Ninth Circuit Rejects Midco Transaction Twice Blessed by Tax Court (7/29/18)

In Slone v. Commissioner, ___ F.3d ___, 2018 U.S. App. LEXIS 20602 (9th Cir. 2018), here, the Ninth Circuit rejected the Midco variant.  The Midco variant itself has subvariants but this example illustrates the basic idea:

A, an individual, owns Corporation X.  Corporation X has assets of $100 with a basis of $10.  There is a built in gain of $90, with a potential tax of $30.  Corporation X is worth, therefore, $70.  Corporation X sells its assets for $100.  Corporation X then has cash of $100, no liabilities except a tax of $30 that will be reported if nothing else happens.  Corporation X is still only worth $70.  So, Corporation Y purchases the Corporation X stock from A for $85 which it finances with the Corporation X cash (the cash moves around incident to the closing, but the $85 in essence comes from the Corporation X cash).  A and his advisors are not real sure why Corporation Y would offer more than the assets are worth.  Corporation Y hints that he has some technique (perhaps tax attributes) that would permit Corporation X to avoid the tax on the sale of the corporate assets.  Immediately after that closing, once the temporary financing for the Corporation X stock is paid off $85 of Corporation's X cash, Corporation X then has $15 cash.  Corporation X buys a bullshit tax shelter for $5 to avoid reporting the gain and the resulting $30 tax.  Corporation Y then takes the net $10 cash as its profits for structuring the transaction.  When Corporation X's bullshit tax shelter is rejected on audit two years later, the IRS assesses the $30 tax plus penalties and interest. Corporation X has no assets to pay the resulting tax, penalties and interest.  Corporation Y is not around to pay. 

Most of the Midco transactions are more complex than that, but when the veneer is peeled back, that is basically it.

The IRS in this situation wants the tax and will look to all involved to get it.  The IRS will look to A and assert transferee liability under § 6901.  A's defense is that he is not a transferee from Corporation X under the transferee liability provisions.  In furtherance of that argument, A will claim that he did not know the tax would not be paid.  He just thought that, magically, the buyer had some technique to avoid having to pay the tax.

Here is what the Court said (cleaned up):

Reasonable actors in Petitioners' position would have been on notice that Berlinetta intended to avoid paying Slone Broadcasting's tax obligation. Berlinetta communicated its intention to eliminate that tax obligation, and Slone's leaders and advisors, despite their suspicions surrounding the transaction, asked no pertinent questions. In Berlinetta's earliest solicitations to Slone Broadcasting, Berlinetta marketed its ability to pay the shareholders a premium on account of its ability to eliminate the company's tax liabilities. Berlinetta's affiliate company, Fortrend, wrote in a letter to Jack Roberts, Petitioners' longtime accountant, that Fortrend could pay a premium purchase price because of its ability to "resolve liabilities at the corporate level." This proposal raised justified suspicions in Slone Broadcasting's leadership. Mr. Slone, the company's president, testified that upon learning that an entity wanted to purchase Sloan Broadcasting, after it had already been effectively sold to Citadel, he asked Jack Roberts, "can that be done?" Unsure, Roberts replied, "well, I'm going to find out." 

That Berlinetta provided little information regarding how it would eliminate Slone Broadcasting's tax liability, coupled with the structuring of the transactions, provided indications that would have been hard to miss. Slone Broadcasting's advisors understood that the transaction made sense from Berlinetta's perspective only if Slone Broadcasting's tax liability were eliminated. This deal was, after all, an uneven cash-for-cash exchange in which Berlinetta paid Petitioners most of what Slone Broadcasting should have paid in taxes. Yet Petitioners' retained counsel testified that when he and Jack Roberts asked for details, Berlinetta told them "it was proprietary, it was a secret, and it was theirs, and we weren't going to be a party to it, and I said fine." And in a lengthy memo retained counsel prepared in November of 2001 analyzing the subject of potential transferee liability, counsel wrote that Berlinetta would distribute almost all of Slone Broadcasting's cash to repay the loan used to finance the deal. The memo never analyzed how Berlinetta could legally offset Slone Broadcasting's taxable gain from the asset sale. The memo merely concluded that Petitioners would not be liable as transferees of the proceeds of Slone Broascasting's asset sale if the Commissioner successfully challenged the entity's attempt to offset the tax liability. 

The Tax Court misinterpreted Petitioners' suspicions and Berlinetta's reassurances to mean Petitioners lacked actual or constructive knowledge of the tax avoidance purpose of the scheme. This record establishes that the Petitioners were, at the very least, on constructive notice of such a purpose. In reaching a contrary conclusion, the Tax Court confused actual and constructive notice, in effect allowing Petitioners to shield themselves through the willful blindness the constructive knowledge test was designed to root out. It is clear that Petitioners' stock sale to Berlinetta, in which Berlinetta assumed Slone Broadcasting's tax liability, and Berlinetta paid Petitioners an amount representing the net value of the company after the asset sale and most of the amount that should have been paid in taxes on that asset sale, operated in substance as a liquidating distribution by Slone Broadcasting to Petitioners, but in a form that was designed to avoid tax liability. Slone Broadcasting's distribution to Petitioners was thus a constructively fraudulent transfer under the Arizona UFTA. Petitioners are liable to the government for Slone Broadcasting's federal tax obligation as "transferees" under 26 U.S.C. § 6901.
REVERSED and REMANDED for entry of judgment in favor of the Commissioner.