Then along came Midcoast.
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.
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.”
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.
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.
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.