2013 - Issue 9—A Look at Transferee Liability Under Starnes
Should selling shareholders concern themselves with a buyer's intentions to pay the target corporation's taxes after it is sold? The IRS's assertion of transferee liability in the Fourth Circuit's Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012), involving a so-called "Midco" or "intermediary" transaction, as well as several similar cases on appeal from the Tax Court, gives cause for concern.
What Is a Midco Transaction?
A Midco transaction, which is a listed transaction, starts with a common problem: a target business with appreciated assets held by a corporation. A buyer cannot purchase the assets and obtain a step-up without triggering two layers of tax to the seller — first to the corporation on the sale of the assets, and then to the shareholders on the distribution of the proceeds. This is certainly unattractive to a seller, to whom a stock sale would make better sense.
To solve this, the parties find an intermediary or Midco that would be able to convey the target's assets to the buyer without incurring a tax liability. In its basic form, the seller sells the target stock to the Midco, which then sells the target's assets to the buyer. The idea is that the Midco is able to sell the target's assets without incurring tax because it has net operating losses or some other characteristics that would shield the gain from tax. The parties then split the resulting tax savings. A variation, like the one used in Starnes, may involve a first-step asset sale followed by a sale of the corporate stock, with the corporate shell containing nothing but cash and the tax liability from the asset sale. The buyer then shelters the gain by causing the target to enter into various loss-generating transactions, which may be listed transactions themselves.
A Thorn in the IRS's Side
Midco transactions have been the subject of an evolving series of IRS notices and tax cases but remain a thorn in the IRS's side. See "Midco Transactions: Do You Know Where Your Target Has Been? Notice 2008-11 and Other Issues," Tax Advisor Weekly, Oct. 5, 2009. They may take place over several months and can be difficult to identify. Moreover, the seller and ultimate buyer may have no interaction with each other or no knowledge of the loss-sheltering transaction.
Should the IRS challenge a Midco transaction, it may seek to recast the overall transaction under one of the following theories articulated in IRS Notice 2001-16, 2001-1 C.B. 730:
- Midco is an agent for the sellers, and consequently the target sold assets while still being owned by the sellers.
- Midco is an agent for the buyers, and therefore the buyer purchased stock rather than assets (thus receiving no step-up)
- The transaction is otherwise characterized to treat the shareholders as selling assets or to treat the target as selling assets while still owned by the selling shareholders.
Even if the IRS identifies a Midco transaction, another problem remains, which was highlighted in Starnes: the target may have been stripped of its cash, and so is unable to pay any additional tax liability. The only pockets remaining to pick are those of the selling shareholders, leaving the IRS to assert transferee liability against them.
Facts of Starnes
Starnes is a typical Midco case. Here, the shareholders who worked at the trucking company they owned (Tarcon, Inc.) 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.
After considering various options, the shareholders caused Tarcon to sell the warehouse to one company, ProLogis, Inc. and then sell their Tarcon stock to another company, MidCoast Investments. MidCoast contractually agreed to operate Tarcon as a going concern and cause Tarcon to file all tax returns related to the $880,000 in federal and state income taxes owed by the company from selling the warehouse on a timely basis.
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. Tarcon's net worth, factoring in 100 percent of the tax liability, was $2.2 million, giving the selling shareholders a $400,000 premium.
Things went awry from there. Eleven days after the closing, MidCoast sold its Tarcon stock to 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. Tarcon never paid its taxes by claiming large offsetting losses for certain transactions that purportedly occurred after MidCoast acquired the company.
Upon audit, these losses were disallowed by the IRS, and Tarcon was assessed with a deficiency of $1.5 million including penalties and interest. Tarcon did not pay any portion of the deficiency, so the IRS sent notices of transferee liability to its former shareholders under the theory that the overall transaction was substantially similar to a Midco tax shelter and was, in substance, a sale of Tarcon assets followed by a distribution of the proceeds to its shareholders. Recast in this light, the IRS then asserted the former shareholders were liable as transferees under Section 6901.
The former shareholders filed a petition in the U.S. Tax Court contesting the IRS's assertion of transferee liability. The Tax Court ruled in favor of the former shareholders, and the IRS appealed that decision in the U.S. Court of Appeals for the Fourth Circuit.
Section 6901 and Transferee Liability
Section 6901(a) provides that the liability of a transferee of a taxpayer's property may be assessed, paid and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred. It provides a procedure through which the IRS may collect unpaid taxes owed by the transferor from the transferee of its property. As the Supreme Court said in Commissioner v. Stern, 357 U.S. 39, 43 (U.S. 1958), it "neither creates nor defines a substantive liability but merely provides a procedure through which the IRS may collect taxes." "The existence and extent of the transferee's liability are determined by the law of the State in which the transfer occurred." (Id. at 45.) The government's substantive rights against the transferee are precisely those that other defrauded creditors would have under the law of the state in which the transfers were made. (John Ownbey Co. v. Commissioner, 645 F.2d 540, 543 (6th Cir. 1981), citing Delia v. Commissioner, 362 F.2d. 400, 402 (6th Cir. 1966)).
Fourth Circuit Affirms the Tax Court in a 2-1 Taxpayer Victory
The IRS's first argument on appeal was that Section 6901 requires a two-step analysis. First, courts should determine whether a person is a transferee under federal law — that is, whether a particular set of transactions should be recast under the "substance over form" doctrine derived from federal tax cases. Second, courts should apply state law to the transactions as recast under federal law.
The Court rejected this bootstrapping argument, however, concluding that Stern foreclosed the IRS's efforts to recast transactions under federal law before applying state law to a particular set of transactions. Stern places the IRS in precisely the same position as that of ordinary creditors under state law. (Starnes, 680 F.3d at 429, citing Stern, 357 U.S. at 45).
After thwarting the IRS's ability to recharacterize the transaction under federal principles, the Court then addressed and rejected various bases for transferee liability purely 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 was: What transfer or combination of transfers should be considered? The IRS and the dissent argued that the transactions should be "collapsed," but the Court found the IRS failed to prove the former shareholders had the requisite knowledge to do so under North Carolina law. In other words, the IRS failed to persuade the Tax Court that the former shareholders knew or should have known that Tarcon would fail to pay its taxes under its new owner — a highly subjective conclusion vigorously contested by the IRS and the dissent. Lastly, the Court 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.
Alvarez & Marsal Taxand Says:
Though Starnes was a taxpayer win, the margin was narrow and the case complex. The theories advanced by the IRS tap a new and potentially rich vein of transferee liability that bears watching. Several similar cases are still before the Tax Court or on appeal. Indeed, in Feldman v. Commissioner, T.C. Memo 2011-297 (T.C. 2011), the transferee-shareholders lost in a case very much like Starnes, but where the facts were better established to show they "knew or should have known that, as a result of the transactions [the taxpayer corporation] had debts beyond its ability to pay." Maybe ignorance is bliss? We say not and submit a measure of diligence is in order to avoid risky situations from the start. But the question remains: Will other circuit courts follow Starnes? It is not hard to imagine a different result if the IRS steps up its game.
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Joseph Plati, Senior Associate, contributed to this article.
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