Tax News
Santa Clara – a Warrant Causes the Termination of S Election
September 27, 2011
Sometimes funds come across a suitable portfolio company that is an S Corporation. Because of the limitations on shareholders and second class of stock, funds could not acquire equity directly in the S corporation. To mitigate this issue the fund could do a number of things such as restructure the company prior to the investment (e.g. have the S corporation contribute assets to an LLC and invest in that LLC.). Sometimes a restructuring is not feasible and the fund may either walk away from the portfolio company or contemplate acquiring debt and/or warrants in the company. The hope is that at a future liquidity event the warrants will be cashed out at levels that reflect any equity appreciation of the S Corporation. The usual concern with this strategy is that the investment could be viewed as equity which could blow the S election of the corporation. Funds would typically rely on the general rule of Reg. § 1.1361-1(l)(4)(i) which provides that “[i]nstruments, obligations, or arrangements are not treated as a second class of stock” and then on the Reg. 1.1361-1(l)(4)(iii)(B) rule which provides that “a call option is not treated as a second class of stock … if it is issued to a person that is actively and regularly engaged in the business of lending and issued in connection with a commercially reasonable loan to the corporation.”

 Until recently there were no cases on point where the IRS has attempted to terminate the S election of a corporation by treating a warrant as a second class of stock which gave further comfort to practitioners.  In Notice 2004-30, however, the IRS gave warning that it would attack certain transactions with tax avoidance purpose that utilized warrants in the S corporation context.  Santa Clara Valley Housing Group Inc. et al. v. United States; No. 5:08-cv-05097 (Sept. 21, 2011) is a recent case where the IRS successfully delivered on this warning. Would I describe this case as significant or very pertinent to the issues investment funds are facing in the S corporation context? – No.  Nonetheless, while the case deals with a tax shelter called SC2 and the facts are different from the typical private equity acquisition deal, keeping the case in mind is useful as an illustration of the type of analysis a court would go through when assessing whether warrants should be viewed as a second class of stock and whether an S election should be terminated. It is further useful as an illustration of the arguments the IRS may raise should it decide to attack the status of an S corporation based on warrant/second class of stock theory.
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Tags: Santa Clara v US. warrants and s corporation