At the end of the fourth year, LAPF sold the 900 nonvoting shares back to the original shareholders for only $1.
Under the first theory, the IRS reallocated to the Schott family shareholders all the income that had ostensibly passed through to LAPF.
The court stated that the warrants "obviously" were designed to permit the Schotts to retain de facto ownership of about 90% of the corporation even though 90% of the shares had been transferred to LAPE Had LAPF refused to sell the shares back, the Schotts could simply have exercised their warrants, thereby greatly diluting LAPF's shares in favor of the Schotts.
9) In fact, they were not exercised; the Schotts had planned to exercise the warrants only if LAPF refused to sell back to them its 900 nonvoting shares.
Regarding the tax effect to LAPF of ordinary income passed through to it, the court simply noted that LAPF, as a tax-exempt entity, paid no taxes on this income.
To see this, assume that, during the four years that LAPF (ostensibly) held the nonvoting stock, Santa Clara had ceased doing business and liquidated.
As argued above, LAPF would never have received 90% of the proceeds upon liquidation, even though it ostensibly held 90% of the stock.
The Schotts probably should not be allowed a charitable deduction for their contribution of the now C stock to LAPF because, as of the date of the purported gift, the contribution could be defeated (to a large extent) by the Schotts exercising their warrants.
Santa Clara's earnings and profits would include the $114 million in earnings, less the small distributions to LAPF and the Schotts while the nonvoting stock was parked with LAPF.
LAPF essentially received an accommodation fee of about $1.
In addition, although LAPF may not have been contractually required to sell the nonvoting shares back to the Schotts, there was no public market for the stock.