United States: MIDCO Transactions And The Expanding Universe Of Transferee Liability*

The Internal Revenue Service's determination of transferee liability, essentially secondary liability, resulting from transactions involving the taxable sale and disposition of corporate stock, is being litigated with increasing frequency in the federal courts. The outcome of these disputes varies as they are highly fact determinative. Thus, not surprisingly, Taxpayers have experienced mixed results in court. Although there are lower courts that have held in favor of the putative transferee, selling shareholders, three recent Tax Court decisions have been reversed on appeal.1 In fact, to date only one taxpayer victory has been affirmed on appeal.2 The IRS's recent successes have emboldened it to utilize transferee liability more frequently as a tax collection mechanism, most notably against corporate shareholders who engaged in so-called Midco or middle-company transactions,3 primarily during the late 1990s to early 2000s. Generally, a Midco transaction is one in which the seller engages in a stock sale (thus avoiding the triggering of built-in gain in appreciated assets) while the buyer engages in an asset purchase (thus allowing a purchase price basis in the assets), through use of an intermediary company. Taxpayers involved in these Midco transactions, and taxpayers who may be contemplating transactions that could be construed as Midcos, should be cognizant of their potential exposure as transferees under Code section 6901. They could potentially be subject to liability for their counterparty's unpaid taxes, interest and potential penalties related to the disposition of the property. Generally, the salient issue in these Midco transferee cases is whether the selling shareholder knew or should have known that the Midco intermediary would incur a tax liability that it could not and would not pay and thus would not be collected.

Section 6901 - Transferee Liability Cases Involving Midcos

The leading transferee liability case in New York involving a Midco transaction is the Second Circuit's decision in Diebold Foundation, Inc.4 Diebold involved Double D Inc. ("Double D"), a New York C corporation with two shareholders: the Dorothy R. Diebold Marital Trust and the Diebold Foundation, Inc. Double D was a holding company containing substantially appreciated assets of $319 million, which consisted of $291.4 million of publicly traded securities.5 The shareholders agreed to sell all of the Double D stock to Shap Acquisition Corp. II ("Shap II"), a newly formed corporation created by Sentinel Advisors for $309 million, which was funded through a bank loan. Immediately afterwards, Shap II sold the securities to Morgan Stanley and repaid the Rabobank loan, netting a $10 million profit.6

Shap II reported all of the gain from the asset sales with Double D, but the gain was entirely offset by losses (from a Son-of-BOSS tax shelter), resulting in no net tax liability.7

The IRS issued a notice of deficiency against Double D for the $81 million tax on its built-in gain and also asserted an accuracy-related penalty based on a determination that the shareholders' sale of Double D stock was in substance an asset sale followed by a liquidating distribution.8 But Double D had been dissolved and its assets were gone. Double D did not contest the tax liability, but the Service was unable to collect the tax. Deciding that any additional efforts to collect from Double D would be futile, the Commissioner then proceeded against the former shareholders as transferees under Section 6901. The IRS pursued the selling shareholders in Tax Court. The Tax Court held that one of the shareholders, a marital trust, was not a transferee of the Midco but that the other shareholder, a foundation and its successor foundations, was a transferee. However, the Tax Court concluded that the foundations were not liable for the unpaid tax liabilities under New York's fraudulent conveyance law because Double D Ranch representatives' level of awareness about Shap II's plan to engage in some sort of tax strategy did not require the representatives to make further inquiry into the circumstances of the transaction.9 The Tax Court concluded that Diebold's facts closely resembled the facts in Starnes10 and Frank Sawyer Trust11 —both cases where the Tax Court decided not to collapse various transactions under the uniform fraudulent conveyance statute.12

On appeal, the IRS acknowledged that it may assess transferee liability under Section 6901 against a party only if two independent prongs are met: (1) the party must be a transferee under Section 6901, and (2) the party must be subject to liability at law or in equity.13 As to the first prong of Section 6901, the court must look to federal tax law to determine whether the party in question is a transferee.14 The Service argued that the two questions were not independent—that the court must first make a determination as to whether the party in question is a transferee, looking to the federal tax law doctrine of "substance over form" to re- characterize the transaction.15

The Second Circuit rejected the IRS's argument that transferee liability should be determined by applying the "substance over form" doctrine to re-characterize the transaction and then assessing liability with respect to the re-characterized transaction.16 Instead, the court adopted a two-prong framework followed by the First Circuit in Frank Sawyer17 and the Fourth Circuit in Starnes18 that determines: (1) whether the taxpayer is a transferee under Section 6901, and (2) whether the taxpayer is liable under state law due to a fraudulent transfer.19

The Second Circuit looked to the New York Uniform Fraudulent Conveyance Act (NYUFCA) to determine whether the shareholders knew or should have known of "the entire scheme" that rendered the sale transaction fraudulent—a conveyance without consideration that rendered the transferor insolvent.20 The court held that the shareholders should have inquired further into the supposed tax attributes that allegedly would have allowed Shap II to absorb the tax liability on the appreciated assets.21 Accordingly, the court concluded that Double D's shareholders evinced "constructive knowledge" because the facts "plainly demonstrate that the parties 'should have known' that this was a fraudulent scheme, designed to let both the buyer of the assets and the seller of the stock avoid the tax liability inherent in a C Corp holding appreciated assets and leave the former shell of the corporation, now held by a Midco, without assets to satisfy the liability."22 The Diebold court relied primarily on the fact that "[t]he parties to this transaction were extremely sophisticated actors, deploying a stable of tax attorneys from two different firms in order to limit their tax liabilities."23 The Second Circuit listed a number of other facts:

  • The shareholders recognized a significant tax "problem" inherent in the appreciated assets;
  • The shareholders actively sought a tax solution—seeking out parties that could avoid the inherent tax liability;
  • The shareholders viewed presentations from three different firms that purported to deal with the tax liability problem;
  • The shareholders' advisors knew that Shap II borrowed funds to purchase the stock and intended to sell its assets immediately after closing to repay the loan; and
  • The shareholders knew that Shap II was a newly formed entity.

The Second Circuit also cited to the purchase agreement, where the buyer's plan to sell the target's assets was apparent to the sellers because it was mentioned in the draft purchase agreement.24 The court concluded that "[c]onsidering their sophistication, their negotiations with multiple partners to structure the deal, their recognition of the fact that the amount of money they would ultimately receive for an asset or stock sale would be reduced based on the need to pay the C Corp. tax liability, and the huge amount of money involved, among other things, it is obvious that the parties knew, or at least should have known but for active avoidance that the entire scheme was fraudulent and would have left the target corporation unable to pay its tax liability."25

Upon determining that the shareholders had constructive knowledge, the court collapsed the sale and post-sale transactions, applying New York law, and concluded that Double D made a fraudulent conveyance. The case was remanded to the Tax Court to consider, among other questions, whether the foundation was a transferee under Section 6901. Briefs have been submitted to the Tax Court, but the matter remains undecided since remand from the Second Circuit.

The Fourth Circuit Rules for Taxpayer Starnes

In Starnes v. Commissioner26 the Fourth Circuit, faced with facts similar to Diebold, applied North Carolina law and upheld the Tax Court's decision that the selling shareholders were not liable as transferees because they did not know, nor did they have reason to know, that the Midco would cause the target corporation to fail to pay its taxes.27 The Starnes transaction was entered into after issuance of Notice 2001-16, but that fact did not appear to influence the court's decision.28

In Starnes, the shareholders had worked at the trucking company they owned (Tarcon, Inc.) for over forty years. In 2003, the shareholders decided to retire and liquidate their interests. At that point, Tarcon had ceased its business operations, and its sole remaining non-cash asset was an industrial warehouse that it leased to others.29 After considering various options and consulting with their real estate broker, accountant and attorneys, the shareholders sold Tarcon's only asset, a warehouse, to one company, ProLogis, Inc., which left Tarcon with only cash. The shareholders then sold their Tarcon stock to another company, MidCoast Investments. MidCoast was introduced to the shareholders through a commercial real estate broker. MidCoast represented that it was in the "asset recovery business." MidCoast met with the shareholders and contractually agreed to operate Tarcon as a going concern; MidCoast would not dissolve, liquidate or merge into another company; MidCoast would cause Tarcon to file all tax returns related to the federal and state income taxes owed by the company from selling the warehouse on a timely basis, and MidCoast represented that Tarcon's tax liabilities would be satisfied.30 The shareholders made no inquiries and did not understand what was meant by the "asset recovery business," but they had no reason to believe MidCoast would not honor these commitments. The parties agreed that the price of the stock would be $2.6 million, equal to the amount of Tarcon's cash ($3.1 million) less 56.25 percent of Tarcon's $880,000 income tax liability.31

According to the stock purchase agreement, Tarcon's $3.1 million was supposed to be transferred into Tarcon's "post-closing" bank account, but that did not occur. A few days after the closing and without prior notice to the former shareholders, MidCoast sold its Tarcon stock to Sequoia Capital, a Bermuda company, for $2.9 million and transferred the cash to an account in the Cook Islands in the name of Delta Trading Partners.32 Tarcon filed its 2003 federal tax return, but never paid its taxes, claiming large offsetting losses for certain transactions that occurred after MidCoast acquired Tarcon. The IRS audited Tarcon and disallowed and assessed Tarcon with a deficiency of $1.5 million including penalties and interest, which Tarcon did not pay. Looking for a pocket to pick, the IRS sent notices of transferee liability to Tarcon's former shareholders under the theory that the transaction was substantially similar to an intermediary transaction (a Midco tax shelter) and was, in substance, a sale of Tarcon assets followed by a distribution of the proceeds to its shareholders. The IRS asserted the former shareholders were liable as transferees under Section 6901. The former shareholders filed petitions in the Tax Court contesting the notices of transferee liability. The Tax Court ruled in favor of the former shareholders, finding that the IRS had failed to carry its burden of proof.33 The IRS appealed that decision in the US Court of Appeals for the Fourth Circuit.

The Fourth Circuit addressed and rejected the Service's various claims for transferee liability under state law, specifically under North Carolina's version of the Uniform Fraudulent Transfer Act (the "NCUFTA") and North Carolina common law. With respect to the arguments advanced by the IRS under the NCUFTA, the threshold question for the court was "what transfer or combination of transfers should be considered to determine whether Tarcon received reasonably equivalent value and/or was rendered insolvent?"34 The IRS argued that the sale and post-sale transactions, which would include MidCoast's transfer of cash to the Cook Islands, should be "collapsed."35 But the court refused to collapse the transactions because it found the IRS failed to prove that the former shareholders had the requisite knowledge to impose transferee liability under North Carolina law.36 The test applied by the court was whether the former shareholders knew or should have known that Tarcon would fail to pay its taxes under its new owner.37

The Service argued that the Tax Court's findings were clearly erroneous and that the shareholders "knew or should have known" that MidCoast had tax avoidance intentions because "MidCoast's promotional materials stated that it targeted corporations that had only cash and offered shareholders a way to minimize their tax burden" and that 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."38 In further support of its position, the Service argued that the shareholders' inquiry was not reasonably diligent based on the fact that one shareholder acknowledged that paying cash for a corporation that held only cash "did sound strange," and that another shareholder stated that he did not understand the deal and did not want to understand it.39 Even the shareholders' accountant questioned whether the sale was "2001-16 reportable."40 But the Circuit Court concluded that while this evidence supported the Service's position it did not persuade the court that the Tax Court's findings were clearly erroneous. The court noted the taxpayers' lack of sophistication and explained that although the selling shareholders had experience in the freight and warehousing business, none of the shareholders had ever sold a business before and "none had any education, training or experience in accounting, taxes or finance."41 In addition, MidCoast represented to the shareholders that Tarcon would not be "dissolved or consolidated," but rather Tarcon would be "'reengineered into the asset recovery business' and become an 'income producer' for MidCoast going forward."42 MidCoast "repeatedly represented that it would ensure that Tarcon would pay its . . . taxes,"43 and MidCoast had been in business since 1958, and represented that it had recently transitioned to asset recovery involving credit card debts. Notably, MidCoast's attorney testified that he had no reason to believe that MidCoast would not ensure that Tarcon's corporate taxes would be paid.44

Based on these facts, the court held that the Tax Court did not commit clear error in finding that the IRS was required but failed to prove that "no reasonably diligent person in the Former Shareholders' position would have failed to discover that MidCoast would cause Tarcon to fail to pay its 2003 taxes."45 The court also rejected an argument that the former shareholders were liable under North Carolina's "trust fund doctrine" because the IRS was unable to demonstrate the transaction amounted to a winding up or dissolution of the company.46

To read this article in full, please click here.


* The following article is an excerpt from a paper presented to The Tax Club on April 20, 2016 by Lawrence. M. Hill.

1 See Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2d Cir. 2013); Frank Sawyer Trust v. Commissioner, 712 F.3d 597 (1st Cir. 2013); Slone v. Commissioner, 778 F.3d 1049, modified 116 AFTR2d 2015-5962 (9th Cir. 2015).

2 See Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2013).

3 See Notice 2001-16.

4 Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2d Cir. 2013).

5 Id. at 176.

6 Id. at 181.

7 Id.

8 Id.

9 See Salus Mundi Foundation v. Commissioner, T.C. Memo 2012-61, *17 (103 T.C.M. (CCH) 1289).

10 See Starnes v. Commissioner, T.C. Memo 2011-63 (101 T.C.M. (CCH) 1283).

11 See Frank Sawyer Trust v. Commissioner, T.C. Memo 2011-298.

12 Salus Mundi Foundation v. Commissioner, T.C. Memo 2012-61, *18, affd 776 F.3d 1010 (9th Cir. 2014).

13 See Rowen v. Commissioner, 215 F.2d 641, 643 (2d Cir. 1954).

14 Id. at 644.

15 Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172, 184 (2d Cir. 2013).

16 Id.

17 See Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597 (1st Cir. 2013).

18 See Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012).

19 See also, Salus Mundi Foundation v. Commissioner, 776 F.3d. 1010 (9th Cir. 2014) The Ninth Circuit noted that although the IRS's argument was a plausible reading of Stern, three other circuits had rejected its position: Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2nd Cir. 2013), Frank Sawyer Trust v. Commissioner, 712 F. 3rd 597 (1st Cir. 2013) and Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012). The Ninth Circuit agreed with the 2nd, 1st and 4th Circuits that Stern is "best interpreted as establishing that the state law inquiry is independent of the federal law procedural inquiry."

20 Diebold, supra, at 187.

21 Id.

22 Id. at 189.

23 Id. at 188.

24 Id. at 179.

25 Id. at 188. The same facts were raised in Salus Mundi Foundation v. Commissioner, 776 F.3d 1010 (9th Cir. 2014). The Ninth Circuit therefore looked to the Second Circuit's decision. The Second Circuit had concluded that under substantive state law, the Double D shareholders had constructive knowledge of the tax avoidance scheme since (1) they knew an asset sale by the corporation would create a large tax liability from the built-in gain, (2) they had a sophisticated understanding of the structure of the transaction, and (3) they knew that Shap was formed to facilitate the transaction and did not have assets to meet its obligation to purchase the stock to sell to Morgan Stanley or to compensate Morgan Stanley if it could not meet its obligations. Since "absent a strong reason" the Ninth Circuit will not create a direct conflict with another circuit, and the Second Circuit addressed the same facts, issues and applicable law, the Ninth Circuit adopted the Second Circuit's reasoning and held that the shareholders had constructive knowledge. As in Diebold, the Ninth Circuit remanded the case to the Tax Court to determine Salus Mundi's status as a transferee of a transferee under federal law and whether the IRS asserted transferee liability within the statutory period.

26 Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012).

27 Id. at 439.

28 Id. at 435.

29 Id. at 423.

30 Id. at 421.

31 Id. at 423.

32 Id. at 424.

33 Id. at 425.

34 Id. at 431.

35 Id. at 429, 432, 437.

36 Id. at 437.

37 Id. at 439.

38 Id. at 435.

39 Id. at 422.

40 Id.

41 Id. at 436.

42 Id.

43 Id. at 422.

44 Id. at 421-422.

45 Id. at 434.

46 Id. at 438-439.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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