Stapley v. State (In re Stapley)

• Decision Date: 29 October 2019
• Docket Number: Case No. 09-47699 RLE,Adversary No. 18-4061
• Parties: IN RE Stephen Lawrence STAPLEY and Nancy Christine Stapley, Debtors. Stephen Lawrence Stapley and Nancy Christine Stapley, Plaintiffs, v. State of California Through its Franchise Tax Board, Defendant.
• Court: United States Bankruptcy Courts. Ninth Circuit. U.S. Bankruptcy Court — Northern District of California

609 B.R. 209

IN RE Stephen Lawrence STAPLEY and Nancy Christine Stapley, Debtors.Stephen Lawrence Stapley and Nancy Christine Stapley, Plaintiffs,

v.State of California Through its Franchise Tax Board, Defendant.

Case No. 09-47699 RLE

Adversary No. 18-4061

United States Bankruptcy Court, N.D. California, Oakland Division.

Signed: October 29, 2019

Bennett G. Young, Jeffer Mangels Butler and Mitchell LLP, San Francisco, CA, for Plaintiff

Cara M. Porter, Lucy F. Wang, California Dept. of Justice, Office of Attorney General, San Francisco, CA, for Defendant

MEMORANDUM DECISION ON FRANCHISE TAX BOARD'S MOTION FOR SUMMARY JUDGMENT

Roger L. Efremsky, U.S. Bankruptcy Judge

I. Introduction

Plaintiffs' complaint in this adversary proceeding states two claims for relief against the Franchise Tax Board (the "FTB"). The first claim is based on Bankruptcy Code § 505(a) and asks the court to find that plaintiffs owe nothing to the FTB on the theory that the tax debt is owed by S & N Holding Company, Inc. ("S & N"), a Subchapter S corporation which plaintiffs controlled at relevant times. The second claim is based on Bankruptcy Code § 523(a)(1) and § 523(a)(7) and asks the court to find that plaintiffs do not owe the penalties the FTB claims they owe because the penalties were discharged in plaintiffs' 2009 Chapter 7 case.

Before the court is the FTB's motion for summary judgment. The motion has been fully briefed and argued. Below are the court's reasons for granting it. The court finds that plaintiffs – not S & N – owe the tax debt to the FTB and the penalties plaintiffs owe on that tax debt were not discharged.

II. Legal Standard

A. Jurisdiction

The court has jurisdiction here pursuant to 28 U.S.C. § 1334(b). This is a core proceeding within the meaning of 28 U.S.C. § 157(b)(2)(I) and (O). The court also has jurisdiction pursuant to Bankruptcy Code § 505(a). In re Mantz, 343 F.3d 1207 (9th Cir. 2003).

B. Summary Judgment Standard

Under Fed. R. Civ. Proc. 56(a), applicable here by Fed. R. Bankr. P. 7056, the court shall grant summary judgment if the moving party shows that there is no genuine dispute as to any material fact and the moving party is entitled to judgment as a matter of law. A party asserting that a fact cannot be or is genuinely disputed must support the assertion by citing to particular parts of materials in the record, or showing that the materials cited do not establish the absence or presence of a genuine dispute, or that an adverse party cannot produce admissible evidence to support the fact. Fed. R. Civ. Proc. 56(c)(1) ; Celotex Corp. v. Catrett, 477 U.S. 317, 323, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986).

A genuine issue of material fact is one that could reasonably be resolved in favor of the nonmoving party, and which could affect the outcome of the suit. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986). The court must view the evidence in the light most favorable to the nonmoving party and draw all justifiable inferences in its favor. Id. at 255, 106 S.Ct. 2505.

If the nonmoving party's version of the facts, as a matter of law, does not entitle it to relief, that is, "[w]here the record taken as a whole could not lead a rational trier of fact to find for the nonmoving party, there is no genuine issue for trial." Matsushita Elec. Indus. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587, 106 S.Ct. 1348, 89 L.Ed.2d 538 (1986).

III. Factual Background

Unless otherwise noted in the following discussion, the facts are undisputed.

A. The SC2 Transaction

In 2001, plaintiffs retained the public accounting firm KPMG, LLP for tax planning and guidance. Through KPMG, plaintiffs engaged in a transaction known as the Subchapter S Charitable Contribution Strategy (the "SC2 transaction") which was designed and sold by KPMG.¹

The SC2 transaction involved the following steps: Plaintiffs formed S & N as a Subchapter S corporation. S & N issued 36,240 voting shares and 326,160 nonvoting shares to plaintiff Stephen Stapley. S & N also issued a warrant to Stephen Stapley giving him the right to purchase 3,261,600 shares of nonvoting stock (the "Warrant"). The Warrant recites that its exercise price is $0.80 per share which had been determined by an independent appraisal to represent 92.036% of the fair market value of each share of nonvoting common stock on June 4, 2001. Stapley Dec., Ex. 2, ¶(c) . Plaintiffs then "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, inter alia , 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 and S & N agreed to pay the fair market value on the date the stock was presented for redemption.²

Through this structure, plaintiffs ostensibly owned ten percent of S & N and were allocated ten percent of its pass-through income. LAPF owned ninety percent of S & N, but because it was a tax-exempt entity, it paid no tax on the ninety percent of the income allocated to it. The Warrant served to ensure that LAPF would cooperate with S & N when it sought to redeem the shares LAPF held.

As part of the transaction, plaintiffs obtained a valuation of S & N in order to take a charitable contribution deduction of $283,000 in tax years 2001 and 2002 for the donation of the 326,160 shares to LAPF. Porter Dec. Ex. B, p. 16 . The valuation obtained by plaintiffs set the S & N share value at $0.87 and the exercise price of the Warrant at $0.80. Porter Dec. Ex. B, p. 37-38 . Plaintiffs also took deductions for the costs of setting up the SC2 transaction. Porter Dec., Ex. B, p. 37.

At all relevant times, S & N filed its federal and state tax returns as an S corporation and plaintiffs' tax returns for tax years 2001–2004 relied on the positions taken in their SC2 transaction. This is the basis for the FTB's position that plaintiffs underpaid income tax for the four tax years in issue.

B. The IRS Examines Plaintiffs SC2 Transaction

In 2002, the IRS offered taxpayers who had participated in an SC2 transaction a chance to obtain a waiver of certain federal penalties if the taxpayer voluntarily disclosed the taxpayer's participation in the SC2 transaction. See Announcement 2002-2, I.R.B. 304. Plaintiffs apparently took advantage of this. Porter Dec., Ex. B, p. 24 .

In April 2004, the IRS issued Notice 2004-30 in which it formally took the position that the SC2 transaction was a "listed transaction" which lacked economic substance and the transfer of the non-voting shares and the allocation of income to the tax-exempt entity would be disregarded. FTB's Request for Judicial Notice, Ex. A, IRS Notice 2004-30, I.R.B. 2004-17 . Designating SC2 as a listed transaction notified taxpayers and their representatives that the claimed tax benefits purportedly generated by any SC2 transaction were not allowable for federal income tax purposes.

C. The IRS Examination Report

At some point after April 2004, the IRS examined plaintiffs' and S & N's tax returns for tax years 2001-2004. In November 2006, the IRS sent plaintiffs its Examination Report for the tax years in question. Porter Dec., Ex B . The IRS identified five issues it had examined. The first issue was whether plaintiffs' transfer of the S & N stock to LAPF in the SC2 transaction would be disregarded for federal tax purposes such that plaintiffs would be treated as if there had been no transfer to the tax-exempt party. The second issue was whether the capital structure created in plaintiffs' SC2 transaction violated the single class of stock requirement for S corporations. The remaining issues were whether the fees and costs plaintiffs had paid were deductible, whether the charitable contribution deduction was proper, and whether plaintiffs were liable for an accuracy-related penalty due to engaging in the SC2 transaction.

As to the first issue, the IRS concluded that plaintiffs' transfer of the S & N stock to LAPF in their SC2 transaction should be disregarded under various judicial doctrines including the Substance Over Form Doctrine, the Economic Substance Doctrine, the Business Purpose Doctrine, and the Step Transaction Doctrine.

In its discussion of the Substance Over Form Doctrine, the IRS stated that it was axiomatic that the substance of a transaction, rather than its form, governed for federal tax treatment, citing Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935) ; Frank Lyon Co. v. U.S., 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) ; Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89 (4th Cir. 1985). To determine whether the true substance of a transaction differs from its form entails an analysis of the facts. Here, the IRS stated that even though the individual pieces of the SC2 transaction literally complied with the Tax Code, it was an "abusive transaction" that produced results other than what the Tax Code and regulations intended. It was a "sham" transaction undertaken solely for the purpose of tax reduction and had no economic or commercial objective. Porter Dec., Ex. B, p. 25-27 . Accordingly, the transaction was without effect for federal income tax purposes.

In its discussion of the Economic Substance Doctrine, the IRS stated that a transaction must have economic substance separate and distinct from the economic benefit achieved solely from tax reduction, citing U.S. v. Wexler, 31 F.3d 117, 122 (3rd Cir. 1994) ; Yosha v. Comm'r, 861 F.2d 494 (7th Cir. 1988) ; Goldstein v. Comm'r, 364 F.2d 734 (2d Cir. 1966). Porter Dec., Ex. B, p. 29-30 .

Here, the IRS concluded that plaintiffs were the true owners of all of S & N and LAPF merely appeared to be a shareholder during the time the S & N shares were "parked" with it. The facts relied on by the IRS included the following: (1) S & N was not going to make any distribution to LAPF other than under the Redemption Agreement, i.e. , LAPF would only...