Consider the following situation: You’re a major stockholder in a corporation whose assets have appreciated in value, and you want to sell. You would really like to structure the deal as a sale of stock in order to avoid capital gains tax on the corporation’s appreciated assets. When you contact potential buyers, you find that they all want to structure the purchase as an asset sale so that they can take the step-up in basis in the assets—and preferable tax treatment. What do you do?
One option that some people have tried is to use a “middle company,” or “Midco,” arrangement. The general idea is that the seller makes a sale of stock to the Midco, and the buyer makes an asset purchase from the Midco. Obviously, things are a little more complicated than that: There is generally a series of intermediate entities and transactions structured so as not to incur a tax liability or—and I’m foreshadowing here—to expose the parties to other kinds of liability. Everybody wins, right?
Well, not according to the IRS and, now, the Eleventh Circuit. In Shockley v. Commissioner of Internal Revenue, 2017 WL 4366237 (11th Cir. Oct 3, 2017), the sellers of a Wisconsin media corporation employed a “labyrinthine array” of intermediate shell companies to effect a “buy stock/sell assets” arrangement. The IRS assessed tax liabilities against the now-defunct media corporation and asserted transferee liability against some of the sellers under 26 U.S.C. § 6901. This statute applies to certain transfers—including the liquidation of a corporation—and allows the IRS to pursue transferees for a transferor’s unpaid tax liability if liability would attach under the applicable state law. Here, the applicable state law was the Wisconsin Uniform Fraudulent Transfer Act (WIUFTA). The Tax Court upheld the IRS’s liability assessment.
The Eleventh Circuit affirmed. Regarding § 6901, application of the “substance over form” test led to the conclusion that the transfer was fraudulent. The Midco companies held the assets for approximately three hours; the Midcos were created for the sole purpose of facilitating the transaction; there was substantial documentation of the sellers’ desire to structure the transfer as a “buy stock/sell assets” arrangement; and the parties could offer no convincing explanation for the transaction’s structure other than tax avoidance. Regarding WIUFTA, the court applied similar “substance over form” principles to determine that the transfer was fraudulent and that it rendered the media corporation insolvent, allowing its tax liability to attach to the transferees.
Importantly, the court noted that there was some dispute over whether transferee liability under a Uniform Fraudulent Transfer Act requires knowledge that the transfer would expose the transferor to the tax liability. It did not need to decide this question, however, because there was ample evidence that the sellers had known about the possible adverse tax consequences.
Shockley serves as a reminder to counsel when structuring a deal that courts, including the Eleventh Circuit, will look to the substance of the transaction when assessing the tax consequences. Parties should be especially mindful that there is potential under some states’ Uniform Fraudulent Transfer Acts for transferees to be held liable even when they did not know that the transferor would incur a tax liability.
Posted by Nick Boyd.