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February 25, 2014

Issue 8-2014 — A year ago, we raised this question following the IRS’s assertion of transferee liability in the Fourth Circuit’s Starnes v. Commissioner, 680 F.3d 417 (4th Cir. 2012): How well should selling shareholders concern themselves with a buyer’s intentions to pay the target corporation’s taxes after it is sold? (See “How Well Do I Need To Know My Buyer? A Look at Transferee Liability UnderStarnes,” Tax Advisor Weekly, Feb. 6, 2013.) In Starnes, the IRS unsuccessfully attempted to stick the selling shareholders with the corporate tax liability caused by a preliminary sale of the target’s assets, which the buyer left unpaid. Initially, the IRS tried to go after the buyer, but the buyer had disappeared along with the proceeds from the asset sales. Instead, the IRS went after the selling shareholders, characterizing the overall transaction as a “Midco” or “intermediary” tax shelter and recasting it as a sale of corporate assets followed by a distribution of the proceeds to the shareholders. By virtue of this fictitious distribution, the IRS then asserted the former shareholders were liable as transferees under Section 6901.

The Fourth Circuit in Starnes rejected this bootstrapping attempt to recast the transaction under federal tax law concepts and now, following its recent denial in Diebold Foundation v. Commissioner, 736 F.3d 172 (2nd Cir. 2013), the IRS is 0-3 in the Circuit Courts, with another loss coming in Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597 (1st Cir. 2013). Despite its lack of success with attempts to establish that a fraudulent transfer occurred under federal tax law, as opposed to state fraudulent conveyance law, however, the momentum may be shifting in the IRS’s favor. Indeed, both Diebold Foundation and Frank Sawyer Trust were remanded on successful state law fraudulent transfer arguments made by the IRS. Moreover, the government is looking to gain the advantage through proposed legislation. As described in the President’s Fiscal Year 2014 Budget1, proposed legislation would impose liability on certain shareholders entering into intermediary transactions (to be defined by the Treasury). Much is at stake. The budget anticipates nearly $5 billion in additional tax revenues from the government, strengthening its efforts around these transactions over the next 10 years — a clear indication the government is going to fight.

This issue of Tax Advisor Weekly first provides an overview of Midco transactions and transferee liability under Section 6901 and then discusses aspects of Diebold Foundation and the President’s proposal that could impact selling shareholders.

Midco Transactions in a Nutshell

A Midco transaction is designed to enable a buyer to purchase a corporation’s appreciated assets while permitting the corporation’s shareholders to avoid suffering the tax burden on the asset sale by interposing an intermediary that will bear the tax instead. In its basic form, the corporate stockholders sell the target stock to the Midco, which then sells the target's assets to the buyer. The catch is that the Midco has no intention of actually paying the tax on the asset sale because it has net operating losses or some other characteristics that would shield the gain. 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.

Now, this causes the IRS great consternation. (See “Midco Transactions: Do You Know Where Your Target Has Been? Notice 2008-11 and Other Issues,” Tax Advisor Weekly, Oct. 5, 2009.) As one might imagine, a Midco transaction can be hard to recognize. It may take place over several months, and the seller and ultimate buyer may have no interaction with each other or no knowledge of the Midco’s loss-sheltering transaction. To confound things, by the time the IRS figures this out, the target and Midco may have been stripped of their cash and disappeared. So even if the IRS is successful in prohibiting the Midco’s loss-sheltering activities from offsetting the gain from the target’s asset sales, the victory is fruitless. The only ones with any fruit are the selling shareholders, leaving the IRS to assert transferee liability against them.

Facts of Diebold Foundation

Double D Inc. (“Double D”) was 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, consisting of $21.2 million of cash, $6.3 million of real estate and $291.4 million of publicly traded securities. Under the deal that was constructed, the shareholders sold all of the Double D stock to Shap Acquisition Corp. II (“Shap II”), a newly formed corporation created by Sentinel Advisors in exchange for $309 million of cash largely funded through a bank loan provided by Rabobank. Immediately afterwards, Shap II then sold the securities to Morgan Stanley and repaid the Rabobank loan, netting a $10 million profit. Shap II reported all of the gain from the asset sales on its consolidated return filed with Double D, but the gain was completely offset by losses (from a Son-of-BOSS tax shelter), resulting in no net tax liability.

The IRS issued a notice of deficiency against Double D under the determination that the shareholders’ sale of Double D stock was in substance an asset sale followed by a liquidating distribution. But Double D had been dissolved and its assets were gone. 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.

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)).

After Initially Rejecting the IRS’s Argument, the Second Circuit Finds a Fraudulent Conveyance

The Second Circuit rejected the IRS’s argument that a court must first make a determination as to whether a party is a transferee by applying federal law “substance over form” doctrine to re-characterize the transaction and then assess liability with respect to the re-characterized transaction. Instead, the Court joined the interpretations of the First Circuit in Frank Sawyer and the Fourth Circuit inStarnes in adopting a two-prong framework 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. Under this analysis, the two prongs are independent, so if a court decides one does not apply — that is, whether the party at issue is a transferee or liable — it need not apply the other.

Next, however, the Court turned to the New York Uniform Fraudulent Conveyance Act (NYUFCA) and found 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. Accordingly it 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.” The Court listed a number of facts including the fact that:

  • The shareholders recognized the “problem” of the tax liability inherent in the appreciated assets;
  • The shareholders sought out parties that could avoid the inherent tax liability;
  • The parties were sophisticated and employed advisors;
  • There were negotiations with multiple parties;
  • A “huge” amount of money was involved;
  • Shap II was a newly formed entity created for the sole purpose of purchasing Double D stock; and
  • The shareholder advisors knew that Shap II intended to sell its assets immediately after closing.

Having found that the shareholders had constructive knowledge, the Court then collapsed the series of transactions, applying New York law, and found that Double D made a fraudulent conveyance (because had Double D actually sold all of its assets and liquidated without retaining sufficient funds to pay the tax liability, it would have been a clear case of fraudulent conveyance). The case was then remanded to the Tax Court to consider, among other questions, whether the Diebold Foundation is a transferee under Section 6901.

Alvarez & Marsal Taxand Says:

So how well must selling shareholders concern themselves with a buyer’s intentions to pay the target’s corporate taxes after it is sold? To anyone other than a tax lawyer, it must seem like a rather odd question. Why should a seller care if a buyer overpays for the stock and doesn’t properly reduce the price for the target corporation’s embedded tax liabilities (recognized or not)? How would a seller even know this? And once the buyer has control of the target, why should the seller care what the buyer does with it or whether its obligations are paid?

Regardless of these questions, the Court in Diebold Foundation did impose a duty to inquire on the selling shareholders and charged them with constructive knowledge for insufficiently doing so. This was done even though many of the facts listed by the Court as troubling are common to plain M&A transactions — leading one to conclude prudent sellers would be wise to satisfy themselves as to the buyer’s post-sale intentions to run the business.

The President’s proposal is an effort to make it easier to recover from selling shareholders and bears watching. If enacted, sellers may want to get indemnification for post-closing transactions over which they have no control, and transaction costs on non-targeted transactions may increase. Ostriches beware! 


1. The President's Fiscal 2015 Budget is anticipated to be released on March 4.


Martin Williams
Managing Director, New York
+1 212 328 8503

Eva Goldstein, Senior Associate, and Joseph Plati, Senior Associate, contributed to this article.

For More Information:

Jill Harding
Managing Director, San Francisco
+1 415 490 2279

Patrick Hoehne
Managing Director, San Francisco
+1 415 490 2134

Keith Kechik
Managing Director, Chicago
+1 312 288 4024

Ernesto Perez
Managing Director, New York
+1 305 704 6720

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