“Dash Six Liability” Problems In Deals
Concerns about “dash six liability” are cropping up in many project sales and foreclosures this year. There are things the purchaser of a project can do in practice to protect himself, but the options are limited.
Many power plants have been put up for sale in the last year and a half since Enron went bankrupt. Some lenders have been handed the keys to projects that are under construction. It is usually easier when taking over a project to buy or foreclose on the shares in the special-purpose company that was set up to own the project. This saves having to have all the contracts, permits and other rights tied to the project individually assigned or transferred to a new entity.
Business people know instinctively that there is danger in taking over an existing company. The company may have run up liabilities. Buyers do due diligence — or investigate carefully — to make sure there are no such liabilities. They also get representations and indemnities from the seller.
“Dash six liability” is often present and is potentially a large number.
Most corporations in the United States file “consolidated” or group income tax returns at the federal level. A parent company files a single return for itself and its domestic subsidiaries — at least its domestic subsidiaries that are treated as corporations for US tax purposes and that it owns at least 80% by both vote and value. (Mexican and Canadian subsidiaries may be included in a US consolidated return in some circumstances.)
The Internal Revenue Service can hold each corporation that is included on a consolidated return accountable for the full taxes that should have been paid by the group in the event there is shortfall. This liability is called “dash six liability” because it is discussed in the IRS regulations at section 1.1502-6. A project company that was part of a consolidated return is exposed for group taxes for all years that it was included in the consolidated return. IRS regulations say that if a subsidiary has left the group by the time the IRS comes after it, then the IRS “may” limit its claim to the share of taxes that the subsidiary contributed to the group return. However, there is no obligation on the IRS to agree to such a limit.
Dash six liability is present when buying shares in a corporation. It is not ordinarily present when buying a partnership interest or when buying a membership interest in a limited liability company that is treated for tax purposes as a partnership or “disregarded entity.”
There may be similar exposure for state income taxes. Corporations sometimes file combined or group returns at the state level. Some state regulations provide explicitly for “joint and several” liability of each subsidiary for the full taxes that should have been paid on the group return.
Some project sales have been called off this year due to fears about dash six liabilities.
The IRS can only reach the subsidiary’s assets — not other assets of the buyer group — but only as long as the subsidiary remains a separate corporation. Thus, for example, if Corporation A buys the shares in Corporation B, the IRS has a claim only against B. It does not have a claim against A as B’s new parent company.
A would be wise not to liquidate B into itself or merge A with another subsidiary that has substantial assets. The dash six liability will carry over to the merged company.
How often does the IRS pursue subsidiaries that have left the group in practice for group taxes? Probably not frequently, but there is no ready data on this. Lawyers at the Justice Department who pursue tax claims said that it is “not the norm” for the government to start with a subsidiary that has left the group. It will try to collect first from the remaining members of the group as a “first option, second option, third option.” However, the government will do what it must to collect if its collection efforts against the other group members are stymied. If the deconsolidated company has “lots of cash,” the government might go after it more readily than it would if it owned a factory because “the IRS does not want a factory, it wants cash,” a government lawyer said. State laws that make it easier for the IRS to collect might play a role. It is a “practical decision,” another government lawyer said. It depends on “who is doing the collection. The IRS has thousands of collection agents, and they all have different ways of doing things.”
The best way to avoid dash six liability is to buy or foreclose on assets and not shares in a corporation. The liability does not follow the assets where the assets were sold for fair market value, according to Ted Zink, a bankruptcy partner with Chadbourne in New York. Zink said that when a bank forecloses on assets, it should also get the assets free from dash six liability.
Questions about whether liability attaches involve issues of both tax law and creditors’ rights. The IRS regulations give the government a claim against a corporation for taxes. When and against whom the government can pursue the claim is a question of law on creditors’ rights. The government is like any other creditor.
Sometimes shares in a corporation are sold but the parties make a “section 338(h)(10) election” to treat the transaction for tax purposes as if it was an asset sale. This does not shed the dash six liability.
A buyer who has no alternative but to purchase shares should get an indemnity from the seller for any dash six liability. It is customary for this indemnity to last for six months after the so-called limitations period for the IRS to bring claims for back taxes against the seller consolidated group. The statute of limitations against back tax assessments usually runs three years, but large corporations routinely extend the limitations period, and it is not unusual to find tax years still open for assessment for five or six years — sometimes longer.
The indemnity might not be very creditworthy. A buyer might ask for security. He might ask for a perfected lien on some of the seller’s assets. In theory, he might hold back part of the sales price, but this is impractical given the amount of time that would have to pass before the issue disappears.
It is hard during due diligence to assess the potential exposure. A buyer might take some comfort if the seller group has been losing money for several years because the odds are reduced that it owed any taxes. (On the other hand, the seller may have had more reason to cut corners.)
It is a good idea to close any share purchase transaction that is pushing up against the end of the seller group’s tax year before the year ends rather than let it slip into the first few days of the next year. A subsidiary is liable for the group taxes for the full tax year, even though it was included in the seller’s consolidated return only for the first few days of the year.
Dash six liability is not ordinarily a concern when buying a foreign company. For example, suppose the project company being sold was formed under Mexican law and is not included in the seller’s consolidated US tax return. The IRS would not have a claim against the project company for group taxes. Dash six liability only extends to corporations that were part of a US consolidated return.
There can be a benefit to buying shares in a bankruptcy proceeding. In such a proceeding, the bankruptcy court has the ability to determine whether the IRS has a claim against any of the bankrupt entities for taxes before letting the subsidiary go. The buyer would be wise to get the judge to address the issue of any outstanding tax claims. Once the issue of what taxes are owed is decided by the bankruptcy court, it cannot be reopened by the IRS. However, since only some entities in a consolidated group may be thrown into bankruptcy, unless the parent company that files the consolidated return were also part of the bankruptcy proceeding, dash six liability would not be foreclosed.
Buyers with no choice but to buy shares have considered asking the seller to convert a corporation into a “disregarded” limited liability company or partnership before the sale. This would spare the buyer from having to buy shares in a corporation. Whether this technique sheds the liability depends on the state law under which the conversion takes place. For example, the Delaware corporate statute that governs conversions of corporations into LLCs does not say explicitly that liabilities are inherited by the LLC, unlike the Delaware statute that governs mergers of one corporation into another, but careful corporate lawyers advise that one should assume the liabilities will be inherited.
Anyone buying an LLC or partnership interest should confirm during due diligence that the project company is not a converted corporation.
Another question asked periodically of tax counsel is whether a buyer of shares in a target corporation can limit his exposure by closing first on the share purchase and then stripping the assets from the target through an intercompany sale to one of the buyer’s other subsidiaries. The answer is this does limit the exposure, provided full value is paid and there is no deemed merger of the two subsidiaries. If the target then distributes the cash to the common parent, the IRS might be able to have the distribution clawed back if it were viewed as an unlawful or excessive dividend or a fraudulent transfer under the relevant state law. Some state laws limit the period of time that a distribution is at risk of being reversed.
by Keith Martin and Samuel R. Kwon, in Washington