Midco Decisions in Tax Court

The Tax Court has issued two opinions in "midco" or "intermediary transaction" cases, both of which involve MidCoast Investments. Both cases were brought against the sellers in a stock sale, which the IRS attempted to recharacterize as a distribution in liquidation in order to impose transferee liability.

In Griffin v. Commissioner, T.C. Memo. 2011-61, petitioner Griffin first sold assets of his company HydroTemp to Pentair, but retained some assets and employees. About six months after the Pentair sale, Griffin sold the stock in HydroTemp to MidCoast. The Court noted the extensive due diligence performed by Griffin, including visiting the offices of MidCoast and examining their books. After signing the Letter of Intent with MidCoast, he became wary of proceeding, but after consulting with his advisors closed the transaction. He reported the gain on the sale of the stock, and had no ownership interest in, or involvement with, HydroTemp after the sale.

HydroTemp on its tax return for the year of the sale showed a $7 million short-term capital loss from the sale of binary options and reported no tax liability. On audit, the IRS disallowed the loss and determined tax, penalty and interest owed by HydroTemp, which it was unable to collect. Consequently the IRS brought an action against Griffin as transferee. Griffin, when he received the transferee notice from the IRS, also pursued HydroTemp in Florida District Court and obtained a judgment, but was unable to collect from MidCoast.

The IRS argued that the first transaction, an asset sale to Pentair, and the second transaction, a stock sale to MidCoast, were part of an integrated plan known as an "intermediary transaction" entered into by Griffin solely to reduce his tax liability. The Tax Court rejected the IRS’s substance over form argument, finding that the two transactions were not arranged in conjunction with each other, each had legal significance, the second was not anticipated at the time of the first, and there was no preconceived plan to sell the stock at the time of the asset sale. Moreover, Griffin also took action to ensure that the corporate tax would be paid by MidCoast, negotiating a tax agreement and indemnity clause which he enforced in Florida State court.

The Court then looked at each transaction separately to determine if it was a fraudulent conveyance under Florida law. It found that after both sales, HydroTemp was not insolvent, an element indicating an actual fraudulent transfer. The Court also found there was not a constructive fraudulent transfer because reasonably equivalent value was transferred for the corporate assets.

Given the facts recited in the opinion of the Tax Court, it is surprising that the IRS pursued this so-called "intermediary transaction" case. There is no evidence of an integrated "plan" or scheme connecting the two sales, or knowledge by Griffin of MidCoast’s actions after the sale of stock.

In Starnes v. Commissioner, T.C. Memo. 2011-63, the facts are likely more typical of a "midco" or "intermediary transaction" case. The shareholders of Tarcon first negotiated for the sale of real estate owned by the corporation. Then they met with representatives of MidCoast who proposed to purchase the stock of Tarcon, assuring the shareholders they would continue to operate the company and that Tarcon’s tax liabilities would be paid. Shortly after the completion of the asset sale of real estate to ProLogis, the Tarcon shareholders sold their stock to MidCoast. After the sale the Tarcon shareholders had no further communications with MidCoast or knowledge with respect to Tarcon’s funds. The Tarcon shareholders reported the gain from the sale of the Tarcon stock on their individual income tax returns.

When Tarcon filed its corporate return for the year of the sale, large losses were claimed to offset the gain from the sale of the Tarcon assets, which the company sold shortly after purchase from the original Tarcon shareholders, and no tax was paid. The IRS determined a deficiency, which was not paid or collected from Tarcon. It then pursued the selling shareholders of the Tarcon stock as transferees, contending the stock sale to MidCoast was in substance a distribution from the corporation in liquidation.

The Court first "followed the money" and found that Tarcon received reasonably equivalent value in the transfer. The IRS, however, argued that the subsequent transfer of the funds by Tarcon three weeks after the sale should be collapsed as a single integrated cash transfer under the Uniform Fraudulent Transfer Act which had the net effect of putting the money out of reach of creditors. The Court held that the party arguing that the transaction should be avoided must prove that the multiple transactions were linked and the purported transferee had "actual or constructive knowledge of the entire scheme". The Court found that the Tarcon shareholders did not have actual knowledge of Tarcon’s postclosing activities, either constructive or actual. Although constructive knowledge may be found when the transferee becomes aware of circumstances that warrant further inquiry but there is no such inquiry, the IRS did not meet its burden of proof only by contending the shareholders "could not have believed MidCoast planned to generate a profit with Tarcon in that manner" following the closing of the Tarcon stock sale. Thus the Court did not collapse the transactions and determined that Tarcon had received reasonably equivalent value. These two significant factors then resulted in the failure of the IRS to prove the elements of a fraudulent conveyance or liability under the trust fund doctrine.

Both cases turn on the pivotal finding by the Tax Court that the IRS failed to prove that multiple transactions were linked or that the selling shareholders had constructive knowledge of, or participated in, a plan or scheme. In both cases the selling shareholders had no further involvement with, or knowledge of, the activities that occurred after the sale. In the absence of collapsing the transactions into one, the Court found that equivalent value was paid. Since the selling shareholders did not receive distributions in liquidation from the corporation, they were not transferees.

Tax Relief/Job Creation Act of 2010

After waiting all year for new estate tax provisions, Congress delivered the week of December 13, 2010. Until the new Tax Act can be more fully analyzed and implications discussed (watch for January addition), see the CCH Tax Briefing on the new law. The estate tax changes are discussed on pages 9-10. Note that this is the law for only the next two (2) years (2011 and 2012).

Highlights: Federal estate tax exemption increased to $5,000,000/individual with maximum 35% tax rate. The gift tax exclusion (before gift tax is due) has also been increased to $5,000,000. Basis is stepped-up to date of death value. Most significantly, the unused exemption of the first spouse to die can now be used by the surviving spouse, which will have planning implications.

These are federal law changes. The Minnesota estate tax exemption remains at $1,000,000.

Increase to Amount before Probate Required

Before a recent change in the law, an individual could avoid probate at death if they did not own more than $20,000 of probatable assets. That amount has changed and is now $50,000. If you have any questions as to the significance of this change and how it affects you, please call our office.

Transfer on Death Deed

Minnesota law allows individuals to have a Transfer on Death Deed (TODD) for real estate.. Prior to this change in the law, an individual could use a Transfer on Death (TOD) designation for securities and a Payable on Death (POD) designation for bank accounts to avoid probate for these assets. Now individuals may use a TODD to avoid probate for real estate in Minnesota.

Please call our office if you wish to discuss the use of a TODD in your estate plan.