Can you make a gift to charity but retain the right to pull back the value of the gift in the future, and still get a charitable deduction for the gift? The court said “no” in In Re Stapley, No. 09-47699 RLE (Bankr. N.D. Cali. 2019). The failed tax shelter included an S corporation whose stock was donated to a non-profit entity and whose stock could later be diluted using a warrant. The case provides guidance on using warrants for S corporations, which are often used for legitimate estate planning purposes.
Facts & Procedural History
The taxpayers approached a Big 4 accounting firm for tax planning advice. The accounting firm sold the taxpayer a tax shelter. The tax shelter cost the taxpayer $550,000 in fees to the accounting firm and, ultimately, resulted in the taxpayers filing bankruptcy.
The tax shelter involved an S corporation. The scheme included the following steps:
- The taxpayers formed the Subchapter S corporation.
- The S corporation issued 36,240 voting shares and 326,160 nonvoting shares to the taxpayer.
- The S corporation issued a warrant to the taxpayer giving him the right to purchase 3,261,600 shares of nonvoting stock (the “Warrant”). The Warrant recites that its exercise price is $0.80 per share which had been determined by an independent appraisal to represent 92.036% of the fair market value of each share of nonvoting common stock.
- The taxpayer then “donated” the nonvoting shares to a tax-exempt entity.
- The S corporation and non-profit entered into a Redemption Agreement pursuant to which the S corporation agreed to remain an S corporation and the non-profit agreed to sell back to the S corporation the 326,160 donated shares at an agreed time and the S corporation agreed to pay the fair market value on the date the stock was presented for redemption.
The IRS announced a voluntary disclosure initiative in 2002 for this transaction. The initiative allowed taxpayers to avoid penalties if they voluntarily disclosed the transaction to the IRS. The taxpayers participated in this initiative.
The IRS’s Audit and Bankruptcy Dispute
The IRS examined the taxpayer’s returns and determined that the transaction lacked economic substance. It also questioned whether the warrant constituted a second class of stock. The taxpayer disputed both issues during the tax dispute.
The instant case involved a dispute between the California FTB and the individual owners. The California FTB picked up the IRS audit adjustments for the individual owners. The dispute was in the bankruptcy court.
The taxpayer later changed its position on the second class of stock issue. Unlike its position at the start of the tax dispute, the taxpayer now argued that the warrant constituted a second class of stock. The result was that the S corporation election was terminated and the entity was really a C corporation. As a C corporation, the entity was subject to tax–not the shareholders.
One Class of Stock for S Corporations
There are a number of unique rules for S corporations. One is the prohibition on having a second class of stock.
While S corporations cannot have a second class of stock, they can have voting and non-voting shares.
With respect to warrants, Treasury Regulation §1.1361-1(4)(iii)(A) provides that a warrant will be treated as a second class of stock if, taking into account all of the facts and circumstances, the warrant is substantially certain to be exercised and has a strike price substantially below the fair market value of the underlying stock on the date it is issued.
The court summarized the law as follows:
Under applicable Treasury Regulations, a warrant is treated as a second class of stock if, taking all the facts and circumstances into account, it is substantially certain to be exercised, and has a strike price that is substantially below the fair market value of the underlying stock on the date a warrant is issued. Treas. Reg. §1.1361-1(1)(4)(iii)(A). The point of the test is to determine whether a warrant is “in the money” when it is issued.
Under Treas. Reg. §1.1361-1(1)(4)(iii)(C), there is a safe harbor test that compares the exercise price of a warrant to the value of the underlying stock on the date a warrant is issued. If the exercise price is at least 90 percent of the fair market value of the underlying stock on that date, there will be no second class of stock created.
The taxpayer complied with this safe harbor by obtaining a valuation for the 326,160 shares contributed to the non-profit. This valuation “was aimed at keeping plaintiffs inside the safe harbor available under Treas. Reg. §1.1361-1(4)(iii)(C) because the strike price of .80/share was at least ninety percent of the fair market value of the underlying stock (.87/share) on the date it was issued.”
The Warrant Safe Harbor
The IRS’s revenue agent report argued that this safe harbor did not apply as the exercise price was not at least 90 percent of the FMV of the stock. It reached this conclusion by noting that the valuation did not count all of the available stock:
The IRS asserted that the strike price was not at least 90 percent of the fair market value of the underlying stock (i.e., the Warrant stock) because the appraisal done for plaintiffs by KPMG in 2001 had valued only the 362,400 outstanding shares of voting and nonvoting stock rather than these outstanding shares plus the 3,261,600 shares that would be issued if the Warrant were exercised.
Because the warrant was certain to be exercised, the additional shares had to be considered.
The court did not address the consistency rules cited by the FTB. It didn’t have to. The court relied on the step transaction doctrine to conclude that the steps in the transactions should be collapsed and, when collapsed, the transaction lacked economic substance.
The final result was that the taxpayers were liable for the tax and penalties and interest thereon and the taxes were not discharged in bankruptcy.
This case shows how the courts use these judicial doctrines to unwind tax shelters. Technical compliance with tax laws generally won’t cut it. This is especially true where the taxpayer changes position late in the game to obtain a tax benefit.
Setting those issues aside, the case is instructive as to when warrants can be used for S corporations. There is little guidance in this area. Warrants can be useful in structures similar to the fact pattern here for estate planning purposes. Those who have entered into these transactions or are considering doing so, should review this court case.