Way back in 2012 I wrote about the Tax Court decision in the case of Ray Feldman et. al. The case was about transferee liability, which is a kind of "when all else fails" weapon that the IRS has in its arsenal. In the Feldman case, the IRS won in Tax Court and over three years later the Seventh Circuit has upheld the Tax Court. The Feldman case concerned the sale of a dude ranch by Woodside Ranch Resort Inc. William Feldman had founded the ranch in the 1920s. It was incorporated in 1952 and sold in 2002. It was probably not such a bad idea to incorporate in 1952. Unless there was a commitment to never sell, it was a really bad idea to not make an S election in 1987.
Feldman was one of several "Midcoast" deals. Midcoast had built a business around closely held companies with appreciated assets that had not been paying much attention when the Tax Reform Act of 1986 changed the playing field. Under the good old Internal Revenue Code of 1954, when the assets of a corporation were sold in connection with the corporation's liquidation, no gain was recognized. Not so under the Internal Revenue Code of 1986, under which we still labor (I'm thinking we might have a reboot in 2017). Since 1987, one of the most reliable ways to make a small fortune is to liquidate a C corporation with a large fortune in appreciated assets.
Then along came Midcoast.
Then along came Midcoast.
Midcoast offered a sweet deal. Have your C corporation sell all its assets, so that the only thing left is a pile of cash and the obligation to file a corporate tax return and pay a boatload of money. For talking purposes say there is a million bucks on hand and a requirement to pay four hundred grand. Midcoast pays you eight hundred grand maybe more. Certainly less than a million, but a lot more than the six hundred grand you would have left if you paid the corporate tax. The six hundred grand that will be subject to another level of tax when it is distributed to the shareholders.
Clearly Midcoast must have had some secret sauce to get around the corporate tax, but that was none of your business. Micdoast paid you and it was not your corporation anymore. What if Midcoast was monkeying around with the corporate taxes? Well. Not your circus, not your monkeys. Or so you would think.
That's where transferee liability comes in. You see if Midcoast used the money that the corporation should have used to pay its corporate tax to pay you instead, then the IRS has a claim on those funds. If that weren't the case, you would not have needed Midcoast. You could have just distributed all the cash and when the IRS came looking for its corporate tax given them the minute books and the corporate seal, because the cupboard was otherwise bare.
So there were two keys to Midcoast deals working. One was that you should have little or no acquaintance with the Midcoast monkeys who would magically help Midcoast deal with the corporate tax. The other more important detail was that the money that you were getting paid had to be coming from someplace else. Midcoast might forthwith loot the company to pay back its capital source, but it had to happen after you were gone.
Dotting The i's Crossing The t's
Whether Midcoast deals worked or not ended up being a matter of good execution. Some of them did work, most notably the Sawyer case. Feldman sadly did not work. This story is an illustration of Reilly's Fourth Law of Tax Planning - "Execution isn't everything, but it's a lot."
One flaw in execution was recording Woodside's understanding of the recipe for Midcoast's secret sauce.
MidCoast promises ... to pay Woodside's taxes because the corporation would not be liquidated but instead be kept alive as a going concern as a part of the MidCoast organization. This deal is profitable for MidCoast because MidCoast purchases large amounts of defaulted and delinquent credit card accounts from the major credit card companies ... and carries forward such losses to offset against the purchase of “profitable” corporation[s] such as Woodside.
Although this letter mentions a “promise” by Midcoast to pay Woodside's taxes, all shareholders understood that Midcoast intended to claim a loss to offset the capital gain from the sale of the ranch.
More importantly the "outside money" that funded the purchase from the shareholders was entirely too transitory.
The parties then executed the share purchase agreement and two escrow agreements to facilitate the transaction. The shareholders and Midcoast were parties to the first escrow agreement; Midcoast and Honora Shapiro—50% owner of Midcoast—were parties to the second. The law firm of Foley & Lardner was the escrow agent under both agreements, and funds were wired into and out of its trust account as follows. First, at 12:09 p.m. on July 18, Woodside's cash reserves of $1.83 million were transferred into the trust account. Then, at 1:34 p.m. Shapiro transferred $1.4 million into the trust account, purportedly as a loan to Midcoast to fund the transaction, although there is no promissory note or other writing evidencing a loan, and (as we will see) the money was immediately returned to Shapiro. At 3:35 p.m. $1,344,451 was wired to Woodsedge LLC as payment to the shareholders. A minute later, at 3:36 p.m., $1.4 million was returned to Shapiro, repaying the undocumented “loan.”
That was not the only flaw in execution, but it was probably the most dramatic.
The tax court found as well that the $1.4 million “loan” from Shapiro was a sham. First, the loan was entirely undocumented; there was no promissory note or other writing setting forth the terms of the loan. It had no interest rate and was “repaid” immediately, with the money cycling into and out of the trust account on the same afternoon. Finally, the loan receivable posted on Woodside's books was (to use the tax court's words) “a mere accounting device, devoid of substance.” Neither Midcoast nor Shapiro owed Woodside anything, and the loan receivable was later marked “paid” without a cent changing hands. Looking past the form of the transaction to its substance, the court found that the stock sale was in reality a liquidation: The funds received by the shareholders came not from Midcoast but from Woodside's cash reserves.
Seventh Circuit Backs The Tax Court And The IRS
The Tax Court had held that the $1.4 million loan from Shapiro was "a ruse, a recycling, a sham".
There also was a pretty elaborate state law analysis which is another hurdle that the Service must overcome to assert transferee liability. The Seventh Circuit supported the Tax Court and the IRS.
This post was originally published on Forbes Mar 18, 2015To see to what extent it is execution that makes a difference compare how the shareholders in GNC Investors Club made out.
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.
Jim Malone wrote a piece on this decision noting the importance of state law issues in transferee liability cases.
While the government would still prefer to recharacterize transfers under federal law, this opinion and other recent appellate opinions such as Diebold Foundation v. Commissioner, 736 F.3d 132 (2d Cir. 2013) demonstrate that the government is perfectly capable of prevailing under state law.