New Seller Due Diligence Responsibilities After the Midco Cases?

By:
Ellen S. Brody, CPA, JD, Esq. and Vivek A. Chandrasekhar, JD, Esq.
Published Date:
Jul 1, 2016

In the post-General Utilities world, shareholders have looked to dispose of their interest in C Corporations with appreciated assets in a way that would avoid the double taxation arising on a sale of assets followed by a liquidating distribution to the noncorporate shareholder. Enterprising parties came up with the so-called "Midco transactions," and promoters got busy looking for likely targets.

In the typical scenario, the promoter creates a middleman entity, "Midco," to facilitate the transaction. The selling shareholders sell the target corporation’s stock to Midco and recognize only one level of tax upon the sale. Midco then causes the target corporation to transfer its assets to the ultimate purchaser, who receives a stepped-up basis in the assets upon acquisition. The typical Midco entity has tax attributes, such as loss deductions, that it uses to minimize or eliminate the built-in gain on the asset sale at the corporate level.

If the purported tax attributes were valid, the form of the transaction should be respected. In many cases, however, the tax attributes did not exist or could not be used to offset the gain from the sale. Certain promoters would claim that they have bogus tax attributes and enter into these transactions only to immediately strip the cash and other assets out of the target corporation, leaving the IRS with no assets against which to collect tax. The Midco cases arose out of the IRS’s attempts to instead collect the tax from third parties.

IRS Notices and Transferee Liability                                          

To counteract Midco transactions, the IRS first issued Notice 2001-16, 2001-9 I.R.B. 730, 2001-1 C.B. 730 in January 2006, in which it "alert[ed] taxpayers and their representatives of certain responsibilities that may arise from participation in [Midco] transactions" and identified Midco transactions as listed transactions under Treasury Regulation section 1.6011-4T(b)(2). Following this original notice, the IRS has issued additional guidance, including factors to consider when determining whether a Midco transaction will be respected—see, for example, Notice 2008-111, 2008-51 I.R.B. 1299 and C.C.N. CC-2001-023. The IRS made clear that it may seek to collect the tax owed by the target corporation from the selling shareholders of the target corporation on a transferee liability theory.

The IRS uses IRC section 6901 to collect tax from a third party—such as the selling shareholder—by asserting that the third party is the transferee of the taxpayer. IRC section 6901 allows the IRS to assess and collect a liability from the taxpayer's transferee in the same manner and subject to the same provisions and limitations as it would have against the transferor taxpayer. The IRS must prove that the selling shareholder qualifies as a transferee, and must do so under a two-part test, as explained in Diebold Foundation, Inc. v. Commissioner. First, it must establish that the party is a transferee of the taxpayer. Second, under Commissioner v. Stern, it must establish that the party has a substantive liability under law or equity. The first prong is satisfied under IRC section 6901 and federal law, while the second prong is generally decided under state law or state equity principles.

The source of substantive liability in Midco cases is found in the applicable state creditor protection laws. Many states have adopted a version of the Uniform Fraudulent Transfer Acts (UFTA), which provides rules allowing creditors to reach the assets transferred by a debtor to avoid the assets' use in satisfaction of the debt. These rules allow transfers to be voided in case of actual fraud or constructive fraud. While the criteria for determining fraud varies by state, the criteria for determining the existence of fraud almost always look to (1) whether property was transferred to the transferee either without consideration or for inadequate consideration and (2) whether the transfer occurred while the transferor was insolvent or the transfer resulted in the transferee being left with insufficient assets to satisfy the tax liability.

The IRS often seeks to recharacterize Midco transactions as an asset sale by the target corporation followed by a liquidating distribution to the selling shareholder. This is because if the form of the transaction is respected, the selling shareholder is not actually a transferee of the target corporation. In keeping with the two-prong test described above, the IRS must recharacterize the transaction twice: once under federal law, which generally looks to substance-over-form principles, and then again under the applicable UFTA, which generally looks to actual or constructive shareholder knowledge of the transaction. See, for example, Frank Sawyer Trust of May 1992 v. Commissioner.

Recent Developments in Midco Case Law

Diebold v. Commissioner was the first case in which the IRS attempted to collect from the selling shareholders in a Midco transaction. While Diebold resulted in a shareholder victory, trends in numerous Tax Court and district court decisions following this case has seemed to favor the IRS. Three recent Midco decisions in the Tax Court, John M. Alterman Trust v. Commissioner, Slone v. Commissioner, and Estate of Marshall v. Commissioner present a nuanced picture of the selling taxpayer's chances of success. Alterman and Slone, in which the shareholders won, suggest that that the tide may be turning against the IRS; however, Estate of Marshall, a case in which egregious facts led to the Tax Court finding for the IRS, provides a reminder that the IRS can use transferee liability to collect from aggressive shareholders. As the Alterman court stated, "[E]ach [Midco] case stands on its own. Outcomes are determined by the facts of each specific case and what is established by the record."  

In Alterman, the corporation sold most of its assets to true third parties before selling stock to the Midco. The court had to determine if transferee liability – which would hold the selling shareholders’ liable for the unpaid taxes of the corporation – was appropriate. Using the two-prong analysis, the court found that the selling shareholders were transferees under IRC section 6901; however, it rejected the IRS’s attempts to establish substantive liability under Florida law.

The IRS’s failure to recharacterize the transaction as an asset sale followed by a liquidating distribution was due to its inability to prove that the selling shareholders had either actual or constructive knowledge of the Midco scheme. The Midco was so devious in hiding its plan that even the IRS admitted that the Altermans and their advisors did not have actual knowledge of the scheme. In order to establish constructive shareholder knowledge under the Florida UFTA, the IRS had to prove that either the shareholders could have discovered the truth through ordinary due diligence or that they actively avoided learning the truth.

The Alterman court rejected all of the IRS's attempts to prove constructive knowledge, noting that "[a] seller's main concern is whether the buyer will be able to close the deal," so there are little due diligence standards in place for selling shareholders. It applauded the shareholders for going above and beyond their due diligence duties to make sure that the corporate taxes would be paid. The Alterman shareholders had negotiated a share purchase agreement that required the Midco to agree to numerous covenants, representations, and warranties. There was no obvious reason why the shareholders couldn't rely on these covenants and restrictions. Thus, the court held that the selling shareholders and their advisors had performed adequate due diligence, refused to impose a requirement of post-closing monitoring, and found that it was not unreasonable for the selling shareholders and their advisors to believe that Midco's tax deferral plan sounded plausible. The court also pointed out that further inquiry would not have uncovered any improprieties, because Midco was deliberately misleading target corporations and was very good at covering its tracks.

Thus, the IRS was left to establish substantive liability based on the form of the transaction without being able to recharacterize it. The IRS raised four different theories under the Florida UFTA to hold the selling shareholders liable as transferees: (1) that there was constructive fraud; (2) that there was actual fraud; (3) that the shareholders were persons for whose benefit the transfers were made; and (4) that the shareholders were liable under a "transferee of a transferee" liability theory (under which Midco was a transferee of the corporation and the shareholders were transferees of Midco). The court found against the IRS on all four grounds: The IRS’s failure to recharacterize the transaction proved fatal.

One could argue that the taxpayers were successful in Alterman because the case was poorly litigated or because the taxpayers were incredibly sympathetic (two of them were terminally ill and the third had died by the time of the trial); however, Slone and Marshall suggest that Alterman should be read more broadly. The Slone court again found that there was no substantive liability under state law. Citing to Alterman, the Slone court determined that the selling shareholders did not have either actual knowledge or constructive knowledge sufficient to recharacterize the transaction. While the Slone shareholders did not seek out the warranties and covenants required by the Alterman shareholders, their inquiry into the purchaser's tax saving strategy—which was rejected as a request to disclose "proprietary" information—was deemed sufficient to satisfy any duty of future inquiry. In contrast, in Marshall, the taxpayers failed to conduct any due diligence, and had advisors who expressed concerns that the transaction at issue was similar to a listed transaction. Unsurprisingly, the Tax Court held for the IRS.

Alterman and Slone suggest that a shareholder may be able to avoid transferee liability resulting from a Midco transaction if the shareholder made inquiries, requested warranties and covenants, or otherwise sought to ensure that the purchaser would be responsible for any tax liability of the target corporation. The tax years at issue in those two cases, however, were well before the first Midco case was ever tried. It is much more difficult today for a tax practitioner to claim ignorance than it was back in 2003, when the Alterman transaction occurred. The Alterman court's point that a "seller's main concern is whether the buyer will be able to close the deal" may no longer be enough to plead ignorance of the purchaser's tax avoidance plan.

The extra steps taken by the Alterman and Slone shareholders may become a requirement for selling shareholders entering into a sale with an eye toward avoiding transferee liability. As such, the end result of over a decade of Midco litigation may be to increase the due diligence required by a stock seller prior to sale.


brodyEllen S. Brody, JD, CPA, is a partner at Roberts & Holland LLP. Ms. Brody can be reached at 212-903-8712 or ebrody@rhtax.com





vivek_ChandrasekharVivek Chandrasekhar, JD
, is an associate at Roberts & Holland LLP. Mr. Chandrasekhar can be reached at 212-903-8747 or vchandrasekhar@rhtax.com


 
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