Santa Clara Valley Housing Group: an S corporation abusive tax shelter.

• Author: Orbach, Kenneth N.

A district court in California (1) is considering a tax shelter case in which, at first blush, the issue is whether warrants issued by an S corporation are a prohibited second class of stock. (2) Upon further reflection, however, it is apparent that the entire tax shelter is an arrangement that is a second class of stock under Regs. Sec. 1.1361-1(I)(4)(ii)(A). A proper analysis of this issue reveals that the S corporation and its shareholders engaged in a promoted tax strategy that had no economic substance or business purpose and that ostensibly transferred tax items to a tax-exempt pension plan while the shareholders retained the corresponding economic benefits.

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Background

The Transaction

Santa Clara Valley Housing Group Inc. (Santa Clara) was an S corporation with five shareholders, all members of the Schott family. (3) Santa Clara had 100 voting common shares outstanding. Under a tax shelter strategy called S Corporation Charitable Contribution (SC2), Santa Clara:

1. Issued, pro rata to its shareholders, 900 shares of nonvoting common stock. In addition, each shareholder received warrants to purchase from the corporation 10 shares of nonvoting stock for each share of nonvoting stock the shareholder held. The warrants were issued solely to protect the Schotts' equity interest in Santa Clara while the family engaged in SC2.

2. Shortly thereafter, the Schotts "donated" (4) the 900 nonvoting shares to the City of Los Angeles Safety Members Pension Plan (LAPF), (5) with the understanding that LAPF would sell all the shares back to the Schotts in four years.

3. Over the next four years Santa Clara reported more than $114 million in ordinary income, of which 90% (more than $102 million) passed through to LAPP under Sec. 1366. LAPP, a tax-exempt entity, paid no tax on the passed-through income.

4. During the four years in which the Schotts "parked" (as the court put it) their nonvoting stock with LAPF, the corporation distributed to LAPF only $202,500 (90% of $225,000 total distributions) or approximately 0.2% of the income that flowed through to LAPE

5. At the end of the fourth year, LAPF sold the 900 nonvoting shares back to the original shareholders for only $1.6 million. Thereupon, the warrants were canceled.

   The Government's Position

   The government argued that the SC2 strategy was an abusive tax shelter under two alternative legal theories: (1) SC2 lacked economic substance and should be disregarded or recharacterized for tax purposes, or (2) the warrants were an impermissible second class of stock under Sec. 1361, thereby terminating Santa Clara's S election.

   Under the first theory, the IRS reallocated to the Schott family shareholders all the income that had ostensibly passed through to LAPF. Under the second theory, the S status of Santa Clara would have terminated as soon as the warrants were issued; all the subsequently earned corporate income would be taxed at the (now) C corporation level. Under both theories, LAPP would not take into account any of the Santa Clara tax items. Santa Clara and one of the shareholders (the taxpayers) paid assessments and sued for a refund. The government and the taxpayers filed cross-motions for summary judgment as to the second theory.

   The District Court's Initial Second-Class-of-Stock Ruling

   In making its decision on the parties' motions for summary judgment, the district court looked to Regs. Sec. 1.1361-1(1)(4) to determine whether the warrants issued to the shareholders were a second class of stock. Under that provision, warrants generally are not treated as a second class of stock, with two exceptions.

1. Warrants are a second class of stock if (a) they constitute equity under general principles of federal tax law, and (b) a principal purpose for their issuance is to circumvent either (i) the rights to distribution or liquidation proceeds conferred by the outstanding stock or (ii) the eligible shareholder restrictions of subchapter S. (6)

2. Warrants are a second class of stock if (a) they are substantially certain to be exercised and (b) they have a strike price substantially below the underlying stock's value. (7)

   The district court held that the warrants constituted a second class of stock under the first exception. The court stated that the warrants "obviously" were designed to permit the Schotts to retain de facto ownership of about 90% of the corporation even though 90% of the shares had been transferred to LAPE Had LAPF refused to sell the shares back, the Schotts could simply have exercised their warrants, thereby greatly diluting LAPF's shares in favor of the Schotts.

   Accordingly, it fairly may be said that the warrants "constitute equity," and were intended to prevent LAPF from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of [Santa Clara's] shares. There is no evidence that the warrants were issued for any purpose other than to protect the Schott family's equity in Santa Clara for the period of time that the majority shares were "parked" in LAPF. (8) On the other hand, the second exception did not apply, according to the court, because it was manifestly not substantially certain that the warrants would be exercised. To the contrary, if all went according to plan, the warrants would not be exercised. (9) In fact, they were not exercised; the Schotts had planned to exercise the warrants only if LAPF refused to sell back to them its 900 nonvoting shares.

   The District Court Reconsiders

   Regs. Sec. 1.1361-1(l)(4)(iii) provides three safe harbors from second-class-of-stock treatment of warrants. First, certain warrants issued to lenders (in the business of lending) in connection with commercially reasonable loans to the corporation are not a second class of stock. (10) Second, certain warrants issued to employees or independent contractors in connection with the performance of services to the...