MIDCO Transactions And The Expanding Universe Of Transferee Liability

The Internal Revenue Service's determination of transferee liability, essentially secondary liability, resulting from transactions involving the taxable sale and disposition of corporate stock, is being litigated with increasing frequency in the federal courts. The outcome of these disputes varies as they are highly fact determinative. Thus, not surprisingly, Taxpayers have experienced mixed results in court. Although there are lower courts that have held in favor of the putative transferee, selling shareholders, three recent Tax Court decisions have been reversed on appeal.1 In fact, to date only one taxpayer victory has been affirmed on appeal.2

The IRS's recent successes have emboldened it to utilize transferee liability more frequently as a tax collection mechanism, most notably against corporate shareholders who engaged in so-called Midco or middle-company transactions,3 primarily during the late 1990s to early 2000s.

Generally, a Midco transaction is one in which the seller engages in a stock sale (thus avoiding the triggering of built-in gain in appreciated assets) while the buyer engages in an asset purchase (thus allowing a purchase price basis in the assets), through use of an intermediary company. Taxpayers involved in these Midco transactions, and taxpayers who may be contemplating transactions that could be construed as Midcos, should be cognizant of their potential exposure as transferees under Code section 6901.4 They could potentially be subject to liability for their counterparty's unpaid taxes, interest and potential penalties related to the disposition of the property. Generally, the salient issue in these Midco transferee cases is whether the selling shareholder knew or should have known that the Midco intermediary would incur a tax liability that it could not and would not pay and thus would not be collected. Practitioners should be forewarned consequently that it would be prudent to give appropriate consideration to Section 6901 and evaluate their client's potential exposure to transferee liability before the transaction is completed. Part I of this paper evaluates Section 6901 on several fronts, with particular emphasis on recent decisions involving Midco transactions. Part II of this paper considers whether there are any limitations or defenses to the statute's reach. Since transferee liability of a taxpayer is derived from statutory authority, it is proper to begin by looking at the Code.

Legislative History of Section 6901 and Transferee Liability

In 1926, as part of an effort to assist in the collection of taxes, Congress enacted a provision that enabled the United States for the first time to proceed against those secondarily liable in the same manner as against those primarily liable.5 The purpose of Section 280 was to provide a summary and expeditious method of collecting income taxes in situations in which a taxpayer disposed of his assets, leaving himself unable to meet his tax liability. Prior thereto, the only avenue of redress open to the Government in such a case was to proceed against the transferee in equity upon a trust fund theory or at law if the debts of the transferor had been assumed. However, in practice, this was difficult and expensive, and was seldom attempted. Consequently, Congress established the alternative summary method of collection by notice to the transferee and extended to the taxpayer the opportunity either to pay and sue for a refund, or else to proceed before the Tax Court.6 No new obligation was created by the statute against the transferee, but merely a new procedure for enforcing the existing tax liability.7 Section 280 followed the enactment of Section 209 of Act of Congress in 1916, which created a liability at law for certain transferees of estates.8 A similar provision was subsequently enacted in 1932 for gift taxes.9

Section 311 of the Internal Revenue Code of 1939 followed as the successor to Section 280.10 The courts also recognized that Section 311 neither created nor defined a substantive liability but provided merely a new procedure by which the Government may collect taxes.11 The U.S. Supreme Court has long since confirmed that this section "neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes."12

In...