A BUSTED “MIDCO” TRANSACTION shows both the perils of such deals and the reach of “transferee liability” for taxes.

The Diebold family, through a trust and a separate foundation, owned all the shares of Double D Ranch, a C corporation that owned

$319 million in assets, primarily publicly-traded securities. The assets had appreciated by approximately $230 million in value. Thus, an asset sale would have triggered a substantial tax.

Mrs. Diebold was getting old and was interested in starting to make cash gifts to her three children.

Tax counsel suggested that there are parties who would buy the stock at a price that would leave the shareholders with more money after taxes than they would have after a sale of assets. Typically, the buyer, known as a “midco,” would resell the assets after its stock purchase and use losses or other shelter to offset the gain. The typical midco is a shell company that is not good for the tax on gain if the strategy used to shelter the gain does not work.

The Diebolds interviewed two financial firms that arranged midcos and chose one called Sentinel Advisors. The midco Sentinel formed bought the shares in Double D for 97% of market value. The discount was Sentinel’s profit. The midco borrowed $297 million from Rabobank with the understanding that the loan would be repaid within five days out of the sales proceeds from selling the assets. The assets were sold to Morgan Stanley for $309 million. The midco retained the difference as profit after repaying the Rabobank loan.

The midco filed a consolidated tax return that included Double D and reported the gain on sale of the assets. It had enough losses to shelter the tax on gain. Double D was liquidated into the midco the day after the sale.

The IRS claimed $100 million in unpaid taxes, interest and penalties against Double D. It said the transaction was in substance an asset sale by Double D to Morgan Stanley, followed by a liquidating distribution to the Double D shareholders.
Double D did not contest the assessment, but the IRS was unable to find any Double D assets from which to collect since the company had liquidated.

The IRS attempted to collect from the shareholders under section 6901 of the US tax code, which allows the IRS to pursue both the transferees of the taxpayer who owes the taxes (Double D) and transferees of the transferees. It went after Mrs. Diebold and the foundations, but lost in the Tax Court. The IRS appealed only with respect to the foundations.

A US appeals court said that the determination whether the foundations could be held accountable had to be made under state law in New York. New York does not allow a creditor to go after a transferee unless the transferee had “actual or constructive knowledge of the entire scheme that renders [its] exchange with the debtor fraudulent.”

The US Tax Court heard the case first and said the shareholders did not have actual or constructive knowledge of the entire series of transactions. It said section 6901 cannot place the federal government in a better position than any other creditor of Double D under state law. However, the appeals court disagreed. It said constructive knowledge only requires a showing of “inquiry knowledge”: they knew enough that should have led them to inquire further. It sent the case back to the Tax Court.

The case is Diebold Foundation, Inc. v. Commissioner. Among other things, the Tax Court will have to decide whether a 3-year or 6-year statute of limitations applies to the IRS’s ability to pursue the claim.