Bernadette’s Lament: The Implications of Changes in Control

Artisan Spirit Summer 2018As originally published in Artisan Spirit – Summer 2018

Picture this.  Bernadette has received a permit for her DSP and has begun production.  She’s making a great product that is well received in the market place.  Her grain-to-glass, artisanal, heirloom variety organically-grown freekeh-based whiskey (just go with it) has won a few awards and she’s even starting to get distribution in far-flung locations both inside and outside the United States.  The recent reduction in federal excise tax (FET) has taken some of the pressure off  her operation, but since she’s no fool (and she reads the pages of this fine magazine) she knows that relief could be short-lived.  So, she’s using that relief to invest in her business and lay the groundwork for success if the FET reduction isn’t renewed (or, hopefully, made permanent).  In short, things are going really well.

In fact, they’re going so well that Bernadette decides now is a good time to bring in some new capital.  She talks with a potential investor (and her securities lawyer!) and ends up raising quite a bit of money.  Her ownership stake in the company decreases, but by her estimation it is better to have a smaller slice of a big pie than all of a small one.

And now things are going really well.  The business is firing on all cylinders, and even though Bernadette now owns less than a majority stake she’s seeing the value of her interest surge ahead.  Plus, she was smart about the terms of her offering so she gets to continue to control her destiny and her new investor can’t push her out without a fight.  Things are good.

Fast forward a few years or so.  Bernadette receives notice that her business is subject to a routine audit by the TTB.  “Not a big deal,” she tells herself, as she’s hired good people and is confident that the business’ records are accurate and it has been paying its taxes.  The auditor comes and goes — and then the bottom falls out.

The result of the audit is word that the business’ basic permit automatically terminated months ago.  As a result, Bernadette’s friends at the TTB believe the company owes many thousands of dollars in back taxes, as well as some pretty substantial fines.  And while he doesn’t yet know about the problem, her investor friend is going to be pretty steamed when he finds out.

This cautionary tale is all too real.  And every year a few folks find out the hard way that it isn’t enough to get square with the TTB at the outset, you need to stay vigilant and monitor any changes in your business that might require you to take action.

In our dream-turned-nightmare scenario above, the failure was in not notifying the TTB that a change in control had occurred.  And, unfortunately for Bernadette, there really isn’t much she can do about it now.

Several relevant provisions of federal law bear on this — but the most troubling for Bernadette is found in 27 U.S.C. §204(g), which provides as follows:

A basic permit shall continue in effect until suspended, revoked, or annulled as provided herein, or voluntarily surrendered; except that (1) if leased, sold, or otherwise voluntarily transferred, the permit shall be automatically terminated thereupon, and (2) if transferred by operation of law or if actual legal control of the permittee is acquired, directly or indirectly, whether by stock-ownership or in any other manner, by any person, then such permit shall be automatically terminated at the expiration of thirty days thereafter; Provided, That if within such thirty-day period application for a new basic permit is made by the transferee or permittee, respectively, then the outstanding basic permit shall continue in effect until such application is finally acted on by the Secretary of the Treasury.

Let’s unpack this provision for a moment and strip out the legalese.  In sum, it means basically two things for Bernadette: First, her business wasn’t allowed to sell its permit.  Second, her business wasn’t allowed to bring in meaningful investment without reapplying for that same permit.

“But wait,” you say — “she didn’t sell her permit, she just brought in a new investor!”  And you’re technically correct.  She didn’t actually sell the permit (or even try to sell it).  But from the TTB’s perspective, it doesn’t really matter.  The statute treats a sale of control of the DSP as if it is a sale of the permit itself.  So, when someone new acquires a controlling position in an existing DSP it is the same as if someone had purchased the entire business.  We know from our hypothetical that Bernadette went from 100% ownership of her business to something less than 50% — so she clearly sold a controlling stake.  And when she closed on that transaction and brought in her new investor, Bernadette’s business had 30 days from the date of that sale to submit an application for a new permit (and had the privilege of being able to continue operating during the pendency of the application).

But of course she didn’t do that.  So what does that mean?

Unfortunately for our heroine, the termination of her DSPs basic permit resulted in some fairly draconian consequences.  The first and most obvious of these is that Bernadette’s business lost its ability to legally make her hooch.  Distillation of spirits in the United States without a valid permit is flatly illegal and if Bernadette’s business continues distilling now that it knows its permit has been terminated, then the business (and Bernadette herself) could be subject to civil and criminal prosecution.

Second, the letter from the TTB informed Bernadette that her business owed many thousands of dollars in taxes.  This confuses our heroine, as she has good records suggesting that she paid all taxes owed throughout the time that — as it turns out — her permit was invalid.  Here’s the rub: Bernadette’s hooch had been so well received that she was starting to export it to markets outside the United States.  And because Bernadette’s no fool, she knew that her business was entitled to withdraw from bond tax-free any spirits that were being exported.  But, unfortunately, that entitlement only applied when Bernadette’s business had its permit in place.  Which means Bernadette’s business now owes federal excise tax on all spirits that it exported while operating without a permit.

Perhaps even worse, Bernadette’s business may owe $10.80 per proof gallon for all spirits removed from bond but not exported during the period.  That $10.80 is the difference between the FET imposed on spirits generally and the temporary FET reduction that went into effect on January 1, 2018.  It “may” owe that amount because there is some ambiguity in the language of the statute that reduced the FET for small distillers.  Certainly some commentators have suggested (and the TTB may claim) that the reduction is only available for so long as the taxpayer has a valid permit in place.  But a technical reading of the language also suggests that the reduction in FET might be in place regardless of whether the permit has expired.  So, again, there is ambiguity that might work in Bernadette’s favor.

But of course the deck is stacked against Bernadette.  If she wants to dispute the amount of the tax owed, she has essentially the same choices that she might have in connection with any other federal tax case.  She can choose to pay the assessment and then sue for a refund in either a federal District Court or the U.S. Court of Federal Claims.  Alternatively, she might choose to litigate the matter in the U.S. Tax Court — an avenue which does not require her to first pay the tax.

But none of these options allow Bernadette to address the real crux of her dilemma — the question of whether she should be able to obtain relief from the termination of the business’ basic permit.  In fact, the recent case of Gulf Coast Mar. Supply, Inc. v. United States, 218 F.Supp.3d 92 (D.D.C. 2016), addressed this particular problem.

In Gulf Coast, the plaintiff business was engaged in the sale of alcohol and tobacco to commercial ships for consumption outside the United States.  Just like Bernadette, Gulf Coast did not pay excise tax on these products since they were being exported.  And also like Bernadette, Gulf Coast experienced a change in control without recognizing the impact of that event on its basic permit.  After the TTB’s assessment (a cool $7 million and change in FET for the tobacco alone!), Gulf Coast sued in Federal District Court alleging, among other things, that it hadn’t been afforded due process with respect to the termination of its permits.

Gulf Coast lost that argument — both at the trial court and on subsequent appeal — because of the basic fact that the termination of its permit was not an action that was taken by the TTB.  If it had been necessary for the TTB to take some form of action to terminate Gulf Coast’s permit, it might have won its case.  But, in fact, the TTB didn’t need to do anything to terminate Gulf Coast’s permit.  The termination is automatic — spelled out right in the statute quoted above — and happens without the TTB taking any action whatsoever.  Put simply, that lack of any action by the TTB (or any other federal authority) means that federal courts don’t have the necessary subject matter jurisdiction to decide a case relating to the termination of the permit.  Basically, those courts don’t have the authority to decide the case.  That meant no relief for Gulf Coast — and the same goes for Bernadette.

So, what is our intrepid protagonist’s best course of action?  Well, Bernadette can cause her DSP to apply for a new permit.  But if she does, there is unfortunately no guaranty that a permit will be issued.  The permit application requires disclosure of whether the applicant or any of its controlling individuals (e.g., Bernadette) has ever had a permit denied, revoked or terminated.  Put another way, the TTB will look at the termination of Bernadette’s prior permit as a strike against the granting of a permit to the business as now constituted.

This is not to say that Bernadette’s new permit will be denied.  In fact, if she’s been living a clean life, has not previously experienced any particular unpleasantness with the agency and engages in a certain amount of groveling, she may be able to get a new permit in place relatively quickly.  But she can’t continue operating the business while she waits for the new one.

Of course, Bernadette has at least two more constituencies that she should be thinking about.  First, if maintenance of TTB permits was a required component of compliance with her state’s liquor laws (as is the case in many states) then Bernadette and her counsel need to do some quick thinking about how to handle the state licensing issue.  It is possible that her state doesn’t yet know that her TTB permit terminated.  And so Bernadette may be tempted to let sleeping dogs lie and not alert her state authorities of her plight.  That is probably a mistake — this particular sleeping dog is likely to awaken and bite her.

It is quite likely that the same transaction that was a change in control for purposes of Bernadette’s TTB permit was also a change in control for purposes of her state’s regulations.  That means her business’ state license, permit or other authorization may have already terminated as well — or at a minimum she may be in violation of its requirements.

Also, just as Bernadette’s parents may have suggested years ago that coming forward to self-report youthful indiscretions is likely to be looked on with favor and result in reduced discipline, federal and state authorities also value and encourage self-reporting.  If Bernadette comes clean now with her friends at her local liquor authority, that could go a long way toward reducing any sanctions they may want to impose if her business has been operating without a valid state permit since the change in control, and may also help assuage any concerns they might have about allowing her to restart operations once her TTB situation is resolved.

In terms of her second constituency, Bernadette will need to think seriously about what she should say to her new investor.  She doesn’t necessarily have a legal obligation to update him on these developments if she isn’t asking him for additional capital or to make decisions (e.g., voting on annual director elections for the business).  But even if she doesn’t have a duty to tell him, principles of good corporate governance and stewardship would suggest that she needs to let him know.

Of course, all of this could have been avoided if Bernadette had simply remembered that when something significant happens in the life of a DSP, the DSP needs to look carefully at that occurrence and consider what, if anything, needs to be done in order to maintain compliance.  What’s that old saying about an ounce of prevention?


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