Thursday, May 31, 2018

Good Execution Protects Sellers From IRS Transferee Liability

This post was originally published on Forbes Feb 18, 2015

The District Court decision in the case of Herbert Allen Andrew et. al. v. United States of America (Sorry, can't find a free link) has inspired me to add to Reilly's Laws of Tax Planning.  I think this will be Reilly's Fourth Law.  It goes "Execution isn't everything, but it is a lot". The case is about another Midcoast deal.  Midcoast was a company operating around the turn of the millennium that helped the owners of C corporations net more from corporate liquidations.  The problem with a C corp, ever since the Tax Reform Act of 1986 repealed the General Utilities doctrine, is that on liquidation there are two taxes.  First the corporation pays a corporate level income tax form the sale of its assets.  Then the shareholders as they receive cash pay capital gains tax.  This is what has made flow through entities so popular.

Around the turn of the millennium there were still quite a few closely held C corporations with appreciated assets floating around.  For this or that reason, there would be a decision to sell the assets and something approaching sticker shock when the tax cost was recognized.  Midcoast stepped into the breach.  After your C corporation had sold all its assets so that all that was left was cash and an obligation to file some income tax returns with whopping big liabilities, Midcoast would buy the all the shares for a premium over the expected net proceeds.

How Do They Do It? Who Cares?

If you were involved in one of these deals, you might be tempted to think that the people running Midcoast were like the two brothers who bought a truck and went out into the country to buy apples for a nickel each to sell in the city for four cents.  When they ran out of money they debated whether it was because their truck wasn't big enough or because the didn't have a presence on the web.  More likely you figured that they must have had some secret sauce to avoid the corporate tax.  Plenty of that going around back then as the Big 4 accounting firms were raiding the treasury.  Of course it wasn't your problem. Or was it?
As it turned out, Midcoast, shockingly, did not have a legitimate way of avoiding the corporate income tax.  Although there might have been some bells and whistles involved, the corporations they bought were quickly stripped of cash, which was all they had, which was used to pay off the banks that had financed the acquisition with the balance of the spoils then divided up.  Nothing was left to pay corporate income taxes.  Of course, if you were one of the shareholders that sold, none of that was any of your business.  Until the IRS makes it your business.

There is this concept called transferee liability.  Without transferee liability, you and the other shareholders could have just liquidated the corporation, stripped out all the cash and left the IRS with a bare cupboard.  When the IRS looked at these deals, that is what it appeared you had done.  Midcoast's transitory ownership of your pile of lucre did not change anything in the view of the IRS.

GNC Investors Club

GNC Investors Club Inc was a C corporation organized in 1957.  It had two functions.  The corporation acquired, held and sold securities and conducted meetings and educated its members about the stock market.  In the spring of 2000, the shareholders began to consider alternative business models to avoid double taxation and make it easier for new members to buy in.  After considering converting to an LLC, they ended up deciding to dissolve.
Michael Haley the president of GNC formed a Dissolution Task Force.  They consulted with Lewis Ritchie, a KPMG tax advisor.  They expected the liquidation to be completed in December 2000 and realized that the corporation would be paying taxes and they would also have to recognize gains.  The dreaded double tax.

Have We Got A Deal For You!

Then things started looking better.  At a social event, Clayton Lee, one of the members of the Dissolution Tax Force met Thomas Watkins, a reputable attorney with over 30 years of experience in the purchase and sale of companies.  As they chatted about this and that, the subject of GNC's looming liquidation arose.  Mr. Watkins told Mr. Lee that there might be another way.  Midcoast Credit Corporation.  Midcoast had sent Mr. Watkins several solicitations in which it outlined its program.  Things moved quickly from there.
MidCoast expressed an interest to Mr. Watkins in purchasing an investment club's stock. (Testimony of T. Watkins.) Mr. Watkins then conveyed MidCoast's interest to Mr. Lee, and Mr. Lee authorized Mr. Watkins to share GNC's information with MidCoast. MidCoast retained Mr. Watkins to represent it in negotiations with GNC.  MidCoast sent a letter of intent to Mr. Watkins on October 17, 2000, stating terms for a deal to buy 100% of GNC's stock. MidCoast proposed that it or its designee would acquire the GNC shareholders' stock as an alternative to the shareholders liquidating GNC.  MidCoast required that GNC liquidate its stock portfolio before the closing date. MidCoast provided a schedule showing that the GNC shareholders would receive more money from selling GNC's stock to MidCoast than from liquidation, taking into account the tax consequences.  Specifically, MidCoast represented that the shareholders would collectively receive $401,325 more in proceeds from the stock sale to MidCoast than if they liquidated GNC; this constituted a premium of approximately 10%.

The same day Mr. Watkins received the letter of intent from MidCoast, he met with the Dissolution Committee members and communicated MidCoast's proposal to them.  At a shareholder meeting that night, the shareholders considered and accepted MidCoast's proposal.
Good Execution

Here is where the good execution starts coming in.
After accepting MidCoast's proposal, the Dissolution Committee checked MidCoast's business references.  Jack Dixon, a GNC shareholder and partner at KPMG, informed the Committee that his company had some dealings with MidCoast in the past, and a Committee member checked with Dun & Bradstreet and reported that MidCoast was a viable company.  On October 20, 2000, the Committee reported to the other shareholders that the MidCoast references were favorable and that GNC would move forward with negotiating a stock purchase agreement with MidCoast.  On November 3, 6, and 7, 2000, GNC liquidated its publicly traded stock and received a total of $4,955,000. Ms. Allen represented GNC and its shareholders in connection with the sale to MidCoast.

Through November 2000, GNC and MidCoast finalized arrangements for the transaction. MidCoast arranged for Battery Street, Inc., a newly formed corporation, to acquire GNC's stock. Mr. Watkins continued to represent MidCoast,  and also represented Battery Street.  The shareholders, through Ms. Allen, reviewed Battery Street's certificate of incorporation and confirmed that it was an existing company.  The shareholders made no additional inquiries about MidCoast or Battery Street because Battery Street planned to pay cash and because they trusted Mr. Haley's ability to review the arrangement with Battery Street and Mr. Watkin's business reputation.
The Good Old Days

It is important to note that this was the year 2000.  There was a raid on the treasury in process engineered by Big 4 accounting firms.  The sad story is chronicled in book titled Confidence Games-Lawyers, Accountants and the Tax Shelter Industry.  Janet Novack had exposed what was going on as early as 1998 remarking in her The Hustling of X Rated Shelters
What do the leaders of this industry have to say about it? Most wouldn’t discuss it. KPMG even sent around a memo warning staffers not to talk to Forbes.
Even two years later, Janet was still something of a voice crying out in the wilderness.  It was not until around 2002 that the excrement hit the air moving machine much to the chagrin of EMC founder Richard Egan, who got into the game late. The point of this diversion is that if in 2003, somebody from KPMG told you they knew all about a company that could help you lower your taxes, the proper response would be to issue a red alert and prepare to repel boarders.

In 2000, thought KPMG vouching for them was like Counselor Troi telling you it was all going to be OK.

Not Our Circus - Not Our Monkeys

When the big day for the sale came.  Here is what happened.
The November 28 transfers resulted in the sale of GNC to Battery Street and consist of Battery Street's transfer of $3,818,000 to the plaintiffs to buy their GNC shares and, in exchange, GNC's transfer of $4,932,676 from its pre-closing accounts to the new GNC account set up by Battery Street at Golden Gate Bank, which gave Battery Street control over GNC and its assets. The Government contends that these transfers were fraudulent under three NCUFTA provisions: § 39-23.5(a), § 39-23.4(a)(2), and § 39-23.4(a)(1). The Court finds and concludes that the November 28 transfers were not fraudulent under any of these provisions.

Under § 39-23.5(a), a transfer made by GNC would be fraudulent if, inter alia, GNC did not receive “a reasonably equivalent value in exchange for the transfer” and GNC “was insolvent at that time or ... became insolvent as a result of the transfer.” N.C. Gen. Stat. § 39-23.5(a). As a result of the November 28 transfers, GNC transferred $4,932,676 from its existing accounts, and $4,932,676 was deposited into the new GNC account. A “separate and distinct” $3,818,000 was transferred from Battery Street to the plaintiffs. See Starnes, 680 F.3d at 432.

Because GNC had the same $4,932,676 before and after the November 28 transfers, the Court finds and concludes that GNC received a reasonably equivalent value in exchange for the transfer of its cash from one bank account to another account.
From then on there may have been quite a bit of shenanigans, since we know that ultimately  the corporate taxes were not paid.  None of that mattered.
The Government's theory fails for two reasons. First, this theory depends on findings of fact that the November 29 through December 1 transfers occurred as described by the Government, and the Court is not satisfied by the preponderance of the evidence that those facts exist. Second, the transfers can be collapsed for NCUFTA purposes only if the plaintiffs had actual or constructive knowledge of Battery Street's post-closing plans, that is, if the plaintiffs “knew or should have known before the deal closed that [Battery Street] would cause [GNC] to fail to pay its ... taxes.”
The GNC shareholders had been paid with outside money.  They had made reasonable inquiries to determine that Midcoast was a legitimate company.  They were perfectly happy to remain innocent of the secret sauce that made it all make sense for Midcoast.  Whatever monkeying around was done after they were no longer shareholders - well - Not their circus, not their monkeys.

More On Midcoast

I've been following Midcoast transferee liability decisions for over  three years now.  If you read my post on the Feldman case, you will see what a difference execution makes.  In the Feldman case, the outside money was in the deal for a matter of hours.  I compared Feldman to the Sawyer decision that had come down around the same time.
The real difference, though, was that Sawyer was a much bigger deal and was better executed. Another company, Fortrend, was pulled into the mix and they actually borrowed money from a bank to pay the Sawyer Trust and waited a couple of days before pillaging the taxi corporations. Also, the Sawyer interests had no curiosity whatsoever about how it was that Midcoast and Fortrend were avoiding the corporate tax. They just assumed it was legitimate.
Other Coverage

Jim Malone gives a lawyerly analysis in two parts that will give you more details on the government's theories, that the court rejected.

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