The following is a case update written by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, analyzing a recent decision of interest:
A California bankruptcy court has held that Chapter 7 debtor-taxpayers are liable for taxes owed to the Franchise Tax Board where the transaction by which the debtors formed and operated their Subchapter S corporation was determined to be a “sham” with no economic substance separate from providing tax benefits to the debtors. [In re Stapley, 609 B.R. 209 (Bankr. N.D. Cal. Oct. 29, 2019)] To view the entire opinion, click here.
In 2001, with the assistance of KPMG, LLP, debtors engaged in a transaction known as the Subchapter S Charitable Contribution Strategy (the “SC2 transaction”) whereby: (i) debtors formed “S&N Holding Company, Inc.” as a Subchapter S corporation; (ii) S&N issued 36,240 voting shares and 326,160 nonvoting shares to real estate executive and business owner, debtor Stephen Stapley; (iii) S&N also issued a warrant to debtor Stephen giving him the right to purchase 3,261,600 shares of nonvoting stock at an exercise price representing 92% of the fair market value of each share of nonvoting stock as of the date of the warrant; and (iv) debtors “donated” the nonvoting shares to a tax-exempt entity known as the City of Los Angeles Safety Members Pension Plan (“LAPF”). S&N and LAPF also entered into a Redemption Agreement pursuant to which, among other things, S&N agreed to remain an S corporation and LAPF agreed to sell back to S&N the 326,160 donated shares at an agreed time for the fair market value of the shares on the date the stock was presented for redemption.
Debtors’ tax returns for tax years 2001-2004 reflected their ten percent (10%) ownership of S&N and allocation of 10% of its pass-through income. LAPF paid no tax on the ninety percent (90%) of income allocated to it because it was a tax-exempt entity.
In 2004, the IRS issued a notice taking the position that the SC2 transaction was a “listed transaction” which lacked economic substance such that both the transfer of the non-voting shares and the allocation of income to the tax-exempt LAPF would be disregarded. In 2008, after examining debtors’ tax returns for years 2001-2004, the IRS concluded that debtors owed approximately $4 million for these four tax years. Following the IRS’ assessment of tax liabilities, to the extent the federal determinations matched California tax law, the FTB subsequently issued Notices of Proposed Assessments for tax years 2001-2004. The debtors filed a protest with the FTB, which was rejected after hearing. In 2018, the FTB issued a Notice of Action for each year at issue. In response, debtors reopened the Chapter 7 case they had filed in 2009 and filed an adversary complaint seeking a determination that they owed nothing to the FTB and that the subject tax debt was instead owed by S&N. After hearing, the court granted summary judgment in FTB’s favor.
The court noted that, for the purposes of litigation, the taxing agencies’ determinations as to tax liabilities are presumed to be correct, and the debtor-taxpayers have the burden of proving such determinations are erroneous. The court also succinctly summarized the various judicial doctrines under which the IRS concluded that debtors’ transfer of the S&N stock to LAPF in the SC2 transaction should be disregarded, including:
- The “Substance Over Form Doctrine,” pursuant to which the IRS determined that even though the individual pieces of the SC2 transaction literally complied with the Tax Code, it was an “abusive” and “sham” transaction undertaken solely for the purpose of tax reduction with no economic or commercial objective;
- The “Economic Substance Doctrine,” pursuant to which the IRS found that the SC2 transaction had no economic substance separate and distinct from the economic benefit achieved solely from tax reduction;
- The “Business Purpose Doctrine,” pursuant to which the IRS concluded that the structuring of S&N and the issuance and purported transfer of the nonvoting stock to LAPF had no nontax purpose; and
- The “Step Transaction Doctrine,” which allows the IRS to treat formally separate steps as one transaction for tax purposes if the steps are part of a single scheme or plan intended at the outset to achieve a specific result—i.e., debtors’ transfer of nonvoting stock to LAPF to avoid responsibility for 90% of S&N’s income.
Observing that transactions lacking economic substance are shams under both federal and state law, the court opined that debtors failed to raise triable issues of fact as to any legitimate business purpose of the SC2 transaction:
Viewed in isolation, there may have been a credible nontax business purpose for forming S&N as an S corporation….But the formation of the S corporation was only one part of the SC2 transaction. The crucial piece of the SC2 transaction was the donation of the nonvoting shares to LAPF. This had no nontax business purpose; there was in fact no “partnering” with LAPF for any legitimate business reason. There was in fact only a temporary arrangement by which LAPF took on the appearance of the owner of ninety percent of the nonvoting shares of S&N through what was a disguised charitable donation…
…Mr. Stapley’s…self-serving statements of a professed subjective intent to engage in a transaction with a legitimate business purpose [are] insufficient to overcome the FTB’s evidence that no rational investor would pursue this SC2 strategy for any business reason other than tax avoidance.
Further evaluating the economic substance of the SC2 transaction, the court examined the specific pieces whose tax consequences were in dispute and concluded that they were all part of a single, sham transaction:
…[A] key piece [of the SC2 transaction] was the transfer of the nonvoting shares to LAPF, and the main question is whether the transfer should be respected for tax purposes. Both the IRS and FTB found it should not be. While the form of the transaction suggested that LAPF was a ninety percent shareholder, it did not bear a commensurate risk or benefit which is how the SC2 transaction was designed. Allair Dec., Ex. C, p. 12; Porter Dec. Ex. B, p. 28-29 (noting that S&N board minutes stated that the purpose was to park the shares at LAPF while S&N made no distributions and then reacquired them)…
The SC2 transaction involved several related parts, each of which was integral to its success as a tax avoidance tool. One of these pieces was S&N’s issuance of the Warrant to purchase 3,261,000 shares of S&N stock. The Warrant enabled plaintiffs to compel LAPF to cooperate in the redemption piece of the transaction, should that have been necessary. It also enabled plaintiffs to maintain control over the value of LAPF’s nonvoting stock because they could dilute the value of what LAPF held if that had been necessary…
…[A]ny purported facts [debtors] try to raise now do not defeat summary judgment. The SC2 transaction itself was a sham and the discrete piece of it involving the issuance of the Warrant will be disregarded for tax purposes.
This result almost seems like a foregone conclusion, considering that debtor Stephen Stapley admitted to the IRS that his goal in entering into the SC2 transaction was to “defer taxes” and to “retain earnings” and the donation to the LAPF was a “by-product” of these goals. It did not help matters any that debtors paid $550,000 to KPMG to set up the SC2 transaction, as these costs on their face appear to outweigh any possible non-tax purpose for the transaction. In this case, the IRS and FTB both concluded that debtors entered the SC2 transaction to allocate 90% of S&N’s income to LAPF and in that manner avoid paying tax on it. On the facts before the court, the debtors faced an uphill and ultimately insurmountable burden to prove the existence of a triable issue of fact as to any legitimate nontax purpose behind the transaction. Counsel evaluating a client’s tax strategies therefore would be wise to examine the substance, not only the form, of any proposed corporate transaction that appears solely to result in tax benefits for their client.
For discussions of cases dealing with related issues, see:
- 2015-14 Comm. Fin. News. NL 28, Jury Verdict in Favor of Guarantors is Reversed for Lack of Substantial Evidence Because Guarantors Who Create New Borrowing Entity Cannot Invoke “Sham Guarantee” Defense.
These materials were co-authored by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, a member of the ad hoc group and 2018-19 Chair of the CLA Business Law Section. Editorial contributions were made by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. Thomas Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomas Reuters.