Santa Clara Valley Housing Group, Inc. v. U.S.: District Court Finds Issues of Warrants Was Second Class of Stock That Terminated S Corporation Status

By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In Santa Clara Valley Housing Group, Inc. v. U.S., No. 5:08-cv-05097-JF (N.D. Cal. 9/21/11), the district court held that warrants constituted a second class of shares under the test set forth in the first exception of the regulations (discussed below), and, therefore, the issuing corporation had ceased to be a small business corporation, and, thus its S corporation status was automatically terminated. In this case, the district court found that warrants constituted a second class of stock even though the parties never intended to exercise them.

In order to elect to be treated as an S corporation for purpose of federal income tax, a corporation must be a small business corporation. Under §1361(b)(1)(D), the definition of a "small business corporation" is limited to those corporations that, among other characteristics, have only one class of stock. If an S corporation issues a second class of stock, it will cease to fit the definition of a small business corporation, and, therefore its S corporation status is automatically terminated under §1362(d)(2)(A).

While, in general, Regs. §1.1361-1(l)(4)(i) provides "[i]nstruments, obligations, or arrangements are not treated as a second class of stock," the regulations set forth two exceptions. The first exception under Regs. §1.1361-1(l)(4)(ii) provides that an "instrument, obligation, or arrangement issued by a corporation" will be treated as a second class of stock if: (1) the instrument "constitutes equity or otherwise results in the holder being treated as the owner of stock under the general principles of Federal tax law;" and (2) a "principal purpose" of issuing the instrument is "to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock." The second exception under Regs. §1.1361-1(l)(4)(iii) provides that a "call option, warrant, or similar instrument" will be treated as a second class of stock if: (1) "taking into account all the facts and circumstances," the warrant "is substantially certain to be exercised;" and (2) the warrant "has a strike price substantially below the fair market value of the underlying stock on the date that the [warrant] is issued."

In the late 1990s, KPMG, LLP (KPMG), a national accounting firm, developed a tax shelter known as the S Corporation Charitable Contribution strategy (SC2). Pursuant to SC2, an S corporation's shareholders temporarily transferred the corporation's non-voting stock to a tax-exempt organization through a purported donation.  Because the annual income of an S corporation passes through to its shareholders on a pro rata basis for purposes of calculating taxes, the effect of this "donation" was to render most of the corporation's income tax-exempt. The "donated" shares would remain "parked" in the charity for a pre-determined period of time, during which the S corporation's income accumulated in the corporation and distributions were minimized or avoided. After the pre-determined period of time had elapsed, the charity would sell the "donated" shares back to the original shareholders.  To protect against the possibility that the donee charity might refuse to sell its majority stock back to the original shareholders after the agreed-upon length of time, warrants were issued to the original shareholders prior to the "donation," which, if exercised, would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately 90% of the outstanding shares. The accumulated income of the S corporation could then be distributed to the original shareholders either tax-free or at the favorable long-term capital gains rate.

Santa Clara Valley Housing Group, Inc. ("Santa Clara"), a closely held California corporation formed by Stephen C. Schott and his wife, Patricia A. Schott, and their three adult children, Kristen Bowes ("Bowes"), Lisa Treadwell, and Stephen E. Schott (collectively, "the Schott family"), had a total of 1,000 shares of outstanding stock: 100 voting shares and 900 non-voting shares. Santa Clara elected to be treated as a S corporation, under §1362(a). In reliance upon KPMG's advice, in June 2000, each of the Schott family shareholders was issued a warrant to purchase 10 shares of non-voting stock for every share of non-voting stock he or she actually held and, in July 2000, the Schotts collectively "donated" the 900 non-voting shares to the City of Los Angeles Safety Members Pension Plan ("LAPF").

Over the following four years, Santa Clara reported more than $114 million in ordinary income, of which more than $100 million was attributed to LAPF. During this four-year period, Santa Clara distributed only $202,500 in earnings to LAPF, which represented approximately 0.02% of the income allocated to it. In December 2004, LAPF sold the 900 non-voting shares back to the original shareholders for a total of $1,645,002. The warrants were canceled in March 2006.

In September 2006, the IRS audited Santa Clara and the individual Schott family shareholders. The IRS concluded that the SC2 transaction was an abusive tax shelter. Firstly, the IRS contended that the SC2 transaction lacked substance and should be disregarded or recharacterized for federal tax purposes. Under this theory, the IRS took the position that the "pass through" income that Santa Clara had allocated to LAPF should be reallocated to the individual shareholders, including Bowes and issued a notice of deficiency against the individual shareholders for tax years 2000 through 2003. Alternatively, the IRS contended that the warrants issued in connection with the SC2 transaction violated the Code and Treasury regulations governing S corporations, and thus automatically terminated Santa Clara's status as an S corporation. Under this theory, the IRS took the position that for tax year 2000, Santa Clara was subject to income tax as a "C" corporation and issued a notice of deficiency against Santa Clara for the 2000 tax year. 

With respect to the second argument, the government contended that both exceptions to the general rule that "[i]nstruments, obligations, or arrangements are not treated as a second class of stock" applied to the warrants utilized in the SC2 transaction.  Conversely, Santa Clara argued that as a matter of statutory construction the first exception does not apply because it broadly addresses "instruments, obligations, or arrangements," while the second exception more narrowly addresses "call options, warrants or similar instruments." According to Santa Clara, "the specific controls the general" and, thus, only the narrower provision would apply.

Looking at the plain language of the exemption, the district court concluded that it was not ambiguous and applied to "any instrument, obligation, or arrangement issued by a corporation." Citing Dreiling v. America Online, Inc., 578 F.3d 995, 999 (9th Cir. 2009), the district court further concluded that the warrants issued by Santa Clara clearly constitute "instruments." Moreover, the district court stated that the two exceptions were not in conflict, but rather set forth separate and independent tests under which an instrument may be considered a second class of stock.

Accordingly, the district court concluded that the rule of construction favoring the specific over the general was not applicable.

The district court held that the warrants constituted a second class of stock pursuant to the first exception. The district court concluded that the warrants constituted equity interests, which were designed to permit the Schott family to retain nominal ownership of approximately 90% of the corporation even though 90% of the existing shares had been "donated" to LAPF, because, if the Schott family exercised the warrants, it would dilute LAPF's 900 shares such that LAPF would go from owning 90% to approximately 10% of the outstanding shares. Accordingly, the district court reasoned that the warrants were intended to prevent LAPF from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of a corporation's shares.

Turning to the second exception, the district court noted that the warrants would not constitute a second class of stock pursuant to this exception because the warrants were not "substantially certain to be exercised." To the contrary, if the SC2 tax shelter worked as planned, the warrants would not be exercised and, in fact, they were not. The district court did not look at the second prong of this exception since the first prong was not satisfied.

With respect to the deficiencies and penalties assessed against Bowes, the district court stated that presumably they were based upon the government's position that Bowes failed to report S corporation income in her tax returns for tax years 2000 through 2003. Because the government established that issuance of the warrants in June 2000 terminated Santa Clara's S corporation status, the district court stated that it appeared that Bowes was entitled to a refund of deficiencies and penalties relating to allegedly unreported S corporation income after June 2000 and that the government could seek to recover corporate taxes on Santa Clara's income for the period after June 2000.

Finally, the district court remanded for trial the charitable deduction of individual shareholder Kristen Bowes, who had claimed a deduction of $7,657 for a gift of her non-voting shares of Santa Clara stock to LAPF. The government had denied the deduction on the basis that there was never an intended transfer of actual value.

While the transaction reviewed in this case was a tax shelter, the theory adopted by the district court did not limit its ruling to cases involving tax shelters. Instead, the district court determined that the warrants were included in the more general term instruments and actually constituted equity that designed to ensure that the original shareholders retained nominal ownership of 90% of the company. This focus on the dilution and control aspects of the warrant makes this case worth considering in non-tax shelter transactions, because it is not uncommon for a corporation to issue warrants for that purpose.

For more information, in the Tax Management Portfolios, see Starr, Smith, and Sobol, 730 T.M., S Corporations: Formation and Termination, and in Tax Practice Series, see ¶4230, Eligibility Requirements, and ¶4250, Terminating an S Election.