609 B.R. 209
Bankr. N.D. Cal.2019Background
- In 2001 plaintiffs Stephen and Nancy Stapley formed S&N Holding Co., an S corporation, and participated in a KPMG-designed “SC2” scheme: they issued large nonvoting shares to the tax‑exempt Los Angeles Police Pension Fund (LAPF), kept voting shares, and received a warrant to repurchase shares.
- The structure allocated ~90% of S&N income to LAPF (tax‑exempt) while plaintiffs retained control via voting shares, a redemption agreement, and a warrant. Plaintiffs claimed charitable deductions and other tax benefits.
- The IRS designated SC2 a listed abusive transaction (2004), audited the Stapleys and S&N, issued an Examination Report (2006) and Notices of Deficiency (2008), reallocating income to the Stapleys.
- The Stapleys filed Chapter 7 in August 2009 and received a discharge in December 2009; the IRS and LAPF filed proofs of claim in the bankruptcy.
- The California Franchise Tax Board (FTB) audited, adopted the IRS adjustments where applicable, issued Notices of Proposed Assessment and assessed two penalties (a noneconomic-substance/NEST penalty and an interest‑based/IB penalty), the Stapleys protested, the FTB upheld the adjustments (2017), and the Stapleys brought this adversary (2018).
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Who is liable for the reassessed tax (Stapleys v. S&N)? | Stapleys: S&N (corporation) owes the tax; statute of limitations bars collection from S&N. | FTB: SC2 is a sham and income properly flows through to the individual Stapleys; they are liable. | Court: Stapleys (individuals) owe the tax; transaction disregarded and income reallocated to them. |
| Was the SC2 transaction respected or a sham (economic substance / business purpose)? | Stapleys: had nontax business purposes (consolidation, capital raising, hoped LAPF investment) and Stapley’s declaration raises factual disputes. | FTB: transaction lacked objective economic substance and no credible nontax business purpose; IRS/FTB findings entitled to deference. | Court: SC2 was a sham; no triable issue on either objective or subjective prongs; summary judgment for FTB. |
| Did the warrant create a second class of stock terminating S status? | Stapleys (later): warrant was “deep in the money” and substantially certain to be exercised, creating a second class of stock (S election terminated). | FTB: the warrant is part of the sham, interdependent with the donation, and is disregarded; plaintiffs are estopped from reversing prior positions. | Court: Warrant disregarded under step‑transaction; plaintiffs estopped from changing position; no triable issue for plaintiff. |
| Were the reassessed taxes and IB penalties discharged in 2009 bankruptcy? | Stapleys: penalties (and allegedly taxes) were discharged because underlying events predated bankruptcy. | FTB: taxes and IB penalties are nondischargeable under §523(a)(1)/§507(a)(8); reporting/assessment occurred after petition; IB penalty not within §523(a)(7)(B) three‑year safe harbor. | Court: Taxes and interest are nondischargeable; IB penalties not discharged. |
Key Cases Cited
- Gregory v. Helvering, 293 U.S. 465 (1935) (substance over form; sham transactions disregarded)
- Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (factors for recognizing transactions with economic substance)
- Casebeer v. Comm’r, 909 F.2d 1360 (9th Cir. 1990) (two‑part sham/economic‑substance inquiry: subjective business purpose and objective economic substance)
- King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (step‑transaction doctrine tests: interdependence and end‑result)
- Herrington v. Comm’r, 854 F.2d 755 (5th Cir. 1988) (duty of consistency/judicial estoppel in tax position changes)
- State of Maryland v. Ciotti (In re Ciotti), 638 F.3d 276 (4th Cir. 2011) (reporting obligations can qualify as "equivalent report or notice" under §523(a)(1)(B))
- McKay v. United States, 957 F.2d 689 (9th Cir. 1992) (timing of penalty assessment controls §523(a)(7) discharge analysis)