In Midco Transaction Malpractice Case, Oregon Court Applies Issue Preclusion From Tax Court Opinion To Dismiss Accounting Firm But Not Law Firm (2/3/22)

A reader of this blog sent me two related opinions decided by the Oregon Court of Appeals in malpractice and related litigation against two advisors—a law firm and an accounting firm advising the shareholders in a firm with a large tax liability in a Midco transaction. The plaintiffs, the Marshalls, were shareholders selling in the Midco transaction that avoided tax liability. The advisers, the defendants, were Schwabe Williamson & Wyatt, P.C. (law firm) and PricewaterhouseCoopers (accounting firm) that advised the Marshalls in the transaction. The opinions are: Marshall v. PricewaterhouseCoopers, Ltd. Liab. P'ship, 316 Or. App. 610, 2021 Ore. App. LEXIS 1845 (2021), here (involving the accounting firm,  PWC); and Marshall v. Pricewaterhousecoopers, Ltd. Liab. P'ship, 316 Or. App. 416, 2021 Ore. App. LEXIS 1775 (2021), here (involving the law firm, Schwabe Williamson & Wyatt, P.C).

In part here pertinent, the Oregon Court of Appeals held that the findings in the Tax Court litigation holding the Marshalls liable for the tax as transferees were (i) issue preclusive as to the accounting firm but (ii) were not issue preclusive as to the law firm. The findings in question were Estate of Marshall v. Commissioner, T.C. Memo. 2016-119, here. The following overview of the Tax Court opinion is from the LEXIS-NEXIS report for the case summarizes the key holdings:

HOLDINGS: [1]-The record supported the Commissioner's decision requiring individual taxpayers who sold a construction company they owned to pay $15,482,046 in income tax the company owed, accuracy-related penalties of $6,192,818 under I.R.C. § 6662, and $9,592,446 in interest; [2]-The taxpayers knew or should have known that the sale of their company was constructively fraudulent under Or. Rev. Stat. § 95.240 because it left the company without sufficient assets to pay its federal tax liability, and the Commissioner had the power under I.R.C. § 6901(a)(1) to collect taxes the company owed from the taxpayers because the company's assets were transferred to them; [3]-The taxpayers' claim that they should not have to pay taxes the company owed because they acted in good faith lacked merit because, inter alia, the good faith defense in Or. Rev. Stat. § 95.270 did not apply to § 95.240.

The Tax Court’s opinion included damning fact-finding regarding the shareholders’ knowledge and/or constructive knowledge that the Midco promoter would strip the target company of assets from which to pay the tax. The Tax Court concluded from the facts that

The Marshalls, Schwabe, and PwC had constructive knowledge of the entire scheme. John [shareholders representative] knew that Essex [the promoter company] was interested 35*35 in buying MAC [the target company with the tax liability] only for its tax liability; that Essex intended to use high-basis low-value assets to offset MAC's income; that Essex intended to obtain a refund of MAC's prepaid taxes, a plan he was leery about; and that Essex was splitting MAC's avoided taxes with the Marshalls.

The key feature that makes a Midco transaction attractive to shareholders of a company with a large tax liability that could not otherwise be avoided was the ability to share in the avoided tax liability through the Midco transaction. The issue in my mind is whether the extra sales price representing a share of the avoided taxes that the shareholder(s) know they are receiving from a Midco transaction makes any sense, particularly when they are advised by sophisticated advisers such as the accounting firm and law firm. In the real world, it probably doesn’t make sense and thus, except for the most naïve, the shareholders must know that the extra sales price means tax is being avoided as a mechanism for them to share in the avoided taxes. Of course, I guess in theory a buyer may have a legitimate tax avoidance strategy, but the Midco transactions seemed not to have legitimate tax avoidance strategies. In any event, all but the most naïve sellers and advisers should be on some type of notice to inquire into the tax avoidance strategy to understand why the sellers were getting what in effect is free money beyond the value of their company if the tax is paid.

Of course, malpractice claims and defenses (such as issue preclusion) are state law matters that may differ from state to state.

 The main reason I report on these cases is to alert practitioners as to the potential consequences of Tax Court findings in later potential state law claim cases. Probably in most Tax Court cases with potential malpractice claims against advisers, avoiding such findings may be difficult if the case is litigated.  But, for example, I suppose that in the right Tax Court case (whether a Midco transaction or not), a taxpayer might find a negotiated settlement in the Tax Court better to preserve the right to pursue malpractice litigation without issue preclusion. Of course, the facts that would be risky in Tax Court litigation would undoubtedly be risky in the malpractice and related litigation and often the tax advisers will have more incentive and perhaps more discovery tools in the malpractice and related litigation to get out the facts.

Finally, in relieving the Marshalls of the issue preclusion bullet against the law firm, the Oregon Court offered the following (Slip op. 30):

            We recognize that the tax court found certain facts that are, no doubt, unfavorable to plaintiffs' negligence claim, particularly with respect to advice and information John Marshall received from PwC about the transaction and its risks. However, that advice, while relevant to the causation element of their negligence claim, is not determinative of it. Whether plaintiffs had been warned about the transaction's risks by PwC does not, as a matter of law, foreclose liability on the part of Schwabe if it breached its duty to plaintiffs in its legal advice and that breach caused plaintiffs damages. This is especially so if the advice plaintiffs received from the two firms  differed, or if Schwabe downplayed the severity of the risks, especially in light of  Schwabe's role as plaintiffs' primary advisor in the transaction. Although we state no  opinion on plaintiffs' likelihood of prevailing at trial on its negligence claim, plaintiffs' success at trial is nevertheless possible under these circumstances and is not precluded by the tax court's factual findings. Because the factual issues in the two proceedings are not identical, issue preclusion does not apply to bar plaintiffs' negligence claim against Schwabe.