALBERT J. STARNES, 

Petitioner-Appellee,

v.

 No. 11-1636

COMMISSIONER OF INTERNAL

REVENUE,

Respondent-Appellant.



ESTATE OF SALLIE C. STROUPE, 

Petitioner-Appellee,

v.

 No. 11-1706

COMMISSIONER OF INTERNAL

REVENUE,

Respondent-Appellant.



ANTHONY S. NAPLES, 

Petitioner-Appellee,

v.

 No. 11-1712

COMMISSIONER OF INTERNAL

REVENUE,

Respondent-Appellant.



2 STARNES v. CIR

RONALD D. MORELLI, SR., 

Petitioner-Appellee,

v.

 No. 11-1714

COMMISSIONER OF INTERNAL

REVENUE,

Respondent-Appellant.



Appeals from the United States Tax Court.

(Tax Ct. Nos. 5199-09; 5200-09; 5202-09; 5201-09)

Argued: March 22, 2012

Decided: May 31, 2012

Before NIEMEYER, DAVIS, and WYNN, Circuit Judges.

Affirmed by published opinion. Judge Davis wrote the opin-

ion, in which Judge Niemeyer joined. Judge Wynn wrote a

dissenting opinion.

COUNSEL

ARGUED: Francesca Ugolini Tamami, UNITED STATES

DEPARTMENT OF JUSTICE, Washington, D.C., for Appel-

lant. Robert Leon Widener, MCNAIR LAW FIRM, PA,

Columbia, South Carolina, for Appellees. ON BRIEF:

Tamara W. Ashford, Deputy Assistant Attorney General, Gil-

bert S. Rothenberg, Kenneth L. Greene, UNITED STATES

DEPARTMENT OF JUSTICE, Washington, D.C., for Appel-

lant.

STARNES v. CIR 3

OPINION

DAVIS, Circuit Judge:

In Commissioner v. Stern, 357 U.S. 39 (1958), the Supreme

Court held that if a person is the "transferee" of a taxpayer’s

assets, the "existence and extent" of that transferee’s liability

for unpaid taxes the taxpayer owed prior to the transfer is

determined by state law, not federal law. Id. at 45. This case

requires that we apply Stern to a transaction the Commis-

sioner of Internal Revenue characterizes as an "intermediary

transaction tax shelter."

Albert J. Starnes, Ronald D. Morelli, Sr., Anthony S.

Naples and Sallie C. Stroupe (collectively, the "Former Share-

holders") worked at Tarcon, Inc., a trucking company, for

over forty years, and together purchased the company in

1972, each holding a 25 percent stake. In 2003, they decided

to sell their interests and retire. After consulting with their

real estate broker, accountant and attorneys, they sold Tar-

con’s only remaining asset (a warehouse) to one company,

ProLogis, Inc., and sold their Tarcon stock to another com-

pany, MidCoast Investments, Inc. (together with its affiliates

MidCoast Credit Corp. and MidCoast Acquisitions Corp.,

hereinafter "MidCoast"). MidCoast contractually agreed that

it would operate Tarcon as a going concern and cause Tarcon

to pay the approximately $880,000 in federal and state corpo-

rate income taxes Tarcon owed on the income the company

received from selling the warehouse. Having become the sole

stockholder of Tarcon, however, within a few weeks Mid-

Coast sold Tarcon to another company, which transferred Tar-

con’s cash to an offshore account. Tarcon’s 2003 tax returns

claimed certain losses that purported to offset entirely the tax

liability it incurred on the income from the sale of the ware-

house. When the Internal Revenue Service ("IRS" or "the

Commissioner") audited the federal return, it disallowed those

losses and thereby imposed the tax liability, but Tarcon never

paid the taxes.

4 STARNES v. CIR

Unable to secure payment from Tarcon, the IRS turned its

efforts toward the Former Shareholders, asserting they were

themselves liable, as transferees, for Tarcon’s unpaid taxes.

Starnes, Morelli, Naples and the Estate of Sallie C. Stroupe

filed petitions in the Tax Court contesting the Commissioner’s

notices of transferee liability. After a bench trial, the Tax

Court ruled in favor of the Former Shareholders.1 Applying

Stern, the Tax Court held that the Commissioner could only

collect from the Former Shareholders if, under North Carolina

law, a Tarcon creditor could recover payments of Tarcon’s

debts from the Former Shareholders. And applying North

Carolina law to the evidence presented at trial, the court held

that the Commissioner had not made the requisite showing.

On appeal, the Commissioner argues the Tax Court (1) com-

mitted legal error in its interpretation of federal law and its

application of state law and (2) clearly erred in making certain

factual findings.

Having carefully considered the parties’ arguments in light

of the record before us in this appeal, we conclude that the

Commissioner’s contentions lack merit. The Tax Court prop-

erly identified and applied the controlling legal framework as

set forth in Stern and it did not commit clear error in its fac-

tual findings. Therefore, we affirm the judgment in favor of

the Former Shareholders.

I.

A.

Starnes, Morelli, Naples and Stroupe began working at Tar-

con, a freight consolidation company, in the 1950s and 1960s.

Each rose through the ranks and, acting jointly, they pur-

chased Tarcon in 1972. They operated Tarcon for decades,

1

Although the Estate of Stroupe was the party in the Tax Court and is

the party on appeal, for consistency we refer to Stroupe or her Estate,

together with Starnes, Morelli and Naples, as the "Former Shareholders."

STARNES v. CIR 5

but business dropped off in the 1980s when the trucking

industry was deregulated. By 2003, Tarcon had ceased busi-

ness operations, and its sole remaining non-cash asset was a

large industrial warehouse in Charlotte, North Carolina,

which it leased to others, generating income.2 In 2003, the

Former Shareholders decided to retire and liquidate their

interests in Tarcon. Their goal was to maximize their after-tax

proceeds and minimize the expenses involved in any transac-

tions.

The Former Shareholders (who were also officers of Tar-

con) considered various options. One option was to sell the

warehouse, wind up the business, and distribute the resulting

cash assets to the shareholders. Another option was to main-

tain Tarcon as a going concern and sell their Tarcon stock.

Yet another option was a combined asset/stock sale, in which

Tarcon would sell the warehouse and then the Former Share-

holders would sell their stock in Tarcon (the sole asset of

which by then would be cash). They hired an independent

broker, Brad Cherry, a commercial real estate broker with

Keystone Partners, L.L.C., to act as an agent and adviser in

connection with leasing and/or selling the warehouse or sell-

ing Tarcon stock.

Cherry began marketing Tarcon’s assets and/or its stock in

light of the various options. Cherry received letters from sev-

eral parties expressing interest in purchasing the warehouse.

One of these letters was from ProLogis, a Maryland real

estate investment trust, which in April 2003 offered to pur-

chase the warehouse for $3,025,000.

By that time, the Former Shareholders had also received

(via Cherry) a letter of intent from MidCoast, which

2

Until 2003 Tarcon also owned four vehicles and a condominium in

Garden City, South Carolina. In 2003, the South Carolina property was

sold for $190,752 and the vehicles were sold to the Tarcon shareholders.

The proceeds of these sales were deposited in Tarcon’s bank account.

6 STARNES v. CIR

expressed interest in buying Tarcon’s stock from the Former

Shareholders. MidCoast’s letter, dated May 21, 2003, stated:

MidCoast is interested in purchasing the stock of

certain C-corporations that have sold business assets

and/or real estate. In instances where a C-corporation

has sold assets for a gain, MidCoast may have an

interest in purchasing 100% of the stock from the

shareholders for a price greater than the net value of

the corporation.

MidCoast pursues these acquisitions as an effective

way to grow our parent company’s core asset recov-

ery operations. It is important to note that after we

complete a stock acquisition, the target company is

not dissolved or consolidated, but is reengineered

into the asset recovery business and becomes an

income producer for us going forward.

J.A. 104. MidCoast also provided a brochure describing the

benefits to the Former Shareholders and Tarcon of undertak-

ing a joint asset/stock sale. The brochure stated its proposal

would "maximize [the Former Shareholders’] net after-tax

proceeds," "maximize( ) sale of all assets (i.e., written-off

receivables, etc.)," and "[r]educ[e] exposure to future claims,

losses, and litigation." J.A. 111. MidCoast’s materials also

represented that Tarcon would not be "dissolved, liquidated,

or merged into another Company." Id. Rather, MidCoast

would "put( ) Company into asset recovery business and oper-

ate( ) Company on a go-forward basis." Id. Furthermore, Mid-

Coast would "cause( ) the Company to satisfy its tax and other

liabilities." Id.

On June 30, 2003, two MidCoast representatives met with

Cherry and the Former Shareholders, together with their

accountant and attorney, in North Carolina. By that time,

ProLogis had submitted a revised letter of intent, and Mid-

Coast knew that Tarcon was negotiating with ProLogis for the

STARNES v. CIR 7

sale of the warehouse. Thus it was understood at the June 30

meeting that when MidCoast purchased the stock, Tarcon’s

only asset would be cash. At the meeting, the MidCoast repre-

sentatives reiterated that if the Former Shareholders were to

go forward with the proposed transaction, MidCoast would

replace the Former Shareholders as owners of the company,

Tarcon would continue to operate under MidCoast’s owner-

ship, and the 2003 Tarcon tax liabilities would be satisfied.

Every witness who knew the details of the stock sale, includ-

ing the attorney for MidCoast, testified that they had no rea-

son to believe MidCoast would not honor these commitments.

MidCoast also explained that it had undertaken a number of

transactions of this type.

As for the tax benefits, MidCoast supplied a chart that com-

pared the after-tax consequences to the Former Shareholders

of a liquidation of Tarcon versus a stock sale. With a liquida-

tion, the Former Shareholders would effectively be taxed

twice: once on the net taxable corporate gain generated from

selling the warehouse and again on the income generated

from the distribution of Tarcon’s cash to the Former Share-

holders. With a stock sale, they would only be taxed once, on

their capital gains; the corporate income taxes would be the

responsibility of Tarcon’s new owner, i.e., MidCoast.

The Former Shareholders testified they did not understand

what was meant by the "asset recovery business" or what

MidCoast planned to do with Tarcon, but they made no inqui-

ries. J.A. 707, 759-61, 823-24. Naples thought "it did sound

strange," but he believed that MidCoast bought "bad debts" to

"use . . . as a write-off against the companies they buy that

have money." J.A. 759. Starnes testified that "[i]t wasn’t

something I wanted to understand. Once they bought my

stock, they could do what they wanted with Tarcon." J.A. 824.

At one point, Tarcon’s accountant, Jerome Epping, who also

was the Former Shareholders’ accountant and who had

attended the meeting with MidCoast, made a notation on an

untitled and undated MidCoast worksheet questioning,

8 STARNES v. CIR

"‘2001-16’ reportable?," J.A. 603, referring to I.R.S. Notice

2001-16, which describes certain "intermediary transactions

tax shelters," transactions that in certain ways are similar to

the transactions at issue here.3 The Commissioner, however,

3

In Notice 2001-16, the IRS announced that it "may challenge the pur-

ported tax results" of certain transactions it considered that type of tax

shelter. I.R.S. Notice 2001-16, 2001-1 C.B. 730 (Feb. 26, 2001). The

transactions involved, among other things, the sale of a corporation’s stock

to one corporation (an "intermediary corporation") and sale of its assets to

a different person or entity. The primary purpose of the Commissioner’s

efforts is to ensure he collects taxes due on long-term gains on the assets.

In full, the pertinent part of the Notice explains:

These transactions generally involve four parties: seller (X)

who desires to sell stock of a corporation (T), an intermediary

corporation (M), and buyer (Y) who desires to purchase the

assets (and not the stock) of T. Pursuant to a plan, the parties

undertake the following steps. X purports to sell the stock of T

to M. T then purports to sell some or all of its assets to Y. Y

claims a basis in the T assets equal to Y’s purchase price. Under

one version of this transaction, T is included as a member of the

affiliated group that includes M, which files a consolidated

return, and the group reports losses (or credits) to offset the gain

(or tax) resulting from T’s sale of assets. In another form of the

transaction, M may be an entity that is not subject to tax, and M

liquidates T (in a transaction that is not covered by § 337(b)(2)

of the Internal Revenue Code or § 1.337(d)–4) of the Income Tax

Regulations, resulting in no reported gain on M’s sale of T’s

assets.

Depending on the facts of the particular case, the Service may

challenge the purported tax results of these transactions on sev-

eral grounds, including but not limited to one of the following:

(1) M is an agent for X, and consequently for tax purposes T has

sold assets while T is still owned by X, (2) M is an agent for Y,

and consequently for tax purposes Y has purchased the stock of

T from X, or (3) the transaction is otherwise properly recharacter-

ized (e.g., to treat X as having sold assets or to treat T as having

sold assets while T is still owned by X). Alternatively, the Ser-

vice may examine M’s consolidated group to determine whether

it may properly offset losses (or credits) against the gain (or tax)

from the sale of assets.

STARNES v. CIR 9

did not present evidence of what the MidCoast worksheet

entailed, why Epping made the notation, or whether he com-

municated with the Former Shareholders regarding potential

concerns about transferee liability.

B.

Having reviewed MidCoast’s proposal, the Former Share-

holders decided to accept it: Tarcon would sell the warehouse

to ProLogis, and the Former Shareholders would sell their

Tarcon stock to MidCoast. On July 30, 2003, ProLogis agreed

to buy the Granite Street property for $3.18 million. The sale

closed on October 30, 2003, and Tarcon received net proceeds

of $2,567,901.83.

Meanwhile, Morelli had been negotiating with MidCoast

for the purchase of the Tarcon stock. MidCoast proposed pur-

chasing the stock for an amount equal to Tarcon’s cash less

a percentage of Tarcon’s estimated federal and state tax liabil-

ity for 2003. The negotiations focused on that percentage,

referring to the excess of the purchase price over the net value

of Tarcon as the "asset recovery premium." J.A. 711-12, 150.

The parties retained prominent law firms to represent them in

the stock sale. MidCoast engaged the law firm of Womble,

Carlyle, Sandridge & Rice ("Womble Carlyle"), and the For-

mer Shareholders engaged Moore & Van Allen, as counsel.

On July 16, 2003, on behalf of Tarcon, Morelli executed a let-

ter of intent to sell the Tarcon stock to MidCoast. The parties

agreed MidCoast would buy all of Tarcon’s stock for an

Id. In 2008 the Commissioner issued another notice to "clarif[y]" Notice

2001-16. See I.R.S. Notice 2008-111, 2008-51 I.R.B. 1299 (Dec. 2, 2008).

Among other things, Notice 2008-111 explained that a transaction "is

treated as an Intermediary Transaction with respect to a particular person"

only if that person "knows or has reason to know the transaction is struc-

tured" in a way such that "the person or persons primarily liable for any

Federal income tax obligation with respect to the disposition of the Built-

in Gain Assets will not pay that tax." Id.

10 STARNES v. CIR

amount equal to Tarcon’s cash less 56.25 percent of Tarcon’s

local, state, and federal corporate income taxes for 2003. Mid-

Coast also agreed to reimburse the Former Shareholders and

Tarcon for legal and accounting fees, up to $25,000.

As of October 31, 2003, after the warehouse was sold, Tar-

con had approximately $3.1 million in cash and no other tan-

gible assets. The sale resulted in a corporate income tax

liability of approximately $880,000, in a pro forma calcula-

tion by Tarcon’s then accountant.4 Thus, as of October 31,

Tarcon’s total assets were $3.1 million and its total liabilities

were $880,000, resulting in a net worth of approximately $2.2

million.

As mentioned, the principal subject of negotiation had been

how much of Tarcon’s $880,000 tax liability MidCoast would

deduct from the value of Tarcon’s $3.1 million in cash to

determine the amount it was willing to pay for the Tarcon

stock. After the warehouse sale closed, the parties reached an

agreement: MidCoast would pay the Former Shareholders

approximately $2.6 million for their stock. This figure meant

the Former Shareholders would contribute 56.25 percent of

Tarcon’s presumed 2003 tax liability, and MidCoast would

cover the remainder. The stock sale closed on November 13,

2003. In the final Share Purchase Agreement, MidCoast reit-

erated a number of the commitments it had been making all

along, including that it would "file all Federal and state

income tax returns related to the [$881,627.74] Deferred Tax

Liability on a timely basis." J.A. 247.

After executing the Agreement, the Former Shareholders

resigned as officers of Tarcon and gave their original Tarcon

share certificates to their attorney at Moore & Van Allen. Tar-

con’s $3.1 million in cash was transferred to an escrow

4

Tarcon’s total gain on the warehouse, which it had bought in January

1978, was $2,366,915. This long-term gain resulted in an expected 2003

tax liability of $881,627.74.

STARNES v. CIR 11

account of Moore & Van Allen, and MidCoast’s $2.6 million

purchase money was transferred to its attorneys’ escrow

account.5 The Former Shareholders’ attorney at Moore & Van

Allen then hand delivered the Tarcon share certificates and

other original closing documents to Womble Carlyle’s office

and transferred Tarcon’s cash into Womble Carlyle’s escrow

account. From that account, which temporarily held both Tar-

con’s and MidCoast’s money, $649,034 was transferred to

each of the Former Shareholders (which they later reported as

income on their 2003 individual tax returns), and $25,000 was

transferred to Moore & Van Allen as reimbursement for its

services.

According to the Agreement, Tarcon’s $3.1 million was

supposed to be transferred into Tarcon’s "post-closing" bank

account. In fact, the cash took a detour. The closing attorney

at Womble Carlyle, rather than transferring the money to Tar-

con’s post-closing account, transferred the funds from the

Womble Carlyle trust account to the "MidCoast Credit Corp.

Operating Account." The record does not disclose how or

why this apparent mistake was made. In any event, the error

was remedied the next day, when the $3.1 million was wired

from the MidCoast operating account to a new Tarcon

account at SunTrust Bank.

C.

If all had gone as the Former Shareholders testified they

thought it would, MidCoast would have continued operating

Tarcon and in 2004 paid Tarcon’s 2003 taxes. That is not

what happened. Instead, on November 24, 2003, eleven days

after the November 13 closing, MidCoast sold its Tarcon

stock to Sequoia Capital, L.L.C., a Bermuda company, for

$2,861,465.96. Two days later, all of the funds in Tarcon’s

5

As the Tax Court aptly put it: "Thus, there was an infusion of cash into

the transaction, not a circular flow of cash." 101 T.C.M. (CCH) 1283,

2011 WL 894608, at *8.

12 STARNES v. CIR

SunTrust account were transferred to an account with Deut-

sche Bank AG, though still under Tarcon’s name. Then, on

December 1, 2003, $2,960,000 was transferred from the Deut-

sche Bank account to an account in the Cook Islands in the

name of "Delta Trading Partners," and $126,822 was trans-

ferred to a MidCoast bank account. After December 1, 2003,

Tarcon never had more than $132,320 in any account.

Tarcon filed its 2003 federal tax return in July 2004, report-

ing capital gains of $1,009,483 and ordinary income of

$1,557,315, principally from the sale of the warehouse and

the related grounds. Tarcon also reported, however, two large

losses. First, it reported a short-term capital loss of

$1,010,000 resulting from a purported December 2003 inter-

est rate swap option. Second, it reported an ordinary loss of

$1,950,000 resulting from a transaction involving an asset

denominated "DKK/USD BINA," which was purportedly

acquired on December 29, 2003, and purportedly sold on

December 31, 2003. Id. Consequently, the 2003 return stated

Tarcon’s only asset was $132,320 in cash. Thus, the return

reported an overall loss and no tax due. In 2005, Tarcon filed

its 2004 federal tax return, marked as its final return, reporting

no tax due and no assets.

D.

In 2005, in the midst of a "promoter penalty examination"

of MidCoast, the IRS audited Tarcon’s 2003 tax return. The

IRS disallowed the claimed deductions for the short-term cap-

ital loss of $1,010,000 and the ordinary loss of $1,950,000.

The IRS sent a notice of deficiency dated April 11, 2007, to

Tarcon, in which it explained:

You have failed to prove that the disposition of the

inflated basis assets generated a bona fide loss. In

addition, it is determined that the inflated basis

assets transaction lacked economic substance.

Accordingly, taxable income is increased

STARNES v. CIR 13

$2,959,483.00 for taxable year ending December 31,

2003.

J.A. 537. Having disallowed the claimed losses, the IRS

determined that Tarcon owed an income tax deficiency for

2003 of $855,237. The IRS also imposed an accuracy-related

penalty of $342,094.

Tarcon did not seek a redetermination of the asserted defi-

ciency in the Tax Court, and so an assessment of tax, penalty

and interest totaling $1,495,641 was made on September 17,

2007. Tarcon did not pay any portion of the deficiency, pen-

alty or interest for the underlying 2003 assessment. Nor was

the IRS able to satisfy the tax liability from tax liens it filed

in North Carolina and Nevada.

In December 2008, the IRS sent notices of transferee liabil-

ity to each of the Former Shareholders. The notices identified

the amount each Former Shareholder received when he or she

sold Tarcon shares to MidCoast, and stated that, as transfer-

ees, they were liable for Tarcon’s tax liability up to the

amount each received for those shares (not including applica-

ble interest). An attached notice of liability statement advised

that the IRS did not recognize the "purported stock sale" to

MidCoast. J.A. 20. "[T]he stock sale and the transactions

involving the sale of Tarcon, Inc.’s assets to ProLogis," the

notice continued, "are determined to be, in substance, a sale

of the assets of Tarcon, Inc., followed by a distribution by

Tarcon, Inc. of its proceeds to its shareholders." Id. The

attachment further explained that the transaction is "substan-

tially similar to an Intermediary transaction shelter described

in Notice 2001–16, 2001–1 C.B. 730," or, alternatively, the

transaction is in substance a sale of the Tarcon assets to

ProLogis followed by a redemption of Tarcon stock owned by

the Tarcon shareholders. Id.

The Former Shareholders filed petitions in the United

States Tax Court contesting the notices of transferee liability.

14 STARNES v. CIR

As discussed in detail below, the Tax Court ruled in favor of

the Former Shareholders, finding the IRS had failed to carry

its burden of proving the Former Shareholders were liable as

transferees for Tarcon’s 2003 taxes. Starnes v. Commissioner,

101 T.C.M. (CCH) 1283, 2011 WL 894608 (2011). The Com-

missioner timely appealed.

II.

We review decisions of the United States Tax Court "on the

same basis as decisions in civil bench trials in United States

district courts." Waterman v. Comm’r, 179 F.3d 123, 126 (4th

Cir. 1999). Questions of law are reviewed de novo, and find-

ings of fact for clear error. Id. The Commissioner challenges

both the Tax Court’s legal conclusions and its findings of fact.

We begin by explicating the legal framework applicable in

cases of this sort. We then explain why we discern no error

in the lower court’s application of the controlling legal princi-

ples. Finally, we examine the evidence and explain why we

are not persuaded by the Commissioner’s contention that the

lower court committed clear error in its factual findings.

A.

Until 1926, if the government was unable to collect taxes

from a particular taxpayer and believed the taxpayer’s assets

had been transferred to someone else, the government could

only proceed against the "transferee" of those assets by bring-

ing a bill in equity or an action at law. See Stern, 357 U.S. at

43. These procedures "proved unduly cumbersome, however,

in comparison with the summary administrative remedy

allowed against the taxpayer himself." Id. Thus, in 1926 Con-

gress authorized the Commissioner to collect taxes from

transferees of a taxpayer’s assets "by the procedure provided

in the [Internal Revenue Code] for the enforcement of tax

deficiencies." Id. (quoting S. Rep. No. 52, 69th Cong., 1st

Sess. 30). It enacted the predecessor of 26 U.S.C. § 6901(a),

STARNES v. CIR 15

which today in pertinent part (only non-substantive revisions

having been made since 1926) reads as follows:

Method of collection.—The amounts of the follow-

ing liabilities shall, except as hereinafter in this sec-

tion provided, 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:

(1) Income, estate, and gift taxes.—

(A) Transferees.—The liability, at law or

in equity, of a transferee of property—

(i) of a taxpayer in the case of a tax

imposed by subtitle A (relating to

income taxes) . . .

26 U.S.C. § 6901(a) (emphasis added). 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 corpo-

ration, . . . the successor of a corporation, . . . and all other

classes of distributees." 26 C.F.R. § 301.6901-1(b).

In Stern, the government sought to collect from a widow

whose husband had died deficient in his payment of income

taxes. 357 U.S. at 40. The husband had held a life insurance

policy from which he could draw down cash during his life,

and which named his wife as the beneficiary. Id. at 41. The

question was whether the widow’s "substantive liability" for

her deceased husband’s tax deficiency was to be determined

"by state or federal law." Id. at 42. After closely examining

§ 6901’s legislative history, the Court concluded Congress

intended § 6901 to be "purely a procedural statute." Id. at 44.

To determine a transferee’s "substantive liability," the Court

concluded it must look to sources other than § 6901. No other

16 STARNES v. CIR

federal statute having defined transferees’ substantive liabil-

ity, the Court was required to choose between "federal deci-

sional law and state law." Id. Citing Erie Railroad Company

v. Tompkins, 304 U.S. 64 (1938), the Court concluded,

"[U]ntil Congress speaks to the contrary, the existence and

extent of liability should be determined by state law," specifi-

cally the law of the state where a particular transfer was made.

357 U.S. at 45.

The Commissioner had argued federal common law should

apply to a transferee’s substantive liability, in part because

"the varying definitions of liability under state statutes

resulted in an absence of uniformity of liability." Id. The

Court did not find this argument based on absence of unifor-

mity persuasive. Congress knew courts had been applying

state law "developed for the protection of private creditors" to

determine transferees’ liability for a transferor’s federal taxes.

Id. at 44-45. Yet Congress, "with knowledge that this was

‘existing law’[,] . . . refrained from disturbing the prevailing

practice." Id. The Court explained:

Uniformity is not always the federal policy. Under

§ 70 of the Bankruptcy Act, for instance, state law is

applied to determine what property of the bankrupt

has been transferred in fraud of creditors. What is a

good transfer in one jurisdiction might not be so in

another. . . . Since Congress has not manifested a

desire for uniformity of liability, we think that the

creation of a federal decisional law would be inap-

propriate in these cases.

Id. at 45 (citations omitted). "Congress has not seen fit to

define that liability," and so "none exists except such as it is

imposed by state law." Id. at 47. In Stern, "Kentucky law

impose[d] no liability against [Stern] in favor of [her hus-

band’s] other creditors," and therefore she was not liable for

her deceased husband’s unpaid taxes. Id.

STARNES v. CIR 17

Thus, Stern stands for the proposition that § 6901 "neither

creates nor defines a substantive liability but provides merely

a new procedure by which the Government may collect

taxes." Id. at 42. As the Tax Court in this case properly articu-

lated, § 6901 "provides a procedure through which the IRS

may collect unpaid taxes owed by the transferor of the assets

from a transferee if an independent basis exists under applica-

ble State law or State equity principles for holding the trans-

feree liable for the transferor’s debts." Starnes, 2011 WL

894608, at *6. "[T]he Government’s substantive rights against

the transferee are precisely those which other defrauded credi-

tors would have under the law of the state in which the trans-

fers were made." John Ownbey Co. v. Commissioner, 645

F.2d 540, 543 (6th Cir. 1981) (internal parentheses and quota-

tion marks omitted).

Notably for our purposes, Stern also teaches another lesson:

whether there has been a "transfer" within the meaning of

§ 6901 (and concomitantly whether a person is a "transferee"

within the meaning of the statute)—a question undisputedly

of federal law—is a separate question from whether the

alleged transferee is substantively liable for a transferor’s

unpaid taxes. In Stern, the Court assumed without deciding

that Stern was "a transferee within the meaning of [§ 6901]."

Stern, 357 U.S. at 41-42. Having avoided deciding that proce-

dural question, it held the Commissioner could not prevail

because "Kentucky statutes govern the question of the benefi-

ciary’s liability," and under Kentucky law Stern was not liable

to her deceased husband’s creditors. Id. at 42.

Thus, to collect taxes from an alleged transferee, the Com-

missioner must prevail on each of these independent require-

ments, one procedural and governed by federal law, the other

substantive and governed by state law. The burden of proof

on each is on the Commissioner. 26 U.S.C. § 6902(a) ("In

proceedings before the Tax Court the burden of proof shall be

18 STARNES v. CIR

upon the Secretary to show that a petitioner is liable as a

transferee of property of a taxpayer . . .").6

B.

In the instant case, the Commissioner seeks to collect from

the Former Shareholders the taxes Tarcon owed for 2003 and

did not pay. As for the availability of the § 6901 collection

procedure, he asserts the economic "reality" is that the

November 13-14, 2003, transactions resulted in the transfer of

Tarcon’s cash to the Former Shareholders, and thus they are

distributees of Tarcon’s assets. On the substantive prong of

the analysis, the Commissioner argues four provisions of

North Carolina law would each render the Former Sharehold-

ers liable to Tarcon’s creditors for debts incurred by Tarcon

prior to the sale of Tarcon stock to MidCoast (and thereby

render them actually liable for Tarcon’s unpaid 2003 taxes):

three provisions of the North Carolina Uniform Fraudulent

Transfer Act ("NCUFTA"), and the common-law doctrine of

corporate trust fund liability.

In the proceedings below, the Tax Court, following the

Supreme Court’s lead in Stern, assumed the Commissioner

had proven the Former Shareholders were transferees within

the meaning of § 6901, and therefore could invoke the admin-

istrative procedure provided by that section. After resolving

that issue in the Commissioner’s favor, the Tax Court pro-

ceeded to determine whether the Commissioner had satisfied

his burden to prove the Former Shareholders’ substantive lia-

bility, i.e., whether "an independent basis exists under appli-

cable State law or State equity principles for holding the

6

While the Commissioner does not have the burden to show "that the

taxpayer [Tarcon] was liable for the tax," 26 U.S.C. § 6902(a), that is irrel-

evant here because whether Tarcon was liable for the approximately

$881,000 in corporate income taxes in 2003 is not disputed. The disputed

issues are whether the Shareholders are transferees under § 6901 and

whether they are liable to Tarcon’s creditors under North Carolina law.

STARNES v. CIR 19

transferee liable for the transferor’s debts." Starnes, 101

T.C.M. (CCH) 1283, 2011 WL 894608, at *6. The Tax Court,

after a bench trial and making factual findings, rejected each

of the proffered bases for substantive liability in a 33-page

memorandum opinion.

As mentioned, on appeal the Commissioner argues the Tax

Court applied incorrect legal principles and committed clear

error in making several of its factual findings. We address

each of the Commissioner’s arguments in turn.

C.

The Commissioner first argues, and our good colleague

agrees in his dissenting opinion, the Tax Court committed

legal error by treating the question of the Former Sharehold-

ers’ substantive liability under state law as independent of

whether, under § 6901, they are "transferees." The Commis-

sioner reads § 6901 as requiring a two-step analysis with the

second step wholly dependent on the first step. First, the

Commissioner and the dissent argue, courts should determine

whether a person or entity is a "transferee" under federal law,

that is, whether a particular set of transactions should be re-

cast under the "substance-over-form" doctrine derived from

federal tax cases. Second, the Commissioner and the dissent

argue, courts should apply state law to the transactions as

recast under federal law. In other words, they argue, the

"facts" to which we apply state law, such as state fraudulent

conveyance statutes, depend in part on whether someone is a

"transferee" for § 6901 purposes; therefore, the first step is a

"threshold question," one courts must resolve before deciding

whether a person or entity is substantively liable under state

law. See, e.g., Appellant’s Br. at 34 ("The Tax Court, how-

ever, never directly addressed whether the Shareholders were

transferees. This was legal error.").

Stern forecloses that argument. In Stern, as noted, the Court

addressed whether a person’s "substantive liability" was

20 STARNES v. CIR

determined by state or federal law. 357 U.S. at 42. On that

question, it concluded state law applied. In reaching that con-

clusion, it assumed without deciding that Stern was "a trans-

feree within the meaning of [§ 6901]." Id. at 41-42. If Stern’s

liability under state law had somehow depended on whether

she was a transferee under federal law, the Court could not

have found it "unnecessary to decide whether [she] was a

transferee within the meaning of [§ 6901]." Id. The Court did

find it unnecessary to decide that question, however, and thus

it did not undertake to make a threshold determination of

whether there was a "transfer" that informed the application

of state law to the facts. Moreover, the Court explicitly con-

sidered § 6901 "purely a procedural statute," and the "exis-

tence and extent" of an alleged transferee’s substantive

liability to be determined purely as a matter of state law.

Stern, 357 U.S. at 44-45.

Furthermore, while the dissent argues Stern is distinguish-

able, the supposedly distinguishing factors it relies upon are

immaterial. In Stern, the state-law basis for the alleged trans-

feree’s substantive liability required evidence that the dece-

dent paid his life insurance premiums "with intent to defraud

his creditors"; if he had, then the disbursement of the policy

to his widow would be considered fraudulent with respect to

his creditors, at least to the extent of the "premiums paid in

fraud of [those] creditors." 357 U.S. at 46 n.4 (citing Ky. Rev.

Stat. Ann. § 297.140 (1948)). Here, unlike in Stern, one ele-

ment of each of the state-law bases for liability is that there

was a "transfer." Also unlike in Stern, there are multiple trans-

fers we must decide whether to "collapse" to determine

whether they were fraudulent (i.e., we must determine "which

transaction is under review," Dissenting Op. at 43). In light of

these distinctions, the dissent argues, Stern does not apply

here, and, unconstrained by Stern, we should apply federal

law rather than state law to decide which if any transfers to

collapse.

Stern, however, did not turn on whether there is overlap

between the factual determinations required by the federal-

STARNES v. CIR 21

law and state-law prongs of the analysis. Rather, the Court

treated those two questions as entirely independent; whether

there was a "transfer" of assets from the decedent to Stern (for

§ 6901 purposes) was irrelevant to whether that transfer was

fraudulent (for state law purposes). We are unpersuaded that

Stern’s instruction that state law governs substantive liability

is inapplicable where one element of the relevant state law is

that there was a "transfer." Similarly, as we explain in greater

detail below, we believe the question of which if any of the

multiple transactions should be "collapsed" to determine

whether they were fraudulent is a question of substantive lia-

bility, not merely a question of the availability of the § 6901

procedure, and thus is governed by state law.

In short, we conclude Stern forecloses the Commissioner’s

efforts to recast transactions under federal law before apply-

ing state law to a particular set of transactions. 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. In terms of

"the existence and extent of liability," Stern places the IRS in

precisely the same position as that of ordinary creditors under

state law. 357 U.S. at 45; see also Sellers v. Comm’r, 592

F.2d 227, 229 (4th Cir. 1979) (affirming Tax Court judgment

against transferee because (1) the taxpayer’s profits "found

their way into petitioner’s possession" and (2) the transfer was

void under Virginia law because Sellers received the proceeds

without paying consideration and intended to hinder and delay

creditors); C.D. Constr. Corp. v. Comm’r, 451 F.2d 470, 471-

72 (4th Cir. 1971) (affirming Tax Court judgment against

alleged transferee because (1) "in substance" it had received

a corporate distribution from the taxpayer and (2) no consid-

eration was given, and so the distribution was void under

West Virginia law).

In this case, because the two questions are independent, and

because the Commissioner has failed to prove the Former

Shareholders are liable under state law (as explained within),

22 STARNES v. CIR

we need not and do not decide whether they are the "transfer-

ees" of Tarcon’s cash within the meaning of § 6901. The

Commissioner’s position that the "substance-over-form" doc-

trine developed in federal tax cases governs the latter ques-

tion, that the doctrine disregards the parties’ actual or

constructive knowledge (or lack thereof), and that in sub-

stance the Former Shareholders received a distribution of Tar-

con’s cash (with MidCoast receiving a "fee"), may well be a

correct framing of the issues related to the § 6901 "transferee"

question.7 But because the Commissioner’s efforts fail on the

state-law front, we proceed directly to explain why the Tax

Court did not commit legal error or clear factual error in con-

cluding the Former Shareholders are not liable under North

Carolina law.

D.

We turn now to the state-law bases for the Former Share-

holders’ alleged substantive liability. The first three arise

under North Carolina’s version of the Uniform Fraudulent

Transfer Act, the NCUFTA. The fourth arises under North

Carolina common law.

1.

We begin with the first of the three NCUFTA provisions

7

Or it may be incorrect. In one of the other transferee liability cases

recently decided by the Tax Court, the court rejected the Commissioner’s

efforts to recast certain transactions using the substance-over-form doc-

trine precisely because the original shareholders of the corporation being

sold "had no reason to believe that [the stock purchaser’s] methods were

illegal or inappropriate" and thus "did not have a duty to inquire further

and are not responsible for any tax strategies [an affiliate of the stock pur-

chaser] used after the closing of the stock sale." Slone v. Comm’r, 103

T.C.M. (CCH) 1265, 2012 WL 691401, *10 (2012). We need not and do

not decide the extent to which, if any, a person or entity’s constructive

knowledge is relevant to the application of the federal substance-over-

form doctrine in this context.

STARNES v. CIR 23

relied on by the Commissioner: N.C. Gen. Stat. § 39-23.5.

That subsection provides in pertinent part that a "transfer"

made by a debtor "is fraudulent as to a creditor whose claim

arose before the transfer was made," if the debtor (1) made

the transfer "without receiving a reasonably equivalent value

in exchange," and (2) "was insolvent at that time" or "became

insolvent as a result of the transfer." Id.

This is where the Commissioner and dissent argue the

"transferee" determination under federal law informs the

determination of liability under state law. The argument is as

follows: Under the substance-over-form doctrine developed in

federal tax cases, the Former Shareholders received a "trans-

fer" of Tarcon’s cash. The fact that a "transfer" occurred for

§ 6901 purposes means a "transfer" occurred for NCUFTA

purposes. As the "creditor[s]" in that "transfer," the Former

Shareholders were required to give Tarcon "a reasonably

equivalent value in exchange," lest Tarcon become "insolvent

as a result of the transfer." N.C. Gen. Stat. § 39-23.5. The For-

mer Shareholders did not give Tarcon "reasonably equivalent

value" in exchange for its cash, says the Commissioner,

because as of December 1, 2003, Tarcon was left with just

$132,000; therefore, the Commissioner argues, the "transfer"

was "fraudulent" as to the Former Shareholders, and the For-

mer Shareholders are liable for the tax liability Tarcon

incurred prior to the transfer.

This argument has some facial appeal. After all, should not

a "transfer" under federal law be a "transfer" under state law?

The answer, however, is "not necessarily"—because Stern

tells us so. In Stern, as explained above, the Court assumed

without deciding that the taxpayer’s widow was a "trans-

feree." After deciding that state law governed her substantive

liability for her deceased husband’s unpaid taxes, the Court

turned to Kentucky law. Under Kentucky law, a defrauded

creditor could only recover from a transferee in the widow’s

position if the insured had paid life insurance premiums "in

fraud of creditors." 357 U.S. at 46. There was no evidence of

24 STARNES v. CIR

fraud, whether actual or constructive. Therefore, the Court

held, the widow was not liable for her deceased husband’s

taxes, even assuming she was a "transferee" for § 6901 pur-

poses.

Here, the Commissioner argues the Former Shareholders

are substantively liable for Tarcon’s unpaid taxes because

there was a "transfer" of Tarcon’s (all cash) assets to the For-

mer Shareholders, and the transfer was fraudulent under

North Carolina law. In Stern, the Supreme Court treated the

alleged transferee’s substantive liability as purely a question

of state law. We must do the same here. As we suggest above,

it may well be that the series of transfers on November 13-14

and December 1, 2003, in the aggregate, constitute a "trans-

fer" for § 6901 purposes. But we need not and do not decide

that question because, as explained infra, they do not consti-

tute a single "transfer" for NCUFTA purposes.8

8

The Commissioner places heavy reliance on Lowndes v. United States,

384 F.2d 635 (4th Cir. 1967), and Owens v. Commissioner, 568 F.2d 1233

(6th Cir. 1977), in support of his argument that federal law rather than

state law governs whether to collapse the November 13-14 and December

1, 2003, transactions. Lowndes is unavailing, however, because it did not

involve transferee liability pursuant to § 6901. In that case, a taxpayer had

purchased all of the outstanding stock of four corporations, which were

liquidated six months later. 384 F.2d at 636. The question was whether the

taxpayer (1) received ordinary income at the time of the purchase, or (2)

received income, taxable either as long term capital gain or as ordinary

income, at the time of liquidation. Id. There was no question of transferee

liability, and so Stern did not apply and the issue was one purely of federal

law.

The reason Owens is distinguishable is a bit more complicated, but it

is materially distinguishable nonetheless. Owens was the sole shareholder

of an S corporation, Mid-Western, that had been involved in various ven-

tures but by mid-1965 held only $299,822.62 in cash. 568 F.2d at 1236.

In August 1965 he entered a contract purporting to sell Mid-Western’s

stock to two buyers for $262,842.26. Id. He reported his income from the

sale as long-term capital gain. Id. Meanwhile, post-closing, the buyers,

who apparently had planned to offset Mid-Western’s 1964 gains with

another corporation’s losses, liquidated and dissolved Mid-Western. Id.

STARNES v. CIR 25

The question is thus: under North Carolina law, what trans-

fer or combination of transfers should be considered to deter-

mine whether Tarcon received reasonably equivalent value

and/or was rendered insolvent? Under the facts here, there are

two options, depending on the time frame. The first option,

the one advocated by the Former Shareholders and adopted by

The Commissioner issued two notices of deficiency against Owens.

First, he asserted the 1965 transaction was in substance a distribution of

Mid-Western’s cash to Owens, not a bona fide sale of stock, and so Owens

owed taxes on the company’s 1965 S-corporation income—not capital

gains taxes on the amount he received in the purported sale. Id. Second,

the Commissioner asserted that (a) certain deductions Mid-Western had

claimed for 1964 related to cattle feed were not allowable, (b) Owens was

the transferee of Mid-Western’s assets, and (c) as transferee Owens was

liable for the 1964 deficiency. The Tax Court agreed with the Commis-

sioner’s theory on both notices. Owens v. Comm’r, 64 T.C. 1, 11-16

(1975).

The Sixth Circuit affirmed the Tax Court’s decision on the first notice,

agreeing that in substance Owens received a distribution of Mid-Western’s

assets, and that the distribution was taxable as ordinary S-corporation

income, not the proceeds of a stock sale. Owens, 568 F.2d at 1240. As to

the asserted 1964 deficiency—the deficiency involving asserted transferee

liability—the court reversed, concluding the deduction was allowable.

Because there was no deficiency, the court did not reach the question

whether Owens was a "transferee" within the meaning of § 6901. See id.

at 1246.

The Commissioner argues the facts here are analogous to those in

Owens, and because in Owens the court re-characterized the purported

stock sale as a distribution of the corporation’s assets to the shareholder,

we should do the same here. The portion of Owens the Commissioner

relies upon, however, relates to the first notice of deficiency at issue in

Owens—which did not involve § 6901 transferee liability. Rather, the

issue was whether to treat the S corporation’s 1965 income as having been

distributed to the sole shareholder or retained by the corporation, an issue

purely of federal law, at least in the circumstances there. While § 6901

transferee liability might have become relevant if the court had found the

claimed 1964 deduction disallowable, the court did not so find; accord-

ingly, the court had no occasion to consider the Supreme Court’s instruc-

tion in Stern that state law governs an alleged transferee’s substantive

liability.

26 STARNES v. CIR

the Tax Court, is to consider only the transfers that occurred

on November 13 and 14, 2003. During those two days, $3.1

million in cash was transferred from Tarcon to MidCoast’s

attorneys’ escrow account and then back into a post-closing

Tarcon account, and a separate and distinct $2.6 million in

cash was transferred from MidCoast to the Former Sharehold-

ers, via the same escrow account. At the end of that period,

Tarcon had $3.1 million in its account, the same amount it

had prior to closing. The second option, the one advocated by

the Commissioner, is to consider not only the November 13-

14 transfers, but also the December 1 transfer of Tarcon’s

cash to the "Delta Trading Partners" account in the Cook

Islands, after which Tarcon was left with just slightly more

than $130,000 in its accounts.9

Which time frame applies is dispositive as to whether the

transfers were fraudulent with respect to the Former Share-

holders. On one hand, if the first, narrower combination of

transfers is considered the "transfer" for NCUFTA purposes,

Tarcon unquestionably received "reasonably equivalent

9

The Commissioner also offers a third alternative time frame, one even

shorter than the Former Shareholders’ timeframe: He argues that the rele-

vant "transaction" included only the transfers that occurred on November

13. At that time, Tarcon had no assets in its accounts, because instead of

immediately transferring the cash in Womble Carlyle’s escrow account to

a Tarcon account, the closing attorney at Womble Carlyle transferred the

cash first to a MidCoast account, and only the next day to a Tarcon

account. This seems clearly to have been a mistake, however, despite the

Commissioner’s argument below that the mistake is evidence MidCoast

intended to bleed Tarcon dry. Within 24 hours the error was corrected

when MidCoast transferred the cash into Tarcon’s account. The dissent

argues in effect that because the Share Purchase Agreement did not "re-

quire" that Tarcon’s cash be returned to Tarcon after the closing, Dissent-

ing Op. at 48, the Tax Court committed clear error by finding that the one-

day delay did not result in the funds being "unavailable" to Tarcon to sat-

isfy its liabilities. Starnes, 101 T.C.M. (CCH) 1283, 2011 WL 894608, at

*8. We disagree. There was substantial evidence that the Former Share-

holders expected the funds to be transferred back to Tarcon, as of course

they were within a day of the closing. We conclude the district court did

not clearly err in this regard.

STARNES v. CIR 27

value" and was not rendered "insolvent as a result of the

transfer." On the other hand, if the combination of transfers

in this broader time frame constitutes the "transfer" for

NCUFTA purposes, Tarcon unquestionably did not receive

reasonably equivalent value in the exchange. This is because

the December 1 transfer, in one fell swoop, took Tarcon from

being fully able to meet its tax obligations to being entirely

unable to do so.

The Tax Court held the shorter time frame controls because

under North Carolina law the transactions are only "col-

lapsed" if the Former Shareholders had actual or constructive

"knowledge of the entire scheme," and the Commissioner did

not prove, even by a preponderance standard (rather than the

clear and convincing evidence standard urged by the Former

Shareholders), that the Former Shareholders had actual or

constructive knowledge of the later transactions. On appeal,

the Commissioner argues the Tax Court erred in choosing the

shorter timeframe, for two reasons: first, the court applied the

wrong legal standard for whether to "collapse" the transac-

tions, and second, the Tax Court’s finding that the Former

Shareholders lacked the requisite knowledge of the nature of

the "entire scheme" to "collapse" the transactions was clearly

erroneous. We reject the Commissioner’s contentions for the

reasons explained within.

i.

As to the legal standard, the Commissioner first argues the

Tax Court required him to prove the Former Shareholders had

"knowledge of the entire scheme," by which it allegedly

meant evidence they knew "the precise manner in which Mid-

Coast would cause Tarcon to evade its taxes." Appellant’s Br.

at 57 (emphasis added). This was legal error, the Commis-

sioner argues, because North Carolina law does not require

the Commissioner to prove that the Former Shareholders

knew precisely how MidCoast would cause Tarcon to fail to

pay its 2003 taxes.

28 STARNES v. CIR

As a literal matter, the Commissioner is correct as to the

standard: the question was not whether the Former Sharehold-

ers knew precisely how Tarcon would become delinquent on

its taxes under MidCoast’s ownership, but rather whether they

knew (or should have known) that Tarcon would become

delinquent in fact. But the Commissioner over-reads the Tax

Court’s opinion. While the court did describe the standard as

requiring knowledge of "the entire scheme," 101 T.C.M.

(CCH) 1283, 2011 WL 894608, at *10, in context it is appar-

ent the court did not require the Commissioner to prove the

Former Shareholders knew that MidCoast would, for exam-

ple, claim a deduction for a purported interest rate swap

option to offset the gain realized from the sale of the ware-

house. Rather, the court required the Commissioner to prove

simply that the Former Shareholders knew or should have

known before the deal closed that MidCoast would cause Tar-

con to fail to pay its 2003 taxes. This was the proper inquiry.10

10

Our conclusion that the Tax Court applied the correct standard is but-

tressed by the primary case it cited for the "entire scheme" standard: HBE

Leasing Corp. v. Frank, 48 F.3d 623 (2d Cir. 1995). In that case, the Sec-

ond Circuit held that because a mortgagee knew or should have known

that the mortgage "was part of a single transaction from which [the mort-

gagor] received no benefit," the mortgagee was liable to the mortgagor’s

creditors under New York’s version of the Uniform Fraudulent Convey-

ance Act, the predecessor to the Uniform Fraudulent Transfer Act. Id. at

629. Although elsewhere the HBE Leasing court described the standard as

requiring "actual or constructive knowledge of the entire scheme that ren-

ders [the mortgagee’s] exchange with the debtor fraudulent," id. at 635

(emphasis added), it did not require knowledge of the precise details of a

particular scheme, but rather knowledge simply that no fair consideration

was received in exchange for the mortgage. See id. at 629; see also United

States v. Tabor Court Realty Corp., 803 F.2d 1288, 1296-97, 1303 (3d Cir.

1986) (collapsing, under Pennsylvania’s analog to N. C. Gen. Stat. § 39-

23.5(a), a series of transactions comprising a leveraged buy-out because

the lender/mortgagee "knew or strongly suspected that the imposition of

the loan obligations secured by the mortgages and guarantee mortgages

would probably render [the debtor] insolvent" and "was fully aware that

no individual member of the [debtor] would receive fair consideration

within the meaning of the Act in exchange for the loan obligations").

STARNES v. CIR 29

The Commissioner next argues that, even if we conclude

the Tax Court applied the narrower standard, the court erred

in articulating the standard for whether the Former Sharehold-

ers should have known (i.e., had constructive knowledge) that

MidCoast would cause Tarcon to fail to pay the taxes. We dis-

agree on that score as well.

Under North Carolina law, the question of constructive

knowledge has two components. As applied to the circum-

stances here, they are: First, did the Former Shareholders have

actual knowledge of facts that would have led a reasonable

person concerned about Tarcon’s solvency to inquire further

into MidCoast’s post-closing plans? Second, if the Former

Shareholders were thereby on "inquiry notice," whether the

inquiry a reasonably diligent, similarly-situated person would

have undertaken revealed MidCoast’s plan to leave Tarcon

unable to pay its 2003 taxes? See, e.g., Vail v. Vail, 63 S.E.2d

202, 207-08 (N.C. 1951) ("[One] having notice must exercise

ordinary care to ascertain the facts, and if he fails to investi-

gate when put upon inquiry, he is chargeable with all the

knowledge he would have acquired, had he made the neces-

sary effort to learn the truth . . . .") (brackets added; quota-

tions and citations omitted); Nash v. Motorola Commc’ns &

Elecs., Inc., 385 S.E.2d 537, 538 (N.C. Ct. App. 1989)

("Plaintiff will be deemed to have had inquiry notice if . . . he

could have ascertained by a reasonably diligent effort from

facts available to him that he was in violation."). Thus, if the

Former Shareholders were on inquiry notice of MidCoast’s

plans and failed to make reasonably diligent inquiry, they are

charged with the knowledge they would have acquired had

they undertaken the reasonably diligent inquiry required by

the known circumstances.

We are confident this is the standard the Tax Court applied.

The court found the Commissioner satisfied his burden on

prong one because it found that although the circumstances

did oblige the Former Shareholders to conduct "[f]urther

inquiry," they "failed to do so." See 101 T.C.M. (CCH) 1283,

30 STARNES v. CIR

2011 WL 894608, at *10. Nevertheless, the court ultimately

found (as described below) the Former Shareholders were not

chargeable with constructive knowledge of the MidCoast

scheme. The opinion thus makes apparent the court’s implied

premise: that the Commissioner was required to prove that no

reasonably diligent person in the Former Shareholders’ posi-

tion would have failed to discover that MidCoast would cause

Tarcon not to pay its 2003 taxes. This was the correct stan-

dard under North Carolina law.

ii.

By imposing that standard and yet finding the Commis-

sioner failed to satisfy his burden of proof on constructive

knowledge, the Tax Court reasonably (if only implicitly)

found that no reasonably diligent inquiry by the Former

Shareholders would have disclosed MidCoast’s intent to

cause Tarcon to fail to pay its taxes. Put differently, even

though the Former Shareholders might have conducted further

inquiry, such a hypothetical effort would not likely have

revealed MidCoast’s post-closing plans to evade Tarcon’s tax

liability.

On appeal, the Commissioner argues these factual findings

are clearly erroneous. He argues the Former Shareholders

"knew or should have known that MidCoast had tax-

avoidance intentions, even if they were not privy to the pre-

cise schemes that MidCoast would later employ to evade the

taxes." Appellant’s Br. at 57. While the Former Shareholders

"claimed that they believed MidCoast’s assertion that it was

acquiring Tarcon to integrate the corporation into MidCoast’s

‘asset recovery business,’" the Commissioner argues, this

belief "is doubtful" and, in any event, is "completely unrea-

sonable." Id. at 58. The dissent shares the Commissioner’s

view that the lower court clearly erred in finding that the For-

mer Shareholders lacked the requisite constructive knowl-

edge.

STARNES v. CIR 31

The Commissioner vigorously argues the Former Share-

holders should have known what 20/20 hindsight now seems

to confirm, namely, that MidCoast had no purpose in acquir-

ing Tarcon’s stock "other than to facilitate a tax shelter." Id.

The Commissioner identifies a number of reasons for this

contention supported by the evidence: MidCoast’s promo-

tional materials stated it targeted corporations that held only

cash and offered shareholders a way to minimize their tax

burden; MidCoast’s offer to buy Tarcon’s stock was contin-

gent on Tarcon holding only cash; the negotiations revolved

largely around the percentage of the amount of Tarcon’s 2003

taxes that MidCoast would pay the Former Shareholders as a

"premium," which ended up as approximately $400,000; and

Tarcon was a defunct shell with no means to generate addi-

tional income.

Moreover, the Commissioner emphasizes, the Former

Shareholders’ inquiry was not reasonably diligent: they did

not investigate MidCoast’s asset recovery business; they did

not obtain a tax opinion regarding the stock sale; Naples

acknowledged that paying cash for a corporation that held

only cash "did sound strange," J.A. 759; another Former

Shareholder (Starnes) testified that although he did not under-

stand MidCoast’s promotional materials, "[i]t wasn’t some-

thing I wanted to understand," and "[o]nce they bought my

stock, they could do what they wanted to with Tarcon," J.A.

824; Starnes also testified that once Tarcon’s cash left the cor-

porate bank account, "we didn’t follow it any more, because

we didn’t own the company any more," J.A. 823; Stroupe

asked at the closing whether the MidCoast deal was "com-

pletely legal," J.A. 801; and the Former Shareholders’

accountant questioned whether the sale was "‘2001-16’

reportable," J.A. 601-03, but failed to confirm whether it was

or was not covered by I.R.S. Notice 2001-16. Finally, the

Commissioner argues, "[r]easonable inquiry would have, at

least, disclosed the existence of Notice 2001-16," which

would have "explicitly cautioned the Shareholders that their

transaction with MidCoast was substantially similar to other

32 STARNES v. CIR

intermediary transactions considered to be tax shelters."

Appellant’s Br. at 61.

This evidence certainly supports the Commissioner’s posi-

tion in this litigation. But they do not persuade us that the Tax

Court was clearly erroneous in finding that, under the circum-

stances shown by the evidence, the Former Shareholders

lacked constructive knowledge that Tarcon was unlikely to

pay its 2003 taxes. To the contrary, there was ample counter-

vailing evidence to that relied on by the Commissioner sup-

porting the lower court’s finding that the admittedly limited

inquiry by the Former Shareholders did little to bolster the

Commissioner’s case. Properly viewed, as we suggest above,

the Tax Court clearly found that the Former Shareholders

would not have learned through further inquiry so much more

of MidCoast’s intentions to justify the court’s imposition of

constructive knowledge.

MidCoast represented that Tarcon would not be "dissolved

or consolidated" but rather "reengineered into the asset recov-

ery business" and become an "income producer" for MidCoast

"going forward." J.A. 104. It also repeatedly represented that

it would ensure that Tarcon would pay its 2003 taxes. Mid-

Coast’s professional-looking brochure stated that MidCoast

was a well-established business that was incorporated in 1958

and in 1996 transitioned from mortgage banking to asset

recovery, mostly collecting defaulted credit card debts. At

every turn, MidCoast represented that Tarcon would continue

to operate as a business, and that Tarcon would pay its 2003

taxes.

There is still further evidence the Former Shareholders’

efforts to ascertain MidCoast’s post-closing plans were rea-

sonable as measured against the hypothetical, "reasonably dil-

igent" efforts North Carolina law contemplates. Joseph

Cogdell, MidCoast’s attorney who also served as the closing

attorney for the stock sale, testified that he had no reason to

believe MidCoast would fail to abide by its contractual obli-

STARNES v. CIR 33

gation to ensure Tarcon’s 2003 taxes would be paid. At the

time of the transaction, he was a senior member of the corpo-

rate and securities practice group at Womble Carlyle, held an

L.L.M. in taxation, and was intimately familiar with the

details of the transaction. Similarly, Brad Cherry, Tarcon’s

real estate broker, testified that MidCoast’s representatives

struck him as ordinary businessmen, and nothing in Mid-

Coast’s proposals raised any concern with him.11 He also

checked MidCoast’s references and apparently received very

positive feedback, and reported to the Former Shareholders

that MidCoast was a "reputable firm." J.A. 785. Moreover,

Michael Cronin, Esq., Tarcon’s attorney at the law firm

Moore & Van Allen, also was familiar with the transaction

and never saw any reason the Former Shareholders should not

enter the transaction with MidCoast. And when the Former

Shareholders asked Cherry and their attorneys whether the

deal was legitimate, they were told that it was, and that Mid-

Coast had "done these [deals] before." J.A. 801. These con-

versations led the Former Shareholders to be "confident" that

the deal was "legitimate" and "completely legal." J.A. 725,

801.

Furthermore, the Tax Court was entitled to weigh other cir-

cumstantial evidence bearing on the issues of "reasonable dili-

gence" and constructive knowledge. Specifically, although the

Former Shareholders had substantial experience in the freight

consolidation business and some warehouse leasing experi-

11

Indeed, Cherry was appropriately circumspect throughout, writing as

follows to the Former Shareholders when he received MidCoast’s initial

communication:

[I]t appears that this is something that they do often, but also

something in which I am definitely out of my league. I would like

to encourage you, when the time is appropriate, to involve both

your accountant and a lawyer to help advise us through this trans-

action should it move forward.

101 T.C.M. (CCH) 1283, 2011 WL 894608, at *2. Obviously, the Former

Shareholders acted on this sage advice.

34 STARNES v. CIR

ence, none had ever sold a business before, and none had any

education, training, or experience in accounting, taxes, or

finance. Naples and Starnes each had a high school education;

Morelli a ninth-grade education. They each worked at Tarcon

for all or nearly all of their adult lives—Morelli began assist-

ing on the docks, Starnes as a janitor. In sum, the Tax Court

could reasonably find, as it essentially did, that the Former

Shareholders learned what any reasonably diligent inquiry

would have disclosed to any similarly situated group of per-

sons through their reliance on their advisors and agents.

For these reasons, we conclude the Tax Court did not com-

mit clear error in finding that the Commissioner failed to

prove that a reasonably diligent person in the Former Share-

holders’ position would have learned that, as a result of the

transaction, Tarcon would fail to pay its 2003 taxes. Given

that factual finding, the Commissioner failed to prove that the

December 1 transfer—which rendered Tarcon essentially

insolvent and unable to satisfy its 2003 tax liability—should

be collapsed with the earlier transfers for purposes of deter-

mining whether Tarcon received "reasonably equivalent

value" in the "transfer," as required by N.C. Gen. Stat. § 39-

23.5.12 Because the transfers were not collapsible under North

Carolina law, they were not fraudulent under § 39-23.5 with

respect to the Former Shareholders. Accordingly, the Tax

Court properly held that § 39-23.5 does not provide a basis for

holding the Former Shareholders liable for Tarcon’s 2003 tax

liability.

12

For the same reason, we reject the Commissioner’s argument that the

Tax Court clearly erred in finding there was no "circular flow of funds."

See Appellant’s Br. at 62-65; see also n.5, supra. The Commissioner’s

clear-error argument on that point also boils down to an argument that the

December 1 transfer should have been collapsed with the earlier transfers.

Because the Tax Court did not clearly err in refusing to collapse the trans-

actions, it did not clearly err in finding there was no circular flow of funds.

STARNES v. CIR 35

2.

The next NCUFTA provision the Commissioner argues

rendered fraudulent the transfer of Tarcon’s assets as to the

Former Shareholders is N.C. Gen. Stat. § 39-23.4(a)(2).

Under that subsection, a "transfer" made by a debtor "is fraud-

ulent as to a creditor" if the debtor (1) made the transfer

"without receiving a reasonably equivalent value in

exchange," and (2) was engaged in a transaction for which its

"remaining assets" were "unreasonably small," or intended to

incur "debts beyond the debtor’s ability to pay." Id. As

explained in the preceding section, the Commissioner failed

to prove the December 1 transfer should be collapsed with the

November 13-14 transfers for NCUFTA purposes. Thus, just

as under § 39-23.5, the Commissioner failed to prove Tarcon

did not receive "reasonably equivalent value" for its cash.

Accordingly, § 39-23.4(a)(2) does not provide a basis for

holding the Former Shareholders liable as transferees for Tar-

con’s 2003 taxes.

3.

The third and last NCUFTA subsection the Commissioner

relies upon is N.C. Gen. Stat. § 39-23.4(a)(1). That subsection

provides that a transfer made by a debtor is fraudulent as to

a creditor if the debtor made the transfer "[w]ith intent to hin-

der, delay, or defraud any creditor of the debtor." Id. The stat-

ute provides thirteen non-exclusive "factors" for determining

whether a debtor had the requisite fraudulent intent. The Tax

Court considered seven of them relevant to the facts here:

(1) The transfer or obligation was to an insider;

...

(5) The transfer was of substantially all the debt-

or’s assets; . . .

(7) The debtor removed or concealed assets;

36 STARNES v. CIR

(8) The value of the consideration received by the

debtor was reasonably equivalent to the value

of the asset transferred or the amount of the

obligation incurred;

(9) The debtor was insolvent or became insolvent

shortly after the transfer was made or the obli-

gation was incurred;

(10) The transfer occurred shortly before or shortly

after a substantial debt was incurred; . . .

(12) The debtor made the transfer or incurred the

obligation without receiving a reasonably

equivalent value in exchange for the transfer

or obligation, and the debtor reasonably

should have believed that the debtor would

incur debts beyond the debtor’s ability to pay

as they became due[.]

Id. § 23.4(b).13

13

The other factors are the following:

(2) The debtor retained possession or control of the property

transferred after the transfer;

(3) The transfer or obligation was disclosed or concealed;

(4) Before the transfer was made or obligation was incurred, the

debtor had been sued or threatened with suit; . . .

(6) The debtor absconded; . . .

(11) The debtor transferred the essential assets of the business

to a lienor who transferred the assets to an insider of the

debtor; . . .

(13) The debtor transferred the assets in the course of legitimate

estate or tax planning.

N.C. Gen. Stat. § 39-23.4(b).

STARNES v. CIR 37

The Tax Court weighed these factors and held that the

Commissioner had not shown that the Shareholders intended

to hinder, delay, or defraud the IRS, which was, after all, Tar-

con’s only creditor at the time. Crucial to its analysis was its

rejection of the Commissioner’s argument for collapsing the

November 13-14 and December 1 transfers, a conclusion we

affirm for the reasons explained above. Because the relevant

time frame is limited to November 13-14, the transfer was not

of substantially all of Tarcon’s assets (factor 5); Tarcon did

not remove or conceal assets (factor 7); the value of the con-

sideration Tarcon received was "reasonably equivalent to the

value of the asset transferred" (factor 8); Tarcon was not ren-

dered insolvent (factor 9); and Tarcon did not make the trans-

fer "without receiving a reasonably equivalent value in

exchange" (factor 12). Thus, although the Former Sharehold-

ers were "insiders" (factor 1) and the transfers occurred

shortly after a substantial debt, namely the tax liability on the

warehouse sale, was incurred (factor 10), the Tax Court con-

cluded the Commissioner had not shown that the Former

Shareholders intended to "hinder, delay, or defraud" the IRS

from collecting Tarcon’s 2003 taxes.

On appeal, the Commissioner argues the Tax Court erred

in applying these factors for largely the same reason the court

erred on the other claims: by requiring evidence of actual or

constructive knowledge that Tarcon would be rendered insol-

vent by the transaction. For the reasons stated above, that was

not legal error. And the Tax Court did not clearly err in mak-

ing the factual findings underlying the conclusion that the

Former Shareholders did not intend to hinder, delay, or

defraud the IRS from collecting Tarcon’s 2003 taxes. There-

fore, the Commissioner has failed to show that § 39-

23.4(a)(1) renders the Former Shareholders liable for Tar-

con’s 2003 taxes.

4.

Lastly, the Commissioner argues the Former Shareholders

are liable to Tarcon’s creditors under the common law "trust

38 STARNES v. CIR

fund doctrine." This doctrine treats the assets of a corporation

as, "in a sense, . . . a trust fund," and the corporation’s officers

and directors as "occupy[ing] a fiduciary position in respect

to stockholders and creditors, which charges them with the

preservation and proper distribution of those assets." Snyder

v. Freeman, 266 S.E.2d 593, 601 (N.C. 1980). "The corporate

debts must be paid before [officers and directors] can appro-

priate any part of the assets to their own use, though they may

also be stockholders." McIver v. Young Hardware Co., 57

S.E. 169, 171 (N.C. 1907). "[T]he stockholders and officers

of the corporation are liable to it and to its creditors for any

acts of malfeasance, misfeasance, or nonfeasance by which

their rights are injuriously affected, and, as a consequence, for

any loss arising out of their fraud or negligence." Id.

The Tax Court rejected this argument because (1) as a legal

matter, the trust-fund doctrine only applies "where circum-

stances exist ‘amounting to a winding-up or dissolution of the

corporation,’" Starnes, 101 T.C.M. (CCH) 1283, 2011 WL

894608, at *13 (quoting Whitley v. Carolina Clinic, Inc., 455

S.E.2d 896, 899–900 (N.C. Ct. App. 1995)), and (2) as a fac-

tual matter, the Commissioner "has not presented evidence

regarding circumstances that existed amounting to a winding

up or dissolution of Tarcon aside from claiming that Tarcon

no longer had a business activity." Id.

On appeal, the Commissioner does not dispute the Tax

Court’s characterization of North Carolina law, limiting the

trust-fund doctrine to the dissolution context. Rather, the

Commissioner argues the court’s finding that Tarcon was not

in dissolution was clearly erroneous. We disagree. At the time

the Former Shareholders entered the transaction, MidCoast’s

representatives assured them that Tarcon would remain a

going concern and would be absorbed into MidCoast’s "asset

recovery" business. Indeed, Tarcon did remain in existence

long past the time MidCoast bought its stock. Just as it was

not clearly erroneous to find that the Former Shareholders did

not know the transaction would leave Tarcon insolvent, it was

STARNES v. CIR 39

not clearly erroneous to find that the transaction did not

amount to a winding up or dissolution of the company.

III.

As we have explained at length, the Commissioner’s efforts

to collect Tarcon’s unpaid 2003 taxes from the Former Share-

holders foundered on his inability to persuade the Tax Court

that the Former Shareholders knew or should have known that

Tarcon would fail to pay its taxes under its new owner. The

Commissioner argues, as a policy matter, that requiring that

he prove actual or constructive knowledge "imposes an

impossible burden on [him] in intermediary tax shelter cases"

and "enables participants in an intermediary tax shelter to eas-

ily defeat transferee liability, by choosing willful blindness of

the promoter’s tax-avoidance intentions and then claiming

ignorance of the ‘entire scheme.’" Appellant’s Br. at 54-55.

Although we are not unsympathetic to the Commissioner’s

concerns, his policy argument is foreclosed by existing law

for the reasons discussed above. It is also overblown. North

Carolina law, like the law of other states that have adopted the

Uniform Fraudulent Transfer Act, requires neither evidence of

actual intent to defraud nor direct evidence of alleged trans-

ferees’ knowledge. The Commissioner could have prevailed

based solely on circumstantial evidence that the Former

Shareholders should have known of MidCoast’s intentions.

That the Commissioner could not persuade the Tax Court

does not mean his burden was insurmountable; it simply

means his evidence was insufficient to persuade the fact

finder in this case.14 Furthermore, as noted above, the IRS

14

Indeed, with evidence of a more persuasive character, or with histori-

cal facts more compelling, the Commissioner has prevailed before the Tax

Court in other transferee liability cases involving MidCoast. See, e.g.,

Feldman v. Commissioner, 102 T.C.M. (CCH) 612, 2011 WL 6781006

(2011); CHC Industries, Inc. v. Commissioner, 101 T.C.M. (CCH) 1148,

2011 WL 320887 (2011). In each such case, as in this case, the primacy

40 STARNES v. CIR

itself has recognized that a person should only be held liable

in intermediary transaction tax shelter cases if he or she knew

or had reason to know that the transaction was structured to

avoid federal taxes due on assets with built-in gains. See n.3,

supra (citing I.R.S. Notice 2008-111).

Ultimately, as the Commissioner had the burden of proof

on the dispositive issues, his "clear error" contentions before

us really amount in substance to an argument that he is enti-

tled to judgment as a matter of law, i.e., that the evidence of

the Former Shareholders’ foreknowledge of the MidCoast

scheme was so one-sided that no reasonable decision-maker

could reasonably rule in their favor. Manifestly, for the rea-

sons we have explained, this is not so. Therefore, we affirm

the judgment of the Tax Court in favor of the Former Share-

holders.

AFFIRMED

WYNN, Circuit Judge, dissenting:

This case involves a straightforward transaction made com-

plicated so as to facilitate the fraudulent avoidance of a tax

liability. Simply put, the petitioners, former shareholders of

Tarcon, reduced the sole asset of Tarcon to cash by selling

that asset, a warehouse, for $3,180,000. After that October 30,

2003 sale, Tarcon had $3,091,955 in its bank account and no

of the Tax Court’s role as fact finder is, of course, undisputed. To para-

phrase the Supreme Court’s statement of the principle in an analogous

context, "the trial court’s decision on the ultimate question of [fraudulent]

intent represents a finding of fact of the sort accorded great deference on

appeal." Hernandez v. New York, 500 U.S. 352, 364 (1991) (plurality

opinion). Application of that principle here means that although there may

have been some evidence of what the Commissioner calls "willful blind-

ness," it was for the Tax Court, not this court, to make findings based on

that evidence, and we are obliged to accord those findings "great defer-

ence." Id.

STARNES v. CIR 41

tangible assets. As a result of the warehouse sale, Tarcon

incurred a federal tax liability of $733,699 and a North Caro-

lina tax liability of $147,931, for a total of $881,628. If the

story had ended there, the four former shareholders, each of

whom owned 25 percent of Tarcon, would have completed

the liquidation of Tarcon by paying those tax liabilities and

dividing the remaining sum, allowing each to receive a distri-

bution of approximately $552,582.

Of course, the story doesn’t end there. Instead, MidCoast

entered with a fraudulent scheme that would allow the former

shareholders to avoid paying their $881,628 tax liability.

Under its proposal, MidCoast would pay the former share-

holders $2,621,136 for their Tarcon stock and legal fees; in

return, Tarcon would transfer its sole asset, roughly $3.1 mil-

lion in cash, to MidCoast. Why, though, would the sharehold-

ers turn over Tarcon’s $3.1 million to MidCoast and receive

only $2.6 million in return?

The answer is evident when Tarcon’s outstanding tax liabil-

ities of $881,627 are factored into the equation. Indeed, it then

becomes clear that the former shareholders actually negoti-

ated to be paid $2.6 million in cash—for cash that in reality

totaled only $2,210,425,1 resulting in a windfall of $410,711.

That windfall was, in fact, a cut from Tarcon’s $881,627 tax

liability, transferred to MidCoast when it purchased the for-

mer shareholders’ stock, and which it undoubtedly was

scheming to avoid under the guise of offering an "asset recov-

ery premium." While I recognize the intricacies of Mid-

Coast’s subsequent actions to avoid paying the full liability of

$881,627,2 this transaction cannot escape its ultimately simple

1

Tarcon’s $3.1 million in cash, less its tax liabilities of $881,627, equals

$2,210,425 in cash—the true value of Tarcon’s assets.

2

The record reflects that less than two weeks after MidCoast purchased

Tarcon’s stock from the former shareholders, it resold the stock to Sequoia

Capital, LLC, a Bermuda company, for approximately $2.8 million. Two

days after that, the $3.1 million in Tarcon’s account was transferred to

42 STARNES v. CIR

label: a transparent scam designed by the parties to fraudu-

lently evade paying taxes. Accordingly, I must respectfully

dissent.

I.

This is a case about transferee liability under 26 U.S.C.

§ 6901. As such, I take issue with the majority’s conclusion

that it need not address the threshold question of whether the

former shareholders are in fact transferees. The majority dis-

misses as "immaterial," ante at 20, what I view as a critical

analytical difference between the substantive state law in

Kentucky at issue in Commissioner v. Stern, 357 U.S. 39

(1958), and the North Carolina Uniform Fraudulent Transfer

Act (NCUFTA), N.C. Gen. Stat. § 39-23.1 et seq., that con-

trols in this case.

In Stern, the question of whether the beneficiary widow

was a transferee was irrelevant under Kentucky law, as she

would not have been liable in either instance for her deceased

husband’s unpaid income tax deficiencies. Stern, 357 U.S. at

45-46. In this case, by contrast, and as noted by the majority

opinion, North Carolina law may indeed impose liability on

the former shareholders, but only if there was a fraudulent

transfer and they are transferees under federal law. See, e.g.,

N.C. Gen. Stat. §§ 39-23.4, 39-23.5 (voiding certain types of

another account, also in Tarcon’s name, with Deutsche Bank AG. On

December 1, 2003, over $2.9 million of those funds was transferred to an

account in the Cook Islands in the name of Delta Trading Partners, and an

additional $126,822 was transferred to a MidCoast bank account.

After that date, Tarcon never had more than $132,320 in any bank

account. When the company filed its 2003 federal income tax return, it

reported an overall loss and no tax due, based on losses from a purported

interest rate swap option and an asset acquired on December 29 and sold

on December 31, 2003, offsetting the gains from the sale of the warehouse

to ProLogis. The return also stated that the $132,320 represented Tarcon’s

sole asset.

STARNES v. CIR 43

transfers as fraudulent, which under § 6901 would in turn

allow for the imposition of substantive liability on the trans-

ferees in such transactions).

Equally significant, the question of whether the former

shareholders are transferees is inextricably linked with, and

informed by, which transaction is under review. In another

significant distinction from Stern, there was no dispute in that

case that a transfer from the original taxpayer to the benefi-

ciary widow had occurred; here, however, depending on

which transaction is considered, there was no transfer from

Tarcon, the debtor owing taxes. Put another way, for § 6901

and Stern to apply and North Carolina law to determine the

former shareholders’ liability, the former shareholders must

be transferees—but they are only transferees if they received

a "transfer" as part of the transaction under review.

Notwithstanding these material distinctions, the majority

opinion, relying on Stern, assumes arguendo that the former

shareholders are transferees—but then proceeds to analyze the

stock sale between MidCoast and the former shareholders as

the sole transaction relevant under North Carolina law. The

problem, of course, is that the "form" of that transaction was

structured such that the former shareholders received Tar-

con’s assets only indirectly: there was no direct "transfer"

between Tarcon and the former shareholders. As such, the

majority reviews a transaction in which the former sharehold-

ers are not actually transferees, while assuming that they are,

an internal inconsistency in which I cannot concur.3

3

The majority opinion disputes the contention that § 6901 requires

courts to determine, when it may not be properly assumed, the threshold

issue of whether a person or entity is a "transferee" under federal law for

the purposes of § 6901. According to the majority opinion, this question

must be answered—if at all—by reference to state substantive law. How-

ever, if this is the case, why then is "transferee" specifically defined by

federal law to include a "donee, heir, legatee, devisee, and distributee." 26

U.S.C. § 6901(h). A logical application of the majority opinion would

allow state substantive law to redefine, for instance, donees and heirs as

something other than potential transferees in clear contravention of

§ 6901(h).

44 STARNES v. CIR

II.

In my view, the Tax Court and this Court must make the

threshold determination of which transaction is properly

under review, which in turn informs the dispositive issue here

of whether the former shareholders are properly characterized

as transferees under § 6901. See generally Frank Lyon Co. v.

United States, 435 U.S. 561, 581 n.16 (1978) ("The general

characterization of a transaction for tax purposes is a question

of law subject to review."); Va. Historic Tax Credit Fund

2001 LP v. Comm’r of Internal Revenue, 639 F.3d 129, 142

(4th Cir. 2011) (same).

A.

To answer that initial question, I look to this Court’s prece-

dent:

A taxpayer may not . . . claim tax benefits that Con-

gress did not intend to confer by setting up a sham

transaction lacking any legitimate business purpose,

or by affixing labels to its transactions that do not

accurately reflect their true nature. Accordingly,

under the "economic substance doctrine," a transac-

tion may be disregarded as a sham for tax purposes

if the taxpayer "was motivated by no business pur-

poses other than obtaining tax benefits" and "the

transaction has no economic substance because no

reasonable possibility of a profit exists." Rice’s

Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91 (4th

Cir. 1985). Similarly, the doctrine of "substance over

form" recognizes that the substance of a transaction,

rather than its form, governs for tax purposes. See,

e.g., W. Va. N. R.R. Co. v. Comm’r, 282 F.2d 63, 65

(4th Cir. 1960) ("It is well settled that in matters of

taxation substance rather than form prevails and that

the taxability of a transaction is determined by its

STARNES v. CIR 45

true nature rather than by the name which the parties

may use in describing it.").

BB&T Corp. v. United States, 523 F.3d 461, 471 (4th Cir. 2008).4

We have further instructed that "[i]n applying the doctrine of

substance over form, we ‘look to the objective economic real-

ities of a transaction rather than to the particular form the par-

ties employed.’" Id. at 472 (quoting Frank Lyon, 435 U.S. at

573 (alteration omitted)).

Here, the "objective economic realities" establish that the

former shareholders effectively wound up Tarcon and

received liquidating distributions of its cash as a result of the

stock sale to MidCoast. As noted in the Tax Court’s Memo-

randum, it is undisputed that "[b]y 2003, Tarcon was no lon-

ger in the freight consolidation business, and its primary

business was leasing warehouse space" at a property in Char-

lotte.5 Starnes v. Comm’r of Internal Revenue, T.C. Memo

2011-63. 2011 WL 894608, *1 (2011). Thus, the transaction

to sell the warehouse to ProLogis reduced all of Tarcon’s

assets to cash, with no apparent plan to use those monies to

commence another business activity. The Share Purchase

Agreement also explicitly acknowledged that "[i]mmediately

prior to the Closing and at Closing, the Company shall pos-

sess assets consisting of cash in an amount not less than the

sum of $3,092,052.54, and the Company shall be subject to no

4

Although federal law generally controls which transaction gives rise to

the original debtor’s federal tax liability, I note that North Carolina also

incorporates substance-over-form principles in its fraudulent-conveyance

law. See N.C. Gen. Stat. § 39-23.1(12) & N.C. Comment (defining "trans-

fer" for NCUFTA purposes as "every mode, direct or indirect . . . of dis-

posing of or parting with an asset"); Havee v. Belk, 775 F.2d 1209, 1219

(4th Cir. 1985) (holding that substance of a transaction, not its form, gov-

erns for NCUFTA).

5

During the relevant time period, this warehouse was Tarcon’s sole

remaining asset; other assets including a number of luxury cars and a con-

dominium were either sold prior to the transactions at issue or are other-

wise immaterial to the analysis.

46 STARNES v. CIR

Liabilities other than the Deferred Tax Liability" of

$881,627.74. J.A. 249.6 By their own admission, the former

shareholders had decided to retire and sell either Tarcon’s

assets or its stock, effectively liquidating the company.

However, after being contacted by MidCoast, the former

shareholders agreed to sell their stock directly to MidCoast.

This decision was surely driven by MidCoast’s representa-

tions, as outlined in the majority opinion, that "[w]ith a liqui-

dation, the Former Shareholders would effectively be taxed

twice," whereas "[w]ith a stock sale, they would only be taxed

once." Ante at 7. Indeed, it is undisputed that "negotiations

primarily focused on the percentage applied to the tax liabili-

ties to determine the share purchase price."7 Starnes, T.C.

Memo 2011-63, 2011 WL 894608, at *3 (emphasis added).

Even more telling, the Share Purchase Agreement included

the condition that "[t]he Company . . . deliver( ) to [Mid-

Coast] . . . all of the Company’s monies by wire transfer . . .

in the amount of" $3,092,052.54. J.A. 249 (emphasis added).

There was no discernible "legitimate business purpose" for

this transfer of Tarcon’s cash to MidCoast; at closing, Mid-

Coast already had complete control over all of Tarcon’s assets

and accounts by virtue of its ownership of all of Tarcon’s

shares.

Based on these objective realities—and despite its

"form"—the sale to MidCoast was not a true sale of stock.

Rather, the "substance" of the transaction reflects that the pur-

ported sale was no more than a cash-for-cash swap in which

6

Citations to the joint appendix are abbreviated as "J.A."

7

This so-called "asset recovery premium," in which MidCoast paid the

shareholders 43.75 percent of Tarcon’s deferred tax liability, explains why

the former shareholders would enter into the Share Purchase Agreement

at all, rather than simply divide and distribute Tarcon’s $3.1 million in

cash, less the $881,627 in tax liability. Described less charitably, the "asset

recovery premium" sounds quite a bit like a scheme not only to avoid pay-

ing taxes, but to profit while doing so.

STARNES v. CIR 47

the former shareholders received MidCoast’s $2.6 million in

exchange for transferring Tarcon’s $3.1 million. Because cash

is fungible, this exchange is no different in substance than if

the former shareholders had received outright distributions of

Tarcon’s cash. See Owens v. Comm’r of Internal Revenue,

568 F.2d 1233, 1239 (6th Cir. 1977) (explaining that "when

a corporation owns just cash . . . the corporation has already

been effectively liquidated[.]"); Lowndes v. United States, 384

F.2d 635 (4th Cir. 1967) (disregarding a purported sale of

stock in four subsidiaries of Bethlehem Steel Company that

had ceased operating and held only cash). In Owens, the Sixth

Circuit explained that:

In view of these circumstances of the sale, . . . [the

purchasers] did not assume the risks of a business.

What taxpayer actually sold . . . was the right to dis-

tribute a quantity of cash to themselves. Moreover,

that right to a distribution of cash was in substance

no different than the cash that taxpayer received for

the stock. Exclusive control of [the company] was

transferred to [the purchasers]. There were no obsta-

cles to the immediate withdrawal of the cash in [the

company’s] bank account. [The purchasers] were

given the right to draw on the [company’s] bank

account in return for taxpayer being given the right

to draw on [the purchaser’s] bank account. The par-

ties were simply exchanging cash.

568 F.2d at 1240 (internal citations omitted). This type of

exchange of cash, which "does not affect a taxpayer’s benefi-

cial interest," "serve[s] no other purpose than tax avoidance."

Id. (citing Haberman Farms, Inc. v. United States, 305 F.2d

787 (8th Cir. 1962)); see also Rice’s Toyota World, Inc. v.

Comm’r of Internal Revenue, 752 F.2d 89, 91 (4th Cir. 1985)

(holding that the form of a transaction may be disregarded as

a sham for tax purposes if the taxpayer "was motivated by no

business purposes other than obtaining tax benefits").

48 STARNES v. CIR

B.

Having determined that the relevant transaction for review

is not the stock sale, but the effective liquidation of Tarcon,

the next issue for consideration is whether, with respect to

that transaction, the former shareholders are "transferees"

within the meaning of § 6901. If they are, then North Carolina

law applies to determine the "existence and extent" of their

liability. Stern, 357 U.S. at 45.

Under § 6901, a "transferee of property" is liable for

income taxes "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" by the taxpayer.

26 U.S.C. § 6901(a). A "transferee" is further defined as

including a "donee, heir, legatee, devisee, and distributee." Id.

§ 6901(h). Again, because cash is fungible, the former share-

holders effectively received distributions of Tarcon’s assets

during liquidation, with MidCoast as a mere conduit. As such,

the former shareholders meet the definition of "transferees."

Moreover, because the Share Purchase Agreement did not

require that Tarcon get anything in return for its $3.1 million,

this transfer was plainly fraudulent under North Carolina law,

as it cannot fairly be said that it "receiv[ed] a reasonably

equivalent value in exchange for the transfer." N.C. Gen. Stat.

§ 39-23.5(a); In re Jeffrey Bigelow Design Grp. Inc., 956 F.2d

479, 484 (4th Cir. 1992) ("What constitutes reasonably equiv-

alent value is determined from the standpoint of the debtor’s

creditors." (quotation and citation omitted)). Moreover, until

MidCoast voluntarily moved the $3.1 million back into a new

Tarcon account the following day, Tarcon did, albeit tempo-

rarily, "bec[o]me insolvent as a result of the transfer." N.C.

Gen. Stat. § 39-23.5(a).

The majority opinion dismissively refers to the transfer

from Tarcon to MidCoast as an "apparent mistake" and a tem-

porary "detour" of Tarcon’s cash, ante at 11, apparently

STARNES v. CIR 49

because, although the $3.1 million was initially transferred

into MidCoast’s account, it was returned to Tarcon’s post-

closing account the next day, per the closing statement. Not-

withstanding what the closing statement may have said or

what happened the next day, it is undisputed that the Share

Purchase Agreement required only that Tarcon to deliver all

of its cash to the trust account of MidCoast’s attorneys.8 As

a result, the critical transfer here was from Tarcon to Mid-

coast, with nothing required to be returned to Tarcon under

the express terms of the Share Purchase Agreement.

Even if one assumes, as the majority does, that MidCoast

was required to transfer the $3.1 million back to Tarcon, such

that Tarcon did receive value, the transfer from MidCoast to

the shareholders must also be voided as fraudulent under

North Carolina law, and the former shareholders would like-

wise be liable as transferees. Under that approach, because

MidCoast became the debtor when it assumed Tarcon’s tax

liabilities by purchasing all of its outstanding shares of stock,

its transfer of $2.6 million to the former sharehold-

ers—including the "asset recovery premium"—was made

with "intent to hinder, delay, or defraud" the IRS.9 N.C. Gen.

Stat. § 39-23.4(a)(1). In other words, the former shareholders

would be liable as "transferees of transferees," as Tarcon

transferred its liabilities to MidCoast, and MidCoast in turn

8

Indeed, the movement of Tarcon’s cash—from a Tarcon account, to a

MidCoast account, back to a Tarcon account—is strongly suggestive of

MidCoast’s leveraging those funds to finance its payment to the former

shareholders. At the least, it calls into question whether the Tax Court was

correct in its determination that this deal did not involve a circular flow

of funds.

9

This "intent to hinder" is illustrated by the realities that: (a) the shares

of stock received by MidCoast, with an actual value of only $2.2 million,

cannot fairly be said to be "reasonably equivalent" to the $2.6 million that

was paid; and (b) by paying the "asset recovery premium" to the share-

holders, MidCoast reduced its ability to pay Tarcon’s tax liability. See

N.C. Gen. Stat. § 39-23.4(b)(1) (outlining factors that would show "intent"

under the previous section).

50 STARNES v. CIR

transferred cash to the former shareholders. See Butler v.

Nationsbank, N.A., 58 F.3d 1022, 1026-28 (4th Cir. 1995)

(finding that indirect transfer was a fraudulent conveyance

under predecessor law to NCUFTA).

III.

The record here shows that the former shareholders did not

understand what was meant by the "asset recovery business"

or what MidCoast actually planned to do with Tarcon, yet

they made no inquiries in part because "it wasn’t something

[they] wanted to understand," and MidCoast could do what it

wanted with Tarcon once they were paid for their stock. J.A.

824. Faced with a windfall of over $410,000, the former

shareholders’ willful blindness is somewhat understand-

able—but it cannot be allowed to stand, lest this type of sham

transaction to avoid paying federal taxes becomes a standard

business practice.

When the substance, rather than the form, of these transac-

tions is properly reviewed, it becomes clear that the deal in

question was nothing more than a new, more sophisticated

version of money laundering. Because I find that the "eco-

nomic realities" here amounted in substance to a distribution

of Tarcon’s cash, less only roughly half of its deferred tax lia-

bilities, to the former shareholders, with a facilitation fee paid

to MidCoast, I would reverse the Tax Court and find the for-

mer shareholders liable as transferees under § 6901 and North

Carolina law. Accordingly, I respectfully dissent.