## Facts

- Santa Clara Valley Housing Group, Inc. (Santa Clara) was a closely held corporation created in 2000 and owned by members of the Schott family.
- At incorporation, Santa Clara’s stock consisted of 100 voting shares and 900 nonvoting shares, all held by the Schott family.
- In June 2000, the Schott family used an S corporation charitable-contribution strategy in which each family member received a warrant to purchase 10 nonvoting shares for every nonvoting share held.
- Later in 2000, the Schott family donated the 900 nonvoting shares to a nonprofit, the City of Los Angeles Safety Members Pension (LASMP), with an understanding that the shares would be sold back to the family after a specified period.
- The arrangement was designed to shift Santa Clara’s income to a tax-exempt owner during the period LASMP held the nonvoting shares.
- The warrants were intended to protect the Schott family’s ability to regain control of Santa Clara if LASMP did not return the shares as expected.
- In 2004, the LASMP shares were sold back to the Schott family for more than $1.6 million.
- The warrants were cancelled in 2006.
- After audit, the IRS issued a deficiency notice for more than $600,000 in taxes and penalties for 2000.
- Santa Clara paid the asserted deficiency and filed a tax-refund suit in the U.S. District Court for the Northern District of California.
- Santa Clara and the United States filed cross-motions for summary judgment on whether the warrants terminated Santa Clara’s S corporation status.

## Issues

1. Whether Santa Clara’s issuance of the warrants caused the corporation to have more than one class of stock, terminating its S corporation status under I.R.C. § 1361(b)(1)(D).
2. Whether the warrants should be treated as equity (rather than a disregarded option) for purposes of the one-class-of-stock requirement.
3. Whether the warrants fell within the Treasury Regulation safe-harbor treatment for certain options and warrants so that they would not be treated as creating a second class of stock.

## Decision

- The court addressed the parties’ cross-motions for summary judgment on the S corporation qualification question.
- The court concluded that the warrants were treated as creating a prohibited second class of stock for S corporation purposes.
- Because the warrants created a second class of stock, Santa Clara’s S corporation status was terminated, supporting the IRS’s deficiency determination in the refund litigation.

## Legal Principles

- An S corporation must have only one class of stock; a second class exists if outstanding interests confer different rights to distribution or liquidation proceeds. I.R.C. § 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l).
- In determining whether an arrangement creates a second class of stock, the analysis looks to the rights created in substance, not only formal labels or drafting choices. Treas. Reg. § 1.1361-1(l)(4).
- Options, warrants, and similar instruments may be treated as stock if they function as equity or are used to avoid the one-class-of-stock requirement; however, qualifying instruments may be excluded from that treatment under specific regulatory conditions. Treas. Reg. § 1.1361-1(l)(4)(iii).
- The economic effect of a warrant—such as its dilutive potential and its role in shifting economic returns—can be relevant to whether it operates as an equity interest inconsistent with S corporation eligibility.

## Conclusion

Santa Clara’s shareholders used warrants and a temporary transfer of nonvoting shares to a tax-exempt pension plan to shift taxable income away from the family, but the court held the warrants created a prohibited second class of stock, which terminated Santa Clara’s S corporation status and defeated the refund claim tied to the asserted S corporation treatment.


Santa Clara Valley Housing Group, Inc. v. United States, 588 S.W. 2d. 554 (1979)