## Facts

- Santa Clara Valley Housing Group, Inc. (Santa Clara) was a closely held corporation formed in 2000 and owned by members of the Schott family.
- At formation, Santa Clara had two types of shares: 100 voting shares and 900 nonvoting shares, all held by the Schott family.
- Santa Clara elected S-corporation status.
- In June 2000, in connection with an “S Corporation Charitable Contribution” (SC2) strategy, each Schott family shareholder received a warrant to purchase 10 nonvoting shares for each nonvoting share already held.
- Later in 2000, the Schott family donated 900 nonvoting shares to a tax-exempt nonprofit pension plan, the City of Los Angeles Safety Members Pension (LASMP).
- The donation was made with an understanding that LASMP would sell the shares back to the Schott family after a specified period, so that Santa Clara’s profits during LASMP’s ownership period would be allocated largely to a tax-exempt owner.
- The warrants were intended to protect the family’s ability to regain control if LASMP did not resell the stock as expected, because exercise of the warrants would substantially dilute the donated nonvoting block.
- In 2004, LASMP sold the nonvoting shares back to the Schott family for more than $1.6 million.
- The warrants were cancelled in 2006.
- After an audit, the IRS issued a notice of deficiency for the 2000 tax year (taxes and penalties), asserting that the warrants created a prohibited second class of stock and terminated Santa Clara’s S-corporation status.
- Santa Clara (and a shareholder seeking a refund) brought a refund suit. The parties filed cross-motions for summary judgment on whether the warrants terminated S status.
- The court’s earlier summary-judgment order concluded the warrants constituted a second class of stock under Treas. Reg. § 1.1361-1(l)(4)(ii). Santa Clara moved for reconsideration, arguing the court failed to evaluate whether the warrants were protected by a regulatory safe harbor for options and similar rights.

## Issues

1. Whether Santa Clara’s warrants were an “instrument, obligation, or arrangement” that created a prohibited second class of stock under I.R.C. § 1361(b)(1)(D) and Treas. Reg. § 1.1361-1(l)(4)(ii), terminating S-corporation status.
2. Whether, even if the warrants fell within Treas. Reg. § 1.1361-1(l)(4)(ii), the court was required to consider the safe harbor in Treas. Reg. § 1.1361-1(l)(4)(iii)(C) before treating the warrants as creating a second class of stock.

## Decision

- The court granted Santa Clara’s motion for reconsideration in part and modified its prior summary-judgment order.
- The court maintained its conclusion that a warrant may be treated as an “instrument, obligation, or arrangement issued by a corporation” for purposes of Treas. Reg. § 1.1361-1(l)(4)(ii).
- The court determined that its prior analysis was incomplete because it did not address whether the warrants fell within the safe harbor in Treas. Reg. § 1.1361-1(l)(4)(iii)(C).
- The court rejected the idea that the safe-harbor analysis in subsection (iii)(C) was categorically irrelevant merely because the warrants had been analyzed under subsection (ii).
- The order did not finally decide whether the warrants satisfied the safe harbor; it required that the safe-harbor question be considered as part of the second-class-of-stock analysis.

## Legal Principles

- An S corporation must have only one class of stock; a second class of stock terminates S-corporation eligibility. I.R.C. § 1361(b)(1)(D).
- Under Treas. Reg. § 1.1361-1(l)(4)(ii), certain “instruments, obligations, or arrangements” can be treated as creating a second class of stock if they effectively confer different distribution or liquidation rights.
- Warrants can qualify as the type of corporate instrument addressed by Treas. Reg. § 1.1361-1(l)(4)(ii), depending on their economic effect.
- Treas. Reg. § 1.1361-1(l)(4) includes safe-harbor provisions that may prevent a right or arrangement from being treated as creating a second class of stock, and a court must consider an applicable safe harbor raised by the parties.
- On reconsideration, a court may modify a prior summary-judgment ruling to correct an omitted legal analysis without resolving all remaining merits issues.

## Conclusion

Santa Clara Valley Housing Group, Inc. v. United States holds that corporate warrants issued in an SC2 transaction may be treated as instruments that create a second class of stock, but the court must still analyze whether the warrants qualify for the safe harbor in Treas. Reg. § 1.1361-1(l)(4)(iii)(C) before concluding S-corporation status was terminated.


Santa Clara Valley Housing Group, Inc. v. United States, 2012 WL 159945 (2012)