In Tricarichi,1 the Tax Court held that the sole shareholder of a corporation was liable as a transferee for the corporation’s unpaid tax liability after he sold his stock in a “Midco” transaction, resulting in a tax deficiency of $15,186,570 and penalties of $6,012,777 under Section 6901 and Ohio fraudulent transfer laws.
The taxpayer was the sole shareholder of West Side Cellular, Inc. (West Side), a C corporation engaged in the cellular telephone business. West Side filed a complaint against certain major cellular service providers with the Public Utilities Commission of Ohio alleging anticompetitive trade practices. Ultimately, a settlement was reached pursuant to which West Side received total settlement proceeds of $65,050,141, in exchange for which West Side agreed to terminate its business as a retail provider of cell phone services and to end all service to its customers.
The taxpayer, who the court stated had no formal tax training but displayed great familiarity with tax concepts, realized that he had a “tax problem” relating to the double taxation of amounts received by C corporations. The taxpayer consulted with a tax lawyer at the firm which handled the lawsuit to “maximize whatever after-tax proceeds were available” from the anticipated settlement. The tax lawyer had prior experience with Midcoast Credit Corp. (Midco) and arranged for Midco representatives to meet with the taxpayer. In preparation for the meeting, the attorneys devoted five days of research and discussion to the “sham transaction” doctrine, “reportable transactions,” and Notice 2001-16.2 The court noted that their billing records described Notice 2001-16 as addressing (among other things) a transaction involving a “shareholder who wants to sell stock of a target” and “an intermediary corporation.” At the meeting, Midco representatives explained to the taxpayer that it was in the debt collection business and that, as part of its business model, it purchased companies that had large tax obligations.
The taxpayer was then introduced to a representative of Fortrend International, LLC, that used the same business model as Midco. Because the taxpayer regarded Midcoast and Fortrend as competitors, he began negotiating with both in hope of stirring up a bidding war. Rather than compete, however, Midco secretly agreed with Fortrend to step away from the transaction in exchange for a fee of $1.18 million.
In addition to the extensive discussions that the taxpayer had with his attorneys about Notice 2001-16 and the risks that the complicated stock sale would give rise to a reportable transaction, the taxpayer also retained PriceWaterhouseCoopers (PWC) to advise him about the proposed stock sale. Upon receipt of PWC’s draft engagement letter, the taxpayer deleted the following sentence contained in the engagement letter:
You agree to advise us if you determine that any matter covered by this Agreement is a reportable transaction that is required to be disclosed.
PWC ultimately concluded that “A position can be taken” that the stock sale would not be a reportable transaction. This was because “a typical Midco transaction has three parties (this transaction only has two), and a typical Midco transaction results in an asset basis step-up and the associated amortization deductions going forward (this transaction does not have these characteristics).” This was an atypical Midco transaction in that it did not involve a sale of assets to a third party by the C corporation, but rather involved receipt of settlement proceeds by the C corporation to essentially terminate its business.
The PWC memorandum also concluded that the proposed transaction was not without risk. It noted a particularly high level of risk in the “high basis/low value” debt receivable strategy that the buyer proposed to use to eliminate West Side’s tax liabilities. In fact, PWC characterized this as a “very aggressive tax-motivated strategy” and indicated that the IRS would likely challenge the deductibility of the bad debt loss expected to be reported by West Side after the stock sale. Regardless, the PWC memorandum suggested that “this is not … taxpayer’s concern” since the result would be a corporate tax liability and not taxpayer’s liability. The memorandum expressly noted that PWC had provided no formal written advice to the taxpayer but it discussed its conclusions orally with him.
The Tax Court went into a discussion of the typical “Midco transaction.” Midco transactions were widely promoted in the late 1990s and early 2000s by both Midcoast and Fortrend. These transactions were chiefly promoted to shareholders of closely held C corporations that had large built-in gains. Promoters of Midco transactions offered a purported solution to the double taxation problem facing C corporations on the sale of their assets to a third party. An “intermediary company” affiliated with the promoter (usually a shell company organized offshore) would buy the shares of the target company. The target company would then sell its assets to the third party as previously negotiated by the target company and its shareholders (or the target company would first sell its assets to a third party and then sell its stock to the intermediary company). The target company’s cash would transit through the “intermediary company” to the selling shareholders. After acquiring the target’s imbedded tax liability, the intermediary company would engage in a tax-motivated transaction that would purportedly offset the target’s realized gains and eliminate the corporate-level tax. The promoter and the target’s shareholder would agree to split the dollar value of the corporate tax avoided by the transaction. The promoter would keep as its fee a negotiated percentage of the avoided corporate tax, and the target shareholders would keep the balance of the avoided corporate tax as a premium above the target’s true net asset value (value of assets less accrued tax liability).
In Notice 2001-16 the IRS listed Midco transactions as “reportable transactions” for federal income tax purposes. In due course, the IRS would audit the Midco transaction, disallow the fictional losses, and assess the corporate-level tax. However, in most instances, the intermediary corporation was a newly formed entity (usually an offshore entity) created for the sole purpose of facilitating such transaction, without other income or other assets and therefore usually judgment-proof. The IRS would then be forced to seek payment from the shareholders of the target corporation under a transferee liability argument.
The court stated that in a nutshell, the taxpayer engaged in a Midco transaction with a Fortrend shell company, the shell company merged into West Side and engaged in a sham transaction to eliminate West Side’s corporate tax, the IRS disallowed those fictional losses and assessed the corporate-level tax against West Side, but West Side, as planned all along, was judgment-proof. Accordingly, the IRS sought to collect West Side’s tax from petitioner as a transferee of West Side’s cash.
Under Section 6901, the IRS can assess tax liability against a taxpayer who is the “transferee of assets of a taxpayer who owes income tax.” While federal law provides the procedure for collecting tax liabilities from a transferee, state law answers the questions of whether the alleged transferee is substantively liable for the tax. Consequently, in order to impose tax liability on a transferee, a court must engage in a two-prong inquiry which is sometimes called the “Stern test.”3 The first prong asks whether the party is a transferee under Section 6901 and federal tax law. Under federal tax law, a transferee is defined as including a “donor, heir, legatee, devisee, [or] its distributee.”4 Reg. 301.6901-1(b) further defines the term “transferee” to include “the shareholder of a dissolved corporation.”
The second prong of the Stern test asks whether the party is substantively liable for the transferor’s unpaid taxes under state law. The test for the second prong depends on the law of the state where the transfer occurred, but typically requires a showing that the transferee had actual or constructive knowledge of the entire scheme that renders its exchange with the debtor fraudulent, which allows a transaction to be recharacterized under state law. In this case, the substantive state law was Ohio’s version of the Uniform Fraudulent Transfer Act of 1984.
In an exhaustive analysis, the Tax Court had no problem finding that the taxpayer was a transferee within the meaning of Section 6901, citing the form over substance doctrine and the Ninth Circuit’s recent decision in Slone.5 The Tax Court then found that the taxpayer had substantive liability under the Ohio Uniform Fraudulent Transfer Act, noting that loans involved in the transaction were “sham loans,” and that there was a “defacto liquidation” of West Side. Specifically, the court found that:
- (1) The IRS’s claim arose before the transfer of the stock.
- (2) The transferor did not receive a reasonably equivalent value in exchange for the transfer.
- (3) The transferor became insolvent as a result of the transfer.
The court went into an extensive discussion of “constructive knowledge” or “inquiry knowledge” that taxpayer had with respect to Fortrend’s plan to avoid West Side’s income taxes. The court noted that neither the taxpayer nor his advisors performed any due diligence into Fortrend or its track record. Additionally, neither the taxpayer nor his advisors performed any meaningful investigation into the high basis/low value scheme that Fortrend suggested for eliminating West Side’s accrued 2003 tax liabilities. The court stated that the taxpayer and his advisors were clearly suspicious about Fortrend’s scheme, but rather than digging deeper, they engaged in “willful blindness and actively avoided learning the truth.”
The court stated that the petitioner and his advisors knew that the transaction that Fortrend was proposing was likely a “reportable” or “listed” transaction. As discussed above, the taxpayer’s lawyers spent several days researching Notice 2001-16, “reportable transactions,” “sham transactions,” and transactions involving an “intermediary corporation.” The court also noted that PWC insisted including in its engagement letter a requirement that the taxpayer advise it of any matter covered by the agreement that is a reportable transaction which the taxpayer intentionally deleted from the engagement letter. The Tax Court also found it significant that PWC advised petitioner only orally that “a position can be taken” that the proposed stock sale would not be a reportable transaction. The Tax Court stated that in “tax-speak,” this translated into a low level of confidence on PWC’s part.
The taxpayer’s lawyers also had attempted to include in the stock purchase agreement a provision prohibiting West Side from engaging in a “listed transaction” after Fortrend acquired West Side, but Fortrend refused to agree to include this provision in the stock purchase agreement. The court stated that any reasonably diligent person would infer from this refusal that a “listed transaction” was very likely what Fortrend, a tax shelter promoter, had in mind.
The Tax Court also noted that numerous other features of Fortrend’s proposal raised red flags that demanded further inquiry. Fortrend offered to pay the taxpayer $11.2 million more than the net book value of West Side, representing a premium of 47%, while insisting that West Side’s assets be reduced to cash. The court noted that the taxpayer was a sophisticated entrepreneur who had built a company and knew how to value a business. It should have provoked tremendous skepticism after the taxpayer discovered that Fortrend was willing to pay a 47% premium to acquire cash, which by definition cannot be worth more than its face value.
The “icing on the cake” according to the Tax Court was the manner in which the purchase price was determined. The numerous spreadsheets prepared in negotiating the purchase price explicitly stated that the purchase price would equal West Side’s closing cash balance plus 68.125% of its accrued tax liabilities. The Tax Court stated that a sophisticated businessman like the taxpayer should have been curious as to why the purchase price for his company was being computed as a percentage of its tax liabilities, and why this was the only number that Fortrend seemed to care about.
Finally, the court stated that although the taxpayer’s lawyers insisted that West Side be kept in formal existence for several years, its notational existence was simply a charade designed to create a defense to the precise argument that the IRS is advancing in the case, an argument that the taxpayer and his attorneys knew the IRS would advance if this Midco transaction came to its attention. Amusingly, the Tax Court stated that “it [West Side] continued as a Potemkin village to deceive the IRS, just as the original was designed to fool Catherine the Great.”
The Tax Court concluded that the taxpayer was liable under Ohio law for the full amount of West Side’s 2003 tax deficiency and the penalties and interest in connection therewith (over $21 million), and that the IRS could collect this aggregate liability from the taxpayer as a transferee under Section 6901.
The Tricarichi case is the most recent case in a continuing battle between the IRS and taxpayers in Midco transactions.6 Although these cases have produced mixed results, with the outcome generally depending on the particular facts and circumstances of each case and variations of state law,7 taxpayers should be very wary of Midco-type transactions.
6 See Feldman, 115 AFTR 2d 2015-896 779 F3d 448 2015-1 USTC ¶50210 (CA-7, 2015) aff’g TC Memo 2011-297 RIA TC Memo ¶2011-297 102 CCH TCM 612 , discussed in Klein and Looney, “Transferee Liability Imposed on Former Shareholders,” 17 BET 27 (September/October 2015); Shockley, TC Memo 2015-113 RIA TC Memo ¶2015-113 109 CCH TCM 1579 , discussed in Klein and Looney, “Shareholders Liable as Transferees in Midco Transaction,” 17 BET 34 (September/October 2015); and Slone, id., discussed in Klein and Looney, “Ninth Circuit Remands Case for Determination of Transferee Liability,” 17 BET 38 (September/October 2015).
7 See e.g., Starnes, 109 AFTR 2d 2012-2326 680 F3d 417 2012-1 USTC ¶50380 (CA-4, 2012), where the Fourth Circuit refused to apply transferee liability to shareholders who sold their stock in a Midco transaction.
About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at firstname.lastname@example.org.