By Caroline Rule
Journal of Tax Practice & Procedure
October – November 2015 Edition
So-called “Midco” transactions have been used by taxpayers who wish to sell appreciated property owned in a C Corporation while attempting to avoid the double tax inherent in causing a C Corporation to sell stock and then distribute the proceeds to shareholders. By selling the corporate stock to a Midco entity—i.e., an entity that has favorable tax attributes such as tax losses or tax credits—the parties hope to avoid a least one level of the double tax. Typically, the sellers and the Midco agree to split the resulting tax savings. Unfortunately, in many cases, the Midco’s tax attributes prove to be illusory or nonexistent, leaving the Midco with a large tax liability when it ultimately sells the property. Even more unfortunately, the Midco is often a shell corporation that distributes all of the money it receives from the transaction, leaving it insolvent when the tax bill arrives. When this happens, the IRS seeks to recover the unpaid tax from the seller of the corporate stock under transferee liability theories pursuant to Code Sec. 6901.
Code Sec. 6901 requires the IRS to prove that the selling shareholders are transferees of the Midco and that they would be liable for the tax under state law transferee liability principles. The IRS has had mixed success in this arena. Initially, courts largely sided with the taxpayers on the issue of whether the sell-ing shareholders were transferees, but the IRS has been more successful recently, although the transferee issue is not free from doubt in many cases. Most of the courts’ analyses have focused on whether the transferees are liable under state law fraudulent transfer statutes.1 This issue and, therefore, the selling shareholders’ liability for the Midco’s unpaid taxes, has turned in large part on whether the selling shareholder knew or should have known that the Midco would have a tax liability that it would not pay.
What Is a Midco Transaction?
When a C Corporation is for sale, the tax law creates a tension between the in-terests of the buyer and the seller. The buyer would like to buy the assets and not the stock of the C Corporation, so as to get a stepped-up basis in those assets and avoid or reduce tax on the sale of those assets. The seller would prefer to sell the stock of the corporation because income from an asset sale is often ordinary income and because the seller pays tax both on the asset sale and on the subsequent distribution of the proceeds from the corporation.
This issue and, therefore, the selling shareholders’ liability for the Midco’s unpaid taxes, has turned in large part on whether the selling shareholder knew or should have known that the Midco would have a tax liability that it would not pay.
A Midco transaction was a way of getting around this dichotomy. It was named after MidCoast Credit Corporation, which engineered many such transactions, most of which took place in the late 1990s and early 2000s. The basic Midco transaction—which was disallowed by the IRS as an “Intermediary Transaction Tax Shelter2 was a mechanism whereby corporate shareholders avoided the tax burden on an asset sale by selling a target corporation’s stock to an intermediary, the Midco, for slightly less than the price of an asset sale but more than the price of a stock sale. The Midco then sold the target’s assets to a buyer, who received a stepped-up basis in the assets. The Midco assumed the target’s tax liabilities and either offset those liabilities with tax losses or credits, or just failed to pay the tax liability, so that the IRS received only a single layer of tax. The Midco kept the difference between the asset sale price and the stock purchase price as its fee.
The key to the Midco transaction is that the Midco never intended to pay the tax on its sale of the assets because it had tax losses, tax credits or some other tax characteristic that would shield the gain from tax. Often the claimed tax losses arose from tax shelters that later were disallowed. In other cases, the Midco simply became insolvent and disappeared. In either case, the tax liability on the sale of the assets was not paid. In most instances, the Midco was a newly formed entity created solely for the purpose of facilitating the transaction, without other income or assets. Even if the IRS successfully assessed tax against the Midco, it usually had to look elsewhere for payment of the tax.
The IRS Has Successfully Used Code Sec. 6901 to Impose Transferee Liability on the Selling Shareholders
Transferee liability under Code Sec. 6901 is a means by which the IRS can collect a transferor’s existing tax liability from the transferee of money or property. In several cases, the IRS has successfully used Code Sec. 6901 to hold the shareholders of the corporation that sold stock or assets to the Midco liable for the Midco’s unpaid taxes. In most of these cases, the IRS was able to prove that the selling shareholders knew or should have known that the Midco to whom they sold the stock or assets was going to have a tax liability that it would not pay.3
The Second Circuit’s decision in Diebold Foundation, Inc.4 is a good example of when the shareholders of a sell-ing corporation will be liable for the Midco’s unpaid tax liability. In Diebold, the shareholders owned stock in a corporation that had approximately $319 million of highly appreciated assets. A sale of the assets would have resulted in approximately $81 million of tax at the corporate level. This meant that the value of the corporate stock was ap-proximately $238 million—i.e., $319 million minus the built-in tax of $81 million. Nevertheless, the shareholders, through an intermediary, located a buyer who offered $309 million for the stock because the buyer would not have to pay the full amount of the built-in tax. Immediately after the stock purchase, the buyer sold the Midco’s assets. The Midco paid no corporate tax on the sale because it became part of a consolidated group with the buyer, which had engaged in a “Son of BOSS” tax shelter and purportedly had significant losses.
Rejecting the tax shelter “losses,” the IRS asserted a tax deficiency against the Midco for the $81 million tax on its built-in gain and also asserted an accuracy-related penalty of around $16 million. The Midco, however, no longer had any assets; it did not contest the tax liability but paid none of it, leaving a huge unpaid tax liability. Unwilling to be left holding the bag, 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 under New York Trust law and that the other shareholder, a foundation together with its successor foundations, was a transferee, but it was not liable for the Midco’s unpaid tax liabilities under New York fraudulent conveyance law.
The IRS appealed the Tax Court’s rulings regarding the foundations. The Second Circuit ruled in favor of the IRS, holding that a successor foundation was liable for the target’s taxes under New York fraudulent conveyance law.
The Second Circuit focused on the issue of whether the selling shareholders knew or should have known of “the entire scheme” that rendered the sale transaction fraudulent, i.e., a conveyance without consideration that rendered the transferor insolvent. If so, under New York law, the stock sale would be recharacterized as an asset sale by the target corporation while it was still owned by the shareholders and a distribution of the proceeds of the sale to them for no consideration, which would consequently be fraudulent and voidable by a third-party creditor, i.e., the IRS. The court ruled that the series of transfers could be collapsed because the shareholders should have known that the buyer was going to engage in improper tax avoidance.
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.5 The court noted the Tax Court’s finding that the taxpayers knew the Midco transaction was a listed transaction.
The Second Circuit also cited to the original sale agreement, which set the price for the target’s stock at the fair market value of its assets, less 4.25 percent of the difference between that value and the assets’ tax basis, indicating that the taxable gain to be avoided was an essential component of the purchase price. The sellers also knew that the buyer was a new corporation formed solely for the purpose of the stock sale. In addition, the buyer’s plan to sell the target’s assets was apparent to the sellers because it was mentioned in a draft purchase agreement. Finally, at the selling shareholders’ insistence, the sales agreement made it clear that the buyer would be liable for all taxes relating to the sale of the target’s assets. The court concluded that “considering their sophistication, their negotiations with multiple partners to structure the deal, their recognition of the fact that the amount of money they would ulti-mately 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.6
In Some Cases, the IRS Has Not Succeeded in Its Assertion of Transferee Liability
The IRS has been far from successful in asserting transferee liability in all Midco cases, however, even where the facts are similar to those described above. For example, in A.J. Starnes,7 the Fourth Circuit, applying Virginia law, upheld the Tax Court’s decision that the selling shareholders did not know, nor did they have reason to know, that the Midco would cause the target corporation to fail to pay its taxes. The court came to this conclusion even though the transaction was entered into after Notice 2001-16, the Midco’s offer to buy the target corporation was contingent on its holding only cash, the negotiations centered around the percentage of the amount of the target corporation’s taxes that the Midco would pay the former shareholders as a premium and the Midco ended up as “a defunct shell with no means to generate additional income.8
Taxpayers who were involved in Midco transactions, and taxpayers who may consider engaging in similar transactions designed to avoid taxes, should be aware that they may be held liable for the taxes of another entity in the transaction under Code Sec. 6901.
The decisive element in Starnes was the taxpayer’s lack of sophistication and the absence of evidence that they knew or should have known that the Midco would have a tax liability that it would not pay. The court relied on the fact that, although the selling shareholders had experience in a certain area of business, none of them had ever sold a business before and none had any education, training or experience in accounting, taxes or finance. None had education further than high-school. The Midco repre-sented to the selling shareholders that the target corpora-tion would not be dissolved or consolidated but instead would be “‘reengineered into the asset recovery business’ and become an ‘income producer’ for [the Midco] going forward,9 and “repeatedly represented that it would ensure that [the target corporation] would pay its … taxes.10 The shareholders’ belief that the deal was legitimate was, therefore, held to be reasonable. The Midco’s “professional-looking brochure” stated that it was a well-established business incorporated in 1958. The selling shareholder’s real-estate broker testified that nothing in the Midco’s proposals raised any concern with him, and their attorney told them the deal was legitimate.
Based on these facts, the court held that the selling shareholders’ belief that the deal was legitimate was reasonable, and that they learned what “any reasonably diligent inquiry would have disclosed to any similarly situated group of persons through their reliance on their advisor and agents.11 The Tax Court, therefore, did not commit clear error in finding that the IRS failed to prove that a reasonably diligent person in the former shareholders’ position would have learned that the transaction would result in the target corporation failing to pay its taxes. The Starnes court so held de-spite 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.
Taxpayers who were involved in Midco transactions, and taxpayers who may consider engaging in similar transac-tions designed to avoid taxes, should be aware that they may be held liable for the taxes of another entity in the transaction under Code Sec. 6901. A comparison of the Diebold and Starnes decisions shows that that courts will focus heavily on the sophistication of the selling taxpay-ers and what they knew or should have known about the possibility that there would be unpaid tax liabilities at the end of the day. If the taxpayers have any sense that the tax may not be paid, there is a good chance that they will end up footing the bill for that unpaid tax.