Fourth Circuit Holds Former Shareholders Not Liable For Corporate Tax In Midcoast Deal

When the Tax Reform Act of 1986 was enacted, I was all over that thing. One thing that was crystal clear to me was that a private company that had appreciated assets or assets likely to appreciate needed an awful good reason to remain a C corporation. At the time I was a rising star at Joseph B. Cohan and Associates, the top public accounting firm in Worcester Massachusetts. At least that's what I thought and so did my managing partner Herb Cohan, whose eponymous father, with a Massachusetts CPA certificate in the low two hundreds, I used to drive home when I was a junior accountant. I used my vast influence to require that senior accountants give an explanation as to why each C corporation that was not electing S status was not electing it. The issue was framed not as why, but rather as why not. There were some good reasons and there were some dumb reasons, but we looked at it very hard.

I'm sure there were other firms that did almost as good a job as JBC, but subsequent experience showed that there were many that did not. Either that or they had mulishly stubborn clients who liked getting all their income on a W-2, so they could get refunds rather than make estimated tax payments, or some other inane reason. There might also have been insurmountable problems to qualifying the corporation as an S corporation, such as uncooperative non-qualifying shareholders.

Every problem is an opportunity for somebody and the C corporations with appreciated assets were an opportunity for Midcoast Acquistions Corp. Midcoast offered a great deal for private C corporations that had not foreseen that they would someday liquidate their appreciated assets. After the corporation had sold all its assets it would have a pile of cash and the obligation to file a corporate income tax return with a substantial balance due. Tarcon Corporation, which is discussed in the recent Fourth Circuit decision Starnes v. Commissioner had $3.1 million in cash and about $880,000 in liabilities (mainly the expected corporate tax on its gain from selling its warehouse) giving it a net worth of about $2.2 million.  Midcoast paid Albert J. Starnes, Ronald D. Morelli, Sr., Anthony S. Naples and Sallie C. Stroupe, the Tarcon shareholders $2.6 million for their stock in the company.

Not that they thought it was their problem or their business anymore, the former shareholders thought that Midcoast was going to operate Tarcon as a going concern.  They were a little mystified as to how Midcoast would make this all work, but it really was not their problem.  Or so they thought:

The Former Shareholders testified they did not understand what was meant by the “asset recovery business” or what MidCoast planned to do with Tarcon, but they made no inquiries.  Naples thought “it did sound strange,” but he believed that MidCoast bought “bad debts” to “use ... as a write-off against the companies they buy that have money.”  Starnes testified that “[i]t wasn't something I wanted to understand. Once they bought my stock, they could do what they wanted with Tarcon.” 

Midcoast did not operate Tarcon as a going concern.  Here is what happened instead:

If all had gone as the Former Shareholders testified they thought it would, MidCoast would have continued operating Tarcon and in 2004 paid Tarcon's 2003 taxes. That is not what happened. Instead, on November 24, 2003, eleven days after the November 13 closing, MidCoast sold its Tarcon stock to Sequoia Capital, L.L.C., a Bermuda company, for $2,861,465.96. Two days later, all of the funds in Tarcon's SunTrust account were transferred to an account with Deutsche Bank AG, though still under Tarcon's name. Then, on December 1, 2003, $2,960,000 was transferred from the Deutsche Bank account to an account in the Cook Islands in the name of “Delta Trading Partners,” and $126,822 was transferred to a MidCoast bank account. After December 1, 2003, Tarcon never had more than $132,320 in any account.

Tarcon filed its 2003 federal tax return in July 2004, reporting capital gains of $1,009,483 and ordinary income of $1,557,315, principally from the sale of the warehouse and the related grounds. Tarcon also reported, however, two large losses. First, it reported a short-term capital loss of $1,010,000 resulting from a purported December 2003 interest rate swap option. Second, it reported an ordinary loss of $1,950,000 resulting from a transaction involving an asset denominated “DKK/USD BINA,” which was purportedly acquired on December 29, 2003, and purportedly sold on December 31, 2003. Consequently, the 2003 return stated Tarcon's only asset was $132,320 in cash. Thus, the return reported an overall loss and no tax due. In 2005, Tarcon filed its 2004 federal tax return, marked as its final return, reporting no tax due and no assets.

You will probably not be shocked to learn that the IRS disagreed with Tarcon's return nor that they could not collect the deficiency from Tarcon.  Remember how the former shareholders thought thought that none of this was their problem.  Well, they were forced to think again.  The IRS started chasing them for the money under a "transferee liability" theory.  The Service has done this with other Midcoast deals meeting with mixed success.  The heirs of the owner of a corporation that at one time was the largest owner of Boston taxi medallions were succesful at resisting the claim.  The former owners of a dude ranch corporation did not do as well.

The cases turn on fine points of the execution of the transactions and interpertations of state law concerning transferee liability.  The Tax Court had found the former shareholders not liable and the Fourth Circuit upheld the Tax Court's finding.  The legal analysis is rather challenging for a CPA, so I will just give you a taste:

Under North Carolina law, the question of constructive knowledge has two components. As applied to the circumstances here, they are: First, did the Former Shareholders have actual knowledge of facts that would have led a reasonable person concerned about Tarcon's solvency to inquire further into MidCoast's post-closing plans? Second, if the Former Shareholders were thereby on “inquiry notice,” whether the inquiry a reasonably diligent, similarly-situated person would have undertaken revealed MidCoast's plan to leave Tarcon unable to pay its 2003 taxes?

The practical lesson is much clearer.  Even though the Tarcon shareholders prevailed, they still, in effect, paid more than half the amount of the tax to Midcoast and the IRS tenacity in pursuing them must have made for a lot of stress, not to mention legal fees.  A timely S election would have avoided all this.  By timely I mean several years before the sale, ideally more than 10. If you have appreciated assets in a private C corporation, you really need to consider whether you might liquidate in the future and take affirmative steps sooner rather than later.

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