Rev. Rul. 85-19

ISSUE

If an individual who had made a gift of shares of stock in a corporation to a family member within the past 10 years reacquires those shares in contemplation of a redemption by the corporation of the donee's other shares in the corporation, does the reacquisition have as one of its principal purposes the avoidance of federal income tax within the meaning of section 302(c)(2)(B) of the Internal Revenue Code?

FACTS

X is a corporation engaged in an ongoing business, whose shares of its sole class of common stock were held by A and A's child, B. A owned 500 shares and B owned 100 shares of X stock, 80 of which B inherited from B's now deceased grandparents and 20 of which B received as a gift from A two years ago. B, who had never been involved in the business affairs of X, wanted to terminate B's interest in the corporation. Therefore, B sold the 20 shares acquired from A two years ago to A at fair market value and X redeemed the remaining 80 shares. Following the redemption, B was not an officer, director or employee of X. X had no plans to redeem any of the shares that A reacquired from B. The earnings and profits of X exceed the amount of the distribution in redemption of the X stock.

LAW AND ANALYSIS

Section 302(a) of the Code provides in part that if a corporation redeems its stock and if section 302(b)(1), (2), (3) or (4) applies, such redemption will be treated as a distribution in part or full payment in exchange for the stock. Section 302(c)(1) provides that section 318(a), relating to constructive ownership of stock, will apply in determining the ownership of stock for purposes of section 302.

Section 302(b)(1) of the Code provides that section 302(a) will apply if the redemption is not essentially equivalent to a dividend. Section 302(b)(2) provides that section 302(a) will apply if the redemption is substantially disproportionate with respect to the shareholder. Section 302(b)(3) provides that section 302(a) will apply if the redemption completely terminates the shareholder's interest in the corporation. Section 302(b)(4) provides that section 302(a) will apply if the redemption is treated as a distribution in partial liquidation of the distributing corporation. Section 302(d) provides that if section 302(a) does not apply, the redemption will be treated as a distribution of property to which section 301 applies.

In the present situation, neither section 302(b)(1) of the Code nor section 302(b)(2) applies since B, through the constructive ownership rules of section 318(a), is treated as owning all the stock of X both before and after the redemption. Section 302(b)(4) does not deal with the type of redemption under consideration.

Section 302(c)(2)(A) of the Code provides that for purposes of section 302(b)(3), section 318(a)(1) will not apply if (i) immediately after the distribution the distributee has no interest in the corporation (including an interest as an officer, director, or employee), other than an interest as a credit or, (ii) the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and (iii) the distributee files an agreement to notify the district director of any acquisition of any such interest in the corporation. However, pursuant to section 302(c )(2)(B)(i), the provisions of section 302(c)(2)(A) do not apply if any portion of the stock redeemed was acquired, directly or indirectly, within the 10-year period ending on the date of the distribution by the distributee from a person the ownership of whose stock would (at the time of distribution) be attributable to the distributee under section 318(a). Additionally, pursuant to section 302(c)(2)(B)(ii), the provisions of section 302(c)(2)(A) likewise do not apply if any person owns (at the time of the distribution) stock the ownership of which is attributable to the distributee under section 318(a) and such person acquired any stock in the corporation, directly or indirectly, from the distributee within the 10-year period ending on the date of distribution, unless such stock so acquired from the distributee is redeemed in the same transaction. However, neither section 302(c)(2)(B)(i) nor (ii) will apply if the acquisition or the disposition by the distributee did not have as one of its principal purposes the avoidance of federal income tax.

The structure and legislative history of section 302 of the Code make it clear that the purpose of section 302(c)(2)(B) is not to prevent the reduction of capital gains through gifts of appreciated stock prior to the redemption of the remaining stock of the transferor, but the prevent the withdrawal of earnings at capital gains rates by a shareholder of a family controlled corporation who seeks continued control and/or economic interest in the corporation through the stock given to a related person or the stock retained. Application of this provision thus prevents a taxpayer from bailing out earnings by transferring part of the taxpayer's stock to such related person and then qualifying the redemption of either the taxpayer's stock or the transferee's stock as a complete termination of interest by virtue of the division of ownership thus created and the availability of the attribution waiver provisions. Rev. Rul. 77-293, 1977-2 C.B. 91.

Tax avoidance within the meaning of section 302(c)(2)(B) of the Code occurs, for example, if a taxpayer transfers stock of a corporation to taxpayer's spouse in contemplation of the redemption of taxpayer's remaining stock in the corporation, terminates all direct interest in the corporation in compliance with section 302(c)(2)(A), but indirectly retains effective control of the corporation through the stock held by taxpayer's spouse. Another example of tax avoidance within the meaning of this provision is the transfer by a taxpayer of part of the stock of a corporation to taxpayer's spouse in contemplation of the subsequent redemption of the transferred stock from the spouse. See H.R. Rep. No. 1337, 83d Cong., 2d Sess., 36, A76 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 236-37 (1954).

Tax avoidance, then, within the meaning of section 302(c)(2)(B) of the Code, necessarily requires both the presence of a certain state of mind on the part of the taxpayer in connection with the acquisition or the disposition of stock, coupled with the accomplishment of the tax avoidance design via a redemption of stock. Tax avoidance, therefore, cannot be present, for example, merely because there has been a transfer of stock by one section 318(a)(1) relative to another, when such transfer was not in contemplation of redemption of the balance of the transferor's stock nor of the stock transferred to the transferee. See Rev. Rul. 56-556, 1956-2 C.B. 177; Rev. Rul. 56-584, 1956-2 C.B. 179; Rev. Rul. 57-387, 1957-2 C.B. 225. Similarly, tax avoidance cannot be present merely because a shareholder has transferred stock to a related person within the meaning of section 318(a)(1) even though such transfer may have been in contemplation of redemption of the balance of the transferor's stock or of the stock transferred to the transferee, if in fact no redemption of either the transferor's stock or the stock transferred to the transferee actually occurs.

In the present situation, A's reacquisition of X stock from B immediately prior to the redemption by X of B's remaining shares is described in section 302(c)(2)(B)(ii) of the Code, since such stock was not redeemed when B's remaining shares were redeemed. Therefore, it is necessary to determine if A's reacquisition of the X stock had as one of its principal purposes the avoidance of federal income tax within the meaning of section 302(c)(2)(B), and this requires an analysis of all the facts and circumstances of the particular situation. Rev. Rul. 77-293.

Here, the facts show that: (i) B had been a relatively minor shareholder, holding only 17 percent of the X stock as compared to A's 83 percent; (ii) B had never been involved in X's affairs and wanted to terminate B's relationship with X; and (iii) A had given only a small number of shares to B (3 percent of the 600 shares outstanding). These facts indicate that B had never been in a position to control the affairs of X. Further, the small percentage of stock given by A to B, 3 percent, indicates that at the time of the gift A had no intention of transferring control to B. Thus, it does not appear that the sale of the 20 shares by B to A was an attempt by B to retain control or influence over the affairs of X, since B apparently never had any such control or influence. Nor does it appear that this was an attempt by B to retain an economic interest in X. There is nothing to show that A holds these 20 shares for B's benefit, and the fact that A had to purchase these shares from B (rather than B giving them to A) makes this less likely. Moreover, since A in any event would hold substantially all the economic interest in X (500 out of 520 shares), the sale of the 20 shares by B to A cannot be viewed as significantly affecting B's ability to retain an economic interest.

Additionally, in determining whether the prohibited intent existed, it should be recognized that, apart from the money received by B on the sale, the net result of the gift from A to B and the sale from B to A is merely a return to the status quo ante. Thus, it is unlikely that the whole overall transaction was motivated by the prohibited intent. If A had not given the 20 shares to B, the redemption of B's 80 shares received from B's grandparents would have qualified as a termination of interest under section 302(b)(3) of the Code, provided the requirements of section 302(c)(2)(A) were satisfied. If the 20 shares were given by A to B with a tax avoidance motive, a redemption by X of all 100 shares of B would not have qualified under section 302(c)(2)(A), because under section 302(c)(2)(B)(i), a portion of the redeemed shares would then have been acquired within the 10-year period preceding the redemption from a person the ownership of whose stock at the time of the distribution would have been attributable to B under section 318(a). However, any possible problem under section 302(c)(2)(B)(i) is avoided in the present situation by B's sale back of these 20 shares. The question is whether the transaction that eliminated the possible section 302(c)(2)(B)(i) problem created a section 302(c)(2)(B)(ii) problem in its place.

In sum, as indicated above, the answer to this question is that the facts do not indicate any attempt by B to retain control or an economic interest in X. Rather, the sale of the X stock by B to A seems merely to have been an attempt to return to the status quo ante and avoid any possible problem under section 302(c)(2)(B)(i) of the Code. Accordingly, the sale of stock from B to A will not be deemed to have had as one of its principal purposes the avoidance of federal income tax under section 302(c)(2)(B)(ii). Thus, if B files the agreement specified in section 302(c)(2)(A)(iii), the redemption by X of its stock from B qualifies as a termination of interest under section 302(b)(3).

HOLDING

A's reacquisition from B of the 20 shares of previously gifted stock, immediately prior to the redemption of B's remaining X shares, is not deemed to have had as one of its principal purposes the avoidance of federal income tax notwithstanding that the gift of such shares and the subsequent reacquisition of such shares occurred within the 10-year period preceding the redemption of B's remaining X shares.