Recent Decision Treats Warrants as a Second Class of Stock in an S Corporation

One of the well-known restrictions on S corporations is that they cannot have more than one class of stock.  "Stock" for these purposes is not limited to equity-denominated rights but can refer to any arrangement that looks like an equity interest in the company.  Warrants are therefore scrutinized for these purposes, but an IRS safe harbor generally blesses most warrant issuances.  Unfortunately, a recent decision by a California federal district court appears to significantly muddy the waters on this issue.  (Find the reported decision in Santa Clara Valley Housing Group, Inc. v. United States here.) While that decision falls within the category of cases where bad facts make bad law, S-corporation shareholders and their advisors should be aware of the potential impact of this case. 

What happened?

The taxpayer in the subject case purchased a "tax shelter product" (as labeled by the court) from a Big Four national accounting firm.  Using that product, the corporation's shareholders avoided tax on roughly 90% of their income from the S corporation (more than $100 million) over a four-year term.  They achieved that result by transferring 90% of their stock to a tax-exempt entity with the understanding that the entity would sell the shares back to the original shareholders at a set point in the future.  To ensure that the tax-exempt entity made that sale, the corporation issued each of the shareholders warrants to purchase stock in the corporation that would dilute the tax-exempt entity's retained ownership interest.  The entity was thus effectively economically compelled to sell the stock back to the original shareholders. 

Why does this case impact "normal" transactions?

It would be easy to limit this case to its facts and assume that its reach applies only to cases where tax shelters are involved.  Unfortunately, however, the court did not adopt any one of several theories that could have supported that reading.  The court instead determined that the warrants actually constituted equity based solely on its determination that the warrants were designed to ensure that the original shareholders retained nominal ownership of 90% of the company.  The court was thus influenced by the corporation's intent in issuing the warrants and paid no attention to the actual terms of those warrants.  

The court's focus on the corporation's anti-dilution intent makes this case worth thinking about in non-tax shelter transactions.  It is certainly not unusual for a corporation to issue warrants precisely for that purpose.  If the case is taken out of context, then, it could have more surprising applications. 

What do I do about this?

This ruling is obviously unique in a number of ways and should not create undue angst in "normal" S-corporation deals.  However, this case counsels towards undertaking a heightened level of diligence and thoughtfulness where the target S corporation has outstanding warrants.  The loss of S-corporation status fundamentally changes the financial picture for a deal.