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(l)(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.
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:
- 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.
- 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.
- 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 LAPF under Sec. 1366. LAPF, a tax-exempt entity, paid no tax on the passed-through income.
- 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 LAPF.
- 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, LAPF 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(l)(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.
- 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
- 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 LAPF. 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 corporation are not a second class of stock. 11 Third, and relevant for purposes of the Santa Clara case, warrants are not a second class of stock if the strike price is at least 90% of the stock’s value on the date the warrants are issued, transferred from a person who is an eligible S shareholder to a person who is not an eligible shareholder, or materially modified. 12 A good-faith determination of fair market value by the corporation is respected unless it can be shown that the value is substantially in error and was arrived at without reasonable diligence.
According to the district court, it had not understood that the taxpayers were arguing that the third safe-harbor provision applied to the warrants issued by Santa Clara. Agreeing with the taxpayers’ arguments that the safe-harbor would apply if the warrants met the strike price requirement, the court granted a motion for reconsideration based on the possible applicability of this third safe harbor. 13
Excludability of Passthrough to LAPF
Regarding the tax effect to LAPF of ordinary income passed through to it, the court simply noted that LAPF, as a tax-exempt entity, paid no taxes on this income. As a publicly controlled pension plan for the benefit of retired or injured firefighters and police officers, LAPF was an eligible S shareholder under Sec. 1361(c)(6). Under Sec. 512(e)(1), LAPF’s unrelated business taxable income included any items that passed through to it from an S corporation under Sec. 1366(a). However, the SC2 promoters took the position that because LAPF was publicly controlled, such income items were excluded, presumably under Sec. 115 (relating to the exclusion of income of states, municipalities, etc.)
As noted above, the court has left open the question whether the warrants are not a second class of stock because they meet the 90% safe harbor in Regs. Sec. 1.1361-1(l)(4)(iii)(C). But the second-class-of-stock issue will not be resolved even if the court holds for the taxpayers that the 90% safe harbor applies. To see this, assume that, during the four years that LAPF (ostensibly) held the nonvoting stock, Santa Clara had ceased doing business and liquidated. Would LAPF have received 90% of the liquidation proceeds? Remember that Santa Clara was very profitable. It strains credulity to believe that under the SC2 strategy, Santa Clara would have permitted LAPF to receive more than $100 million upon the corporation’s liquidation. Instead, the Schotts would have exercised their warrants before the liquidation to greatly dilute the shares in the hands of LAPF. In other words, LAPF, the ostensible owner of 90% of the stock, would never have received anything close to 90% of the proceeds upon liquidation. 14
The court appears to have recognized this aspect of the SC2 transaction when it initially ruled that the warrants constituted a second class of stock under Regs. Sec. 1.1361-1(l)(4)(ii)(A). In so ruling, the court looked to all components of SC2—the warrants and nonvoting stock, plus the stock donation and the agreed-upon buyback. The court on reconsideration should focus not on whether the warrants as an instrument constituted a second class of stock under Regs. Sec. 1.1361-1(l)(4)(ii)(A) but rather on whether the whole SC2 arrangement is a prohibited arrangement under that regulation and thus a prohibited second class of stock. The safe harbors under Regs. Sec. 1.1361-1(l)(4)(iii) by their terms do not apply to the SC2 arrangement because it is not a warrant. It has a warrant component but is much more than a warrant. 15 On the other hand, the 90% rule may prevent second-class-of-stock-treatment of the warrants alone.
Finally, because no safe harbors apply, the court should find that the SC2 arrangement meets the conditions of Regs. Sec. 1.1361-1(l)(4)(ii)(A) and thus is a prohibited second class of stock, because:
- It was issued by Santa Clara.
- The SC2 arrangement was not outstanding stock. 16
- The SC2 arrangement constituted equity or otherwise resulted in the Schotts’ being treated as the owners of stock under general principles of tax law. The court has already ruled that the warrants alone constituted equity. So, too, therefore, must the SC2 arrangement, of which the warrants (and additionally, the nonvoting stock) are a component, constitute equity.
- A principal purpose of entering into the SC2 arrangement was to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock. As argued above, LAPF would never have received 90% of the proceeds upon liquidation, even though it ostensibly held 90% of the stock. Perhaps more important, the court has already ruled that the warrants alone “were intended to prevent LAPF from enjoying the rights of distribution or liquidation that ordinarily would come with ownership of the majority of a successful company’s shares.” So, too, therefore, was the SC2 arrangement.
The requirements of Regs. Sec. 1.1361-1(l)(4)(ii)(A) are met with respect to the SC2 arrangement, and no safe harbors are available. Thus, the SC2 arrangement is a prohibited second class of stock. Under this legal theory the taxpayers would suffer the following consequences:
- Santa Clara’s S election terminated when the warrants and nonvoting stock were issued to the Schotts.
- The Schotts probably should not be allowed a charitable deduction for their contribution of the now C stock to LAPF because, as of the date of the purported gift, the contribution could be defeated (to a large extent) by the Schotts exercising their warrants. 17
- Santa Clara would be liable for corporate tax on its $114 million in income.
- When Santa Clara distributed its income after the Schotts reacquired the nonvoting stock, the Schotts would recognize dividend income to the extent of Santa Clara’s earnings and profits.
Santa Clara’s earnings and profits would include the $114 million in earnings, less the small distributions to LAPF and the Schotts while the nonvoting stock was parked with LAPF. Earnings and profits are also reduced by corporate income taxes. Because as a C corporation Santa Clara almost certainly would be required by Sec. 448 to use the accrual method of accounting (none of the exceptions in Sec. 448 appear to apply), so, too, it would have to use the accrual method for earnings and profits purposes. 18 If Santa Clara had been on the cash method as an S corporation, then the S termination and change to the accrual method would have Sec. 481 implications, as well.
Lack of Economic Substance
The IRS’s other theory—that SC2 lacks economic substance and should be disregarded or recharacterized for tax purposes—is also a winner. 19 Stated otherwise, SC2 lacks both economic substance and a business purpose, having no nontax bona fides. 20 The Tax Court has stated in this regard that “[n]umerous courts have held that a transaction that is entered into primarily to reduce tax and which otherwise has minimal or no supporting economic or commercial objective, has no effect for Federal tax purposes.” 21 In addition, effective for transactions entered into after March 30, 2010, the codified economic substance doctrine in Sec. 7701(o)(1) provides that a transaction to which the economic substance doctrine is relevant is treated as having economic substance only if: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (again, apart from federal income tax effects) for entering into the transaction. 22
LAPF essentially received an accommodation fee of about $1.8 million ($202,500 distribution plus $1.6 million repurchase proceeds) so that the Schotts could avoid recognizing $102 million of passthrough ordinary income from Santa Clara. The Schotts at all times retained control of the corporation because they owned all the voting stock. The 900 shares of nonvoting stock were issued to the Schotts and ostensibly donated to LAPF simply as the vehicle by which the income was assigned to LAPF. LAPF agreed at the front end to sell the shares back to the Schotts after four years at their value at that time ($1.6 million). The value was that low because of the dilutive effect of the warrants in the Schotts’ hands, because virtually no distributions were paid (or would be paid while the nonvoting stock was not in the Schotts’ hands), and because the stock was nonvoting.
In addition, although LAPF may not have been contractually required to sell the nonvoting shares back to the Schotts, there was no public market for the stock. Thus, the stock for all practical purposes had no value to LAPF except for the Schotts’ repurchase commitment. In other words, the upside potential of the nonvoting stock in LAPF’s hands was very limited. In the usual SC2 transaction, the shareholders guaranteed the repurchase price would be at least the value at the time of the putative donation; LAPF therefore incurred virtually no downside risk. Taken together, the facts show the Schotts retained the burdens and benefits of ownership of the nonvoting stock they ostensibly donated to LAPF. Hence, the Schotts retained beneficial ownership of the stock, there was no donation for federal income tax purposes, and the SC2 transaction fails.
Losing under this theory, Santa Clara and the Schotts would be treated as if the arrangement (nonvoting stock and warrants) had never been issued, the shareholders had not made a donation of stock to LAPF, and all of Santa Clara’s $114 million of income had flowed through to the Schotts, who would have to include it as ordinary income. The $1.8 million of accommodation fees received by LAPF are not deductible under Sec. 162 (not ordinary and necessary in carrying on any trade or business) or as a charitable contribution. 23
Under the subchapter S regime, S corporation items of income, loss, deduction, and credit pass through pro rata to the corporation’s shareholders, for whom the items have the same character as recognized by the S corporation. These items must be recognized by the shareholders in their tax year in which the S corporation’s tax year ends. 24 To prevent double taxation of a shareholder, 25 (1) income (or loss or deduction) items that pass through to a shareholder increase (or decrease) the shareholder’s stock basis, 26 and (2) shareholders receive distributions of the previously taxed income tax free. 27
The SC2 arrangement in the Santa Clara case is contrary to the subchapter S regime, for three reasons: First, the ordinary income that passed through to LAPF, which represents substantially all of Santa Clara’s income, was ostensibly not subject to current tax. 28 Second, LAPF patently would not have received 90% of the proceeds had Santa Clara liquidated while LAPF held the nonvoting stock. Third, once the Schotts repurchased the nonvoting stock from LAPF, Santa Clara could distribute to the Schotts the previously undistributed income, the vast majority of which had been allocated to LAPF. This distribution would be tax free to each shareholder to the extent of stock basis and thereafter would be long-term capital gain. 29 Thus the SC2 arrangement inappropriately would allow the Schotts to defer the inclusion of the income and transmute ordinary income into long-term capital gain. 30
Thus, for a small accommodation fee, 90% of the tax items of the Santa Clara business were allocated to LAPF (at no tax cost to LAPF), but the corresponding economic items inured to the benefit of the Schott family. This is patently contrary to congressional intent in promulgating subchapter S 31 and is an affront to our tax system. 32
Stripped to their cores, the second-class-of-stock and economic substance analyses in the case are essentially two sides of the same abusive tax shelter coin (although the tax consequences to Santa Clara and the Schott shareholders, if they lose, will differ depending on which of the two theories the government prevails on). The district court should expand its review of the second-class-of stock prohibition from warrants to the SC2 arrangement as suggested above, using an economic substance analysis.
5 LAPF is an acronym for “LA Pension Fund,” which is what the plaintiffs called the Los Angeles Safety Members Pension Plan in their complaint. The court used the acronym in its opinion, and this article follows that usage.
7 Regs. Sec. 1.1361-1(l)(4)(iii)(A). This exception is tested on the date the warrants are issued (or transferred from an eligible S shareholder to an ineligible S shareholder, or when the terms of the warrants are materially modified). In addition, if under the terms of the warrant, the strike price cannot be substantially below the underlying stock’s value at time of exercise, then the second exception does not apply.
9 However, in another SC2 transaction engaged in by different parties, the shareholders sought to rescind their transfer of stock to the tax-exempt party after the IRS denied the charitable deduction (Austin Firefighters Relief & Retirement Fund v. Brown, No. 3:07-cv-228TSL-JCS (S.D. Miss. 9/29/08 and 2/11/10)). Instead, the IRS concluded that the cash paid to the tax-exempt organization was an accommodation fee to effectuate the SC2 strategy.
13 Santa Clara Valley Housing Group, Inc., No. 08-cv-05097 (N.D. Cal. 1/18/12). The promoters of SC2 typically set the strike price at a price that ostensibly meets this 90% safe harbor on the issue date. For this purpose, the participants in the transaction claim that the value of the nonvoting stock is substantially reduced because of the existence of the warrants. See Notice 2004-30, 2004-1 C.B. 828. The IRS may take the position that the value of the nonvoting stock is not reduced for this purpose on the warrant issue date due to the issued warrants.
14 Whether this practical effect rises to the level of a governing provision under Regs. Sec. 1.1361-1(l)(2)(i) (and would therefore make the nonvoting stock a prohibited second class of stock) is questionable, but it does suggest the line of argument to follow.
15 In addition to the three warrant safe harbors, other safe harbors under Regs. Sec. 1.1361-1(b)(4), (l)(4), and (l)(5)—certain deferred compensation plans, certain short-term unwritten advances, proportionately held debt, and straight debt—do not apply to SC2.
16 One must look to Regs. Sec. 1.1361-1(l)(2) to determine whether outstanding stock is a prohibited second class. The SC2 arrangement, of course, has a stock component and a warrant component (plus other terms) and therefore is not outstanding stock for purposes of Regs. Sec. 1.1361-1(l)(2).
17 See Regs. Sec. 1.170A-1(e). It is hard to believe also that the Schotts had donative intent (an issue that is beyond the scope of this article). In addition, even under the second-class-of-stock theory the cash payments to LAPF as the SC2 facilitator should be deemed nondeductible accommodation fees for services. See note 23 below and accompanying text.
19 Because the district court only ruled on the parties’ cross-motions for summary judgment on the second-class-of-stock issue, it did not address the economic substance argument. The SC2 type of transaction is detailed at length in a report by the minority staff of the Permanent Subcommittee on Investigations of the U.S. Senate Committee on Governmental Affairs, U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals, S. Print No. 108-34, 108th Cong., 1st Sess., at 122–125 (2003).
20 The IRS identified SC2 as a listed transaction in Notice 2004-30, 2004-1 C.B. 828, and Notice 2009-59, 2009-2 C.B. 170. Therefore, had current law applied to the transaction, LAPF and any person who qualified as an “entity manager” of LAPF would have been subject to excise tax under Sec. 4965.
21 Reddam, T.C. Memo. 2012-106, quoting CMA Consol., Inc., T.C. Memo. 2005-16. See also Frank Lyon Co., 435 U.S. 561 (1978); Bail Bonds by Marvin Nelson, Inc., 820 F.2d 1543 (9th Cir. 1987); and Sacks, 69 F.3d 982 (9th Cir. 1995). Both the Supreme Court and Ninth Circuit precedents are binding on the Santa Clara district court.
22 Sec. 7701(o) was enacted in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, which also included amendments to the penalty provisions under Secs. 6662, 6662A, 6664, and 6676 that apply to taxpayers that engage in transactions that do not have economic substance.
23 There is no evidence (and no reason to otherwise believe) that the amount paid to LAPF exceeded the value of the accommodation services, nor that the plaintiffs intended it to. See Regs. Sec. 1.170A-1(h)(1).
28 Congress has given its blessing to one type of shareholder to which allocated income is tax free: employee stock ownership plans (Sec. 512(e)(3)). Of course, the passthrough of corporate tax-exempt income is tax exempt in the hands of the shareholders.
29 Because Santa Clara was a virgin S corporation, under Sec. 1368(b) distributions to its shareholders would have first been applied against stock basis and then would have been capital gain. Had the corporation previously been a C corporation with earnings and profits, the result would have been the same, because the undistributed income accumulated during the LAPF years would have increased the corporation’s accumulated adjustments account (AAA) dollar for dollar. Distributions thereafter of the accumulated income would have come out of AAA and therefore would have first been applied against stock basis and would then have been capital gain (Secs. 1368(e)(1) and (c)(1)).
30 Because the Schotts’ stock bases increased minimally during the period the nonvoting stock was parked with LAPF, and because of the stock’s small “repurchase” price, it appears that most of the distribution to the Schotts after they “reacquired” the stock would be long-term capital gain.
31 See Crispin, T.C. Memo. 2012-70 (“A court may disregard a transaction for Federal income tax purposes under the economic substance doctrine if it finds that the taxpayer failed to enter into the transaction for a valid business purpose but rather sought to claim tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations.”).
32 “Gregory v. Helvering [293 U.S. 465 (1935)] requires that a taxpayer carry an unusually heavy burden when he attempts to demonstrate that Congress intended to give favorable tax treatment to the kind of transaction that would never occur absent the motive of tax avoidance.” Coltec Industries, Inc., 454 F.3d 1340, 1355–6 (Fed. Cir. 2006), quoting Diggs, 281 F.2d 326 (2d Cir. 1960).
Ken Orbach is a professor of accounting at Florida Atlantic University in Boca Raton, Fla., and is a member of the AICPA S Corporation Technical Resource Panel and The Tax Adviser Editorial Advisory Board. He is grateful to his colleagues on the S Corporation TRP for their comments and advice. For more information about this article, contact Prof. Orbach at email@example.com.