Originally Published on forbes.com on January 13th, 2012
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It never ceases to amaze me that 25 years after the Tax Reform Act of 1986, there is still a significant amount of appreciated property inside closely held C corporations. There are legitimate ways to deal with the problem if you can plan ahead. It really is not the sort of problem that should sneak up on you. Nonetheless, it snuck up on enough people to allow an outfit called Midcoast Credit Corp to build a business around helping people deal with the problem – kind of.
The way it worked was that your closely held company would sell its pile of taxi medallions or as in this case (Ray Feldman, et al. v. Commissioner, TC Memo 2011-297)a dude ranch to somebody. Your closely held C corporation now has cash and the obligation to file a corporate tax returnthat will absorb quite a bit of that cash- that’s it. For illustrative purposes let us say $1,000,000 in cash of which 40% will go in with the return (I know it doesn’t literally go in with the return, don’t be petty.), leaving $600,000 to distribute in liquidation. Midcoast will buy the corporation from you for maybe $720,000. It reminds me of the story of the two brothers who went out into the country and bought apples for a nickel and sold them in the city for four cents. After they ran out of money they debated whether the problem was not having a big enough truck or not having a presence on the web. Clearly Midcoast was planning on paying something less than $400,000 – a lot less, like nothing. Since you had sold them the stock, though, it was not your problem – kind of.
You might ask why not just take the $1,000,000 from the corporation and not get involved with Midcoast. When the IRS comes knocking give them the minute book and the corporate seal and tell them its all theirs. The reason that does not work is because of a concept called “transferee liability”. If the corporation gives the money it should have used to pay taxesto somebody, then the IRS chases that person for the corporate taxes. What the IRS has argued on Midcoast deals is that is what happened in essence, since Midcoast was clearly going to get the money to pay you from the corporation you just sold them. The IRS has had mixed success. It happens that the Tax Court came down with two decisions on the same day. The taxi medallion people, whom I discussed here won. Mr. Feldman, one of the dude ranch shareholders, lost. What made the difference ? Here is the dude ranch story.
In the fall of 2001 negotiations began with an individual named Damon Zumwalt (Zumwalt) for the sale of Woodside Ranch, with the expectation on both sides that commercial operation of the dude ranch would be continued by Zumwalt. A stock sale was proposed to Zumwalt, who “just laughed and chuckled and said, `not on your life, it’s got to be an asset sale’.”
After the asset sale to Zumwalt, Woodside Ranch had no operating assets and ceased to engage in any meaningful business activity.
In the early spring of 2002 Fred Farris (Farris), an accountant and financial adviser to Woodside Ranch and to some of the individual shareholders, introduced the Woodside Ranch officers, directors, and shareholders to MidCoast Credit Corp. and to MidCoast Acquisition Corp.
As reflected in written notations of petitioner Ray Feldman of a meeting that apparently occurred later in the day on June 11, 2002, the MidCoast representatives explained that under the MidCoast proposal MidCoast would purchase bad debts from entities unrelated to target corporations (such as Woodside Ranch) and would use the bad debts to offset or eliminate unpaid tax liabilities of the newly acquired target corporations.
(It makes about as much sense as the apple selling brothers, but that is neither here nor there.)
The transaction proposed by the representatives of MidCoast was also referred to by the MidCoast representatives as a “no- cost liquidation”. (Emphasis added.) In other words, instead of directly liquidating Woodside Ranch and distributing to the Woodside Ranch shareholders the cash proceeds from the Zumwalt asset sale (less the combined Federal and State tax liability that would have been paid), the MidCoast proposal was designed so that the cash, in effect, still could be “liquidated” or transferred to the Woodside Ranch individual shareholders, but indirectly and via a few additional steps.
The practical problem in implementing this transaction was that you are not supposed to use the corporate cash to pay off the shareholders. They are supposed to get the money from somebody else who then gets to pillage the corporation. Midcoast found a fellow named Shapiro to help out. Execution on this piece was not great:
July 18, 2002 12:09 p.m. $1,835,209 Woodside Ranch cash transferred into the Foley trust account; 1:34 p.m. $1.4 million cash purportedly lent from Shapiro to MidCoast transferred into the Foley trust account; 3:35 p.m. $1,344,451 cash transferred out of the Foley trust account into an account of Woodsedge in favor of petitioners; 3:36 p.m. $1.4 million cash transferred out of the trust account back to Shapiro.
Per the purchaser’s escrow agreement, the purported $1.4 million loan from Shapiro was not to be disbursed until the $1,835,209 proceeds of the Woodside Ranch asset sale were placed into the escrow fund, and only then was: $1,344,351 to be disbursed to Woodsedge on behalf of the Woodside Ranch shareholders; $452,728.84 to be disbursed to Midcoast; and $1.4 million to be “immediately” returned to Shapiro without interest. The closing statement shows $1.4 million coming from Shapiro and going back to Shapiro as part of the very same closing transaction.
The Court did not think well of the Shapiro gambit:
The Court did not think well of the Shapiro gambit:
The $1.4 million from Shapiro came into escrow only momentarily and went right back to Shapiro without ever serving a legitimate, economic purpose in this transaction. Were it a legitimate loan, the $1.4 million would have been outstanding for a period of time and would have had some business purpose. Interest would have been charged. There would have been a written promissory note. The $1.4 million from Shapiro constitutes aruse, a recycling, a sham.
Midcoast’s “marketing material” also did not help the cause:
The “no-cost liquidation” terminology used by the MidCoast representatives is telling. In substance, it really was a liquidation, not a stock sale. The effort, assisted by MidCoast’s sleight of hand, to reduce the tax cost of the Woodside Ranch liquidation by cloaking the liquidation in the trappings of a stock sale is to be ignored.
MidCoast offered a “no-cost” liquidation as a solution to the tax “dilemma” in which petitioners found themselves. In spite of representations to the contrary in some of the transaction documents, the record is replete with notice to petitioners that MidCoast never intended to pay Woodside Ranch’s Federal income tax liability.
On the same day, the Tax Court found that the Frank Sawyer Trust was not liable on another Midcoast deal. “Transferee liability” can turn on issues of state law. Frank Sawyer, through his corporations, was the largest owner of Boston taxi medallions. The Feldman dude ranch was in Wisconsin. The real difference, though, was that Sawyer was a much bigger deal and was better executed. Another company, Fortrend, was pulled into the mix and they actually borrowed money from a bank to pay the Sawyer Trust and waited a couple of days before pillaging the taxi corporations. Also, the Sawyer interests had no curiosity whatsoever about how it was that Midcoast and Fortrend were avoiding the corporate tax. They just assumed it was legitimate. As another blog post noted on the Sawyer case “Ignorance is bliss“.
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