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IRS DEFEATS 'MIDCO' TAX SHELTER

April 02, 2008

When a C corporation sells its business, there is typically a little tug of war between the buyer and seller.

The seller wants to sell his stock because he will be taxed twice if he sells the assets -- first on the gain on the assets themselves, and again when he liquidates the corporation.

The buyer, in contrast, wants to buy assets. The buyer doesn't want to take on any unknown liabilities of the old corporation, but he also wants to recover his purchase price through depreciation and amortization. The cost of stock isn't recoverable until it is sold.

A tax shelter launched in the 1990s tax shelter frenzy sought to give both sides what they want. The "Midco" shelters would set up a tax-indifferent middleman to buy the stock -- giving the seller his sought-after stock sale -- and then sell the assets to the buyer. The IRS won a court battle against this shelter in a U.S. District Court in Houston yesterday; the court upheld the IRS position on summary judgement.

Accounting firm PriceWaterhouse Coopers (PWC) arranged for a tax-indifferent "Midco" named "K-Pipe" to buy the stock of Bishop Group Ltd. and sell the assets to Midcoast Energy Resources. The judge disregarded the midco and said the transaction was a stock sale:

Moreover, there is no objective evidence in the record that K-Pipe negotiated the stock sale at all. All of the communications involved Midcoast, and it was at the insistence of Midcoast's tax advisors that certain actions be undertaken, such as the agreement not to liquidate Bishop for two years and the formation of the Butcher Interest Partnership to add "good facts" to the transaction. Additionally, K-Pipe's obligations were almost entirely indemnified by Midcoast through various side agreements and under the Stock and Asset Purchase Agreements. It was Midcoast's loan that acted as security for the $195 million, which K-Pipe borrowed. K-Pipe, having been created for the purposes of this transaction, could not have provided any assets as security. After the transaction, K-Pipe engaged in virtually no business activity and was, in substance, a mere shell. Finally, K-Pipe's sole purpose in participating in the transaction was to allow Midcoast to step up the basis of the Bishop Assets. Under the facts of this case, the court finds that K-Pipe's role in the transaction should be disregarded.

Another blow to the big-firm tax shelter industry.

Cite: Engbridge Energy Company, Inc. v. U.S., No. 4:06-cv-00657 (DC-SD Texas)

Tags: tax shelters.

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