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Midco transactions: when is one party liable for another's taxes?

Yesterday news broke about the merger of AT & T and Time Warner. The deal is worth a reported $85 billion, so understandably there's a lot of buzz.

There are all sorts of deals, however, involving little media attention but important tax issues. In this post, we will discuss a fairly common scenario known as a "midco transaction."  This is a transaction in which a third party serves as an intermediary between buyer and seller when a business is sold.

Can companies use these midco entities to keep tax liabilities of the first entity from being transferred to the entity that acquires it?

The IRS has been working on this issue for the better part of a decade. The agency contends that it should be able to collect taxes from the seller - and not let the seller avoid those taxes by transferring assets to an intermediary before the assets go to the buyer.

The federal circuit courts of appeal have not been very inclined to agree with the IRS in these cases. They have required the IRS to show that shareholders of the selling company knew or should have known that taxes on the sale of company assets would not be paid because of the transfer to a third party.

Having to show such knowledge on the party of shareholders makes it difficult for the IRS to win these cases. In one recent case, however, the IRS did prevail.

The case is called Feldman v. Commissioner and was decided by the Seventh U.S. Circuit Court of Appeals. In Feldman, the Seventh Circuit said the IRS did not have to consider the level of the shareholders' knowledge before the IRS classified a midco deal as liquidation subject to taxation.

Feldman is not a standalone case, either. The Tax Court has followed it in two subsequent cases.

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