Continuation Theory: Collecting Taxes Owed by Prior Business
If a business has or expects to have a significant debt, it may transfer its assets and/or operations to a new business entity to try to avoid the debt. There are a number of non-tax cases where the courts have addressed this. The courts generally apply a “continuation” theory in these cases which asks whether the subsequent business is a successor to the prior business. In Eriem Surgical, Inc. v. United States, No. 14-3540 (7th Cir. 2016), the court addressed this type of continuation theory in the context of unpaid taxes.
The Facts and Procedural History
The Eriem case involves a business that did not pay its taxes (“Business 1”). The individual owner in the case had owned 40% of Business 1. The individual’s wife formed a new business entity (“Business 2”) the day after the Business 1 went out of business. Business 2 then purchased the assets and inventory of Business 1. Business 2 took over the office space, hired the employees of, used the website and phone number for, and was in the same business as Business 1.
According to the IRS, Business 2 was a successor to Business 1. The IRS made this argument even though:
- Business 1 was owned by the husband and Business 2 was owned by his wife.
- The individual who owned Business 2 had only previously owned 40% of Business 1.
- Business 1 was not in exactly the same business as Business 2.
The IRS then levied on Business 2’s assets for the unpaid taxes owed by Business 1.
Business 2 brought a wrongful levy suit against the IRS.
The issue for the court was whether Business 2’s assets could be taken to satisfy Business 1’s tax liability. The trial court applied Illinois state law, which employs a multi-factor balancing standard to determine business successorship. In applying this standard, the trial court concluded that Business 2 was the successor of Business 1.
On appeal, the Seventh Circuit agreed with the trial court. It interpreted the prior Illinois law as saying that a complete change of ownership prevents a finding of successorship, not that complete identity of ownership is essential to successorship.
What Law Applies
Whether state or Federal law applies has been the subject of several prior cases. The Seventh Circuit summarized the cases as follows:
The Supreme Court has never decided whether state or federal law governs corporate successorship when the dispute concerns debts to the national government. One might infer from United States v. Kimbell Foods, Inc., 440 U.S. 715 (1979), that federal law controls but generally absorbs state law, unless it is hostile to national interests. But, a generation after Kimbell Foods, the Supreme Court noted a conflict among the circuits on the subject and postponed its resolution, in an opinion that did not cite Kimbell Foods. See United States v. Bestfoods, 524 U.S. 51, 63 n.9 (1998). The next year the Court held in Drye v. United States, 528 U.S. 49 (1999), that in tax cases state law determines the taxpayer’s rights in property that the IRS seeks to reach, while federal law determines which of those rights the IRS can collect on.
With respect to business succession, there are states where the law says that one business is not liable for the debts of another business absent an express agreement to assume the liability. Texas provides an example of this.
If Texas law had applied in Eriem, the IRS might not have prevailed using a continuation theory. It may have had to pursue the successor business using transferee liability or even by challenging the prior business using state or Federal fraudulent transfer laws. These options would be more difficult for the government than simply issuing an administrative levy on bank accounts or other assets as it did in this case.