Court finds “midco transaction” stock deal in substance an asset deal and permits IRS to recover target corporation’s tax from its shareholders

Sellers, a husband and wife duo, founded in 1985, and formerly owned (along with other shareholders) Target, a television and radio company. Target owned six radio stations, and six tv stations, one tv station in Minnesota and five tv stations in Wisconsin.

In conjunction with their retirement, Sellers wanted to sell Target. Target’s international accounting firm presented Sellers with analyses that compared the projected impacts on both buyers and sellers of a stock sale versus an asset sale. One such analysis, which assumed a value of $190 million for Target’s radio and television assets, showed net after-tax liquidation proceeds to Target shareholders of $94 million for a hypothetical stock sale, but only $75 million for the correlating proceeds of a hypothetical asset sale.

Sellers and Target liked a stock deal for its obvious tax advantages, but an asset deal would be more attractive to potential buyers because it would be very difficult to get a buyer to take both the 6 tv stations and 6 radio stations. Probably, the best price for selling Target would be to sell the radio stations to one buyer and the tv stations to another.

However, Sellers and the other shareholders preferred the greater net proceeds from a stock sale. And their advisers came up with a structure referred to in the trade as a “midco transaction”.

“Midco,” stands for “middle company,” and a midco transaction generally refers to a transaction in which Sellers and other shareholders would sell the Target stock (thus avoiding the triggering of built-in gain in Target’s appreciated radio and tv assets) while the buyer then sells Target’s assets, through use of an intermediary company.

Sellers were informed of a risk that the IRS might recharacterize the transaction as an asset sale. Their adviser on the structure of midco transactions, however, represented that none of the similarly structured transactions it had facilitated over an 18-year period had been successfully challenged or unwound.

Ultimately, Sellers with the help of advisers, sold their Target stock to a company run by a breakout specialist, who specializes in buying private companies and breaking up the assets in subsequent sales. The buyer then sold the five Wisconsin tv stations to an Illinois media company, the six radio stations to a Wisconsin radio company and the Minnesota tv station was distributed to Sellers.

The stock sale and the subsequent sale by the buyer of the tv stations all happened on May 31, 2001 within a span of less than three hours. The sale of the radio stations to a Wisconsin radio company occurred on September 21, 2001.

The transaction was very complicated involving Target, its shareholders, and four other entities. As a result, Target’s appreciated radio and tv stations were sold without generating any correlating tax liability to anyone.

In exchange for their Target shares, Sellers and a company Sellers owned ultimately received about $26 million. Sellers timely filed federal income tax returns for calendar year 2001 reporting gains from the May 31, 2001 sale of Target stock.

But this result was too good to be true. The IRS recast the transaction of Target (which had dissolved) as a sale by Target of its tv and radio assets, followed by a distribution of the sales proceeds to Sellers and the other shareholders as a liquidating distribution from Target.

This resulted in the IRS assessing Target with tax, penalties and interest of almost $79 million. However, Target no longer existed.

So, the IRS came after Sellers for the $26 million they had received from the transaction to recoup part of the $79 million tax liability the insolvent and now dissolved Target owed the IRS. The IRS based their claim on Internal Revenue Code section 6901.

The IRS said that under Section 6901, Sellers can be held liable for the taxes of Target. Sellers challenged the IRS claim in the U.S. Tax Court and lost and they appealed to the federal appellate court. Sellers also lost on appeal and thus were liable to pay over the entire $26 million sales proceeds to the IRS.

The court first said the IRS was correct in assessing Target the $79 million tax liability by recasting the stock sale into an asset sale because the deal was in substance an asset sale and the only purpose in doing a stock sale was to avoid taxes. The court then said that Sellers were liable for Target’s tax liability under Wisconsin’s fraudulent transfer law.

And Sellers were liable under Wisconsin’s law because Sellers received the sales proceeds which really were earned by Target when it in substance sold its assets; and the receipt of the sales proceeds by Sellers made Target insolvent.

This case is referred to as Shockley v. CIR, No. 16-13473, United States Court of Appeals, Eleventh Circuit, (October 3, 2017).

Comment. This stock deal was based upon an aggressive tax plan. Nevertheless, Sellers claimed that they did not know that this structure was aggressive and risky.

Seller’s accounting firm and the media broker were experienced and well-known advisers. Unfortunately, Seller’s claimed good faith and reliance upon experts did not matter under the Wisconsin fraudulent transfer law. It only mattered that the deal turned out not to work, triggering a large Target tax liability that rendered Target insolvent, and gave the IRS the right to come back after Sellers for their sales proceeds.

Federal income taxes are often by far the largest expense in doing a deal. And a deal structure that is very complicated and saves a bundle of the tax expense may be too good to be true. And if the deal blows up there is a real risk that the seller may be in a far worse position that had seller done a simpler transaction reflecting the substance of the deal, rather than getting cute.

By John McCauley: I help people start, grow, buy and sell their businesses.



Telephone:      714 273-6291

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Posted in asset vs stock deal, midco transaction, transferee liability for taxes IRC Section 6901

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