Citations: Rev. Rul. 77-218; 1977-1 C.B. 81
Rev. Rul. 77-218
Advice has been requested regarding the Federal income tax treatment of the transaction described below.
Corporation X had outstanding one class of stock consisting of 100 shares of common stock which were held as follows:
Corporation Y had outstanding one class of stock consisting of 1,000 shares of common stock which were held as follows:
L, M 150
X and Y were founded by G who is deceased. A, who manages and controls the affairs of X and Y, and D are the children of G and W, G's widow. C and B are the respective spouses of A and D. L and M are the grandchildren of G and W. The Trust was established pursuant to G's last will and testament. W is the sole life income beneficiary of the Trust with the remainder going to her grandchildren in equal shares. A and D serve as co-trustees of the Trust. F is unrelated to all of the other shareholders of X and Y.
The Trust sold all of its stock in corporation X to corporation Y for cash. The purchase price of the X stock was its fair market value. The earnings and profits of Y exceeded the amount of cash paid by Y to the Trust for the X stock. The X stock was sold to Y because X did not have sufficient cash available to redeem the stock.
Section 304(a)(1) of the Internal Revenue Code of 1954 provides that for purposes of sections 302 and 303, if one or more persons are in control of each of two corporations and in return for property, one of the corporations acquires stock in the other corporation from the person so in control, then such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock. In any such case, the stock so acquired shall be treated as having been transferred by the person from whom acquired, and having been received by the corporation acquiring it, as a contribution to the capital of such corporation.
Section 304(b)(2) of the Code provides that where section 304(a)(1) applies the determination of the amount that is a dividend shall be made solely by reference to the earnings and profits of the acquiring corporation.
Section 304(c)(1) of the Code provides that for purposes of section 304 control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock.
Section 304(c)(2) of the Code makes section 318(a) (relating to the constructive ownership of stock) applicable to section 304, with certain modifications not here relevant, for the purposes of determining control under section 304(c)(1).
Section 318(a)(1)(A) of the Code provides, in part, that an individual is considered as owning the stock owned, directly or indirectly, by the individual's children and grandchildren. Thus, with respect to corporation X, W is considered as owning the stock of X owned by A. In addition, with respect to corporation Y, W is considered as owning the stock of Y owned by A, D, and her grandchildren, L and M.
Section 318(a)(3)(B)(i) of the Code, relating to attribution to trusts, provides as follows:
Stock owned, directly or indirectly, by or for a beneficiary of a trust (other than an employees' trust described in section 401(a) which is exempt from tax under section 501(a)) shall be considered as owned by the trust, unless such beneficiary's interest in the trust is a remote, contingent interest. For purposes of this clause, a contingent interest of a beneficiary in a trust shall be considered remote if, under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property.
Since W is the life income beneficiary of the Trust, her interest in the Trust is not contingent for purposes of section 318(a)(3)(B)(i) of the Code. See Rev. Rul. 76-213, 1976-1 C.B. 92. However, since her interest in the Trust, computed actuarially, exceeds 5 percent, her interest in the Trust is not remote. See Rev. Rul. 76-213. Accordingly, the Trust is considered to own all of the X and Y stock owned, directly or indirectly, by W.
By application of section 318(a)(3)(B)(i) of the Code, the Trust is considered to have owned 60 percent of the stock of X before the transaction and 75 percent of the stock Y before the transaction. Since Y acquired the stock of X for cash from a person (the Trust) in control of both the issuing corporation (X) and the acquiring corporation (Y), the transaction is considered to be an acquisition of stock by a related corporation within the meaning of section 304(a)(1) and thus a redemption of the stock of Y, the acquiring corporation.
Under section 1.304-2(a) of the Income Tax Regulations the amount received by the Trust is treated as a distribution of property under section 302(d) of the Code unless the distribution is to be treated as received in exchange for stock pursuant to section 302(a) or 303. Section 303 of the Code (relating to distributions in redemption of stock to pay death taxes) is not applicable in the instant case. Section 302(a) is applicable if the requirements of section 302(b) are satisfied.
Section 304(b)(1) of the Code provides that the applicability of section 302(b) is determined by reference to the stock of the issuing corporation, X. After the transaction, through the application of section 318(a)(2)(C), the Trust owns 55 percent of X (the 40 percent attributed from A plus 75 percent times the 20 percent owned by Y, or 15 percent, equals 55 percent). See Rev. Rul. 59-233, 1959-2 C.B. 106. Therefore, there is neither a complete termination of the Trust's interest in the stock of X within the meaning of section 302(b)(3) nor a substantially disproportionate redemption within the meaning of section 302(b)(2).
Section 1.302-2(b) of the Regulations, relating to section 302(b)(1) of the Code provides, in part, that the question whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a dividend under section 302(b)(1) depends upon the facts and circumstances of each case.
In United States v. Davis, 397 U.S. 301 (1970), rehearing denied, 397 U.S. 1071 (1970), 1970-1 C.B. 62, the Supreme Court of the United States held that a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation in order to qualify as not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Code and that the business purpose of the redemption is irrelevant to this determination. The Supreme Court further held that section 318(a) applies for the purpose of determining whether a distribution is "not essentially equivalent to a dividend" under section 302(b)(1).
Rev. Rul. 75-502, 1975-2 C.B. 111, indicates factors to be considered in determining whether a reduction in a shareholder's proportionate interest in a corporation results in a meaningful reduction within the meaning of Davis. The factors considered relate to a shareholder's right to vote and exercise control, a shareholder's right to participate in current earnings and accumulated surplus, and a shareholder's right to share in net assets in liquidation.
In the instant case, the redemption did not constitute a meaningful reduction of the Trust's interest in X within the meaning of Davis: (i) while the Trust experienced a 100 percent reduction in its direct stock interest in X, it retained an indirect interest in X's stock in excess of 50 percent; (ii) most of the remaining X stock is held, directly or indirectly, by shareholders who are related to the Trust under section 318 of the Code; and (iii) A manages and controls the affairs of both X and Y and serves as a co-trustee of the Trust.
Accordingly, the sale by the Trust of the 20 shares of X stock to Y, recast as a redemption under 304(a)(1) of the Code, is essentially equivalent to a dividend and, therefore, is not a distribution in part or full payment in exchange for the X stock under section 302(a). Thus, under section 302(d), the redemption in the instant case is a distribution of property to which section 301 applies.