REDEMPTIONS OF STOCK HELD BY ESOP QUALIFY; CORPORATION MAY NOT DEDUCT PAYMENTS FOR SHARES.

UIL Number(s) 0302.01-02, 0302.05-00

                                             Date: August 1, 1995

[2] On Date A, Corp X amended Plan to add an employee stock ownership component. On Date B, Corp X established the ESOP by selling GG shares of its Class C stock to the ESOP for $HH. After the establishment of the ESOP, the ESOP became Corp X's largest shareholder, holding approximately II% of Corp X's voting power. The ESOP received a favorable determination letter that the form of the ESOP satisfies sections 401(a), 409, and 4975(c)(7).

[3] To finance the sale, the ESOP borrowed $HH from various institutional investors and Corp X ("ESOP Loan"). The dividends received on the Class C stock are the ESOP's primary source of income for making payments of principal and interest on the ESOP Loan. Corp X also makes contributions directly to the ESOP, which the ESOP uses to pay down the ESOP Loan.

[4] The Class C stock that the ESOP purchased from Corp X is a class of convertible preferred stock. The convertible preferred stock has the following features:

     o One vote per share

     o Allocate the dividends on the Class C stock in a Participant's

[7] Upon retirement or termination of employment ("Triggering Event"), a Participant may elect to receive the value of the Participant's individual account in whole shares of Corp X common stock or cash. If a Participant elects to receive payment in the form of Corp X common stock, the ESOP trustee may convert the Class C stock into common stock in accordance with the conversion feature of the Class C stock and distribute the shares to the Participant. If selling the Class C stock would produce a higher value for the Particpant, the trustee may sell the Class C stock to Corp X. In this case, Corp X may purchase the Class C stock for cash (in which case the trustee would purchase shares of Corp X common stock and distribute the shares to the Participant). Corp X may also purchase the Class C stock for shares of Corp X common stock (in which case the trustee would distribute the shares to the Participant).

[8] If a Participant elects to receive the value of the Participant's individual account in cash, the ESOP trustee may convert the Class C stock into common stock in accordance with the conversion feature of the Class C stock, sell the Corp X common stock and distribute the proceeds to the Participant. If selling the Class C stock would produce a higher value for the Participant, the trustee may sell the Class C stock to Corp X. In this case, Corp X may purchase the Class C stock for cash (in which case the trustee would distribute the cash to the Participant). Corp X may also purchase the Class C stock for shares of Corp X common stock (in which case the trustee would sell the shares of Corp X common stock and distribute the cash to the Participant).

[9] In the year which includes Dates A and B, some of the Participants retired or terminated their employment and elected to receive the value of their Plan individual account balances in cash. As a result, the trustee tendered and Corp X redeemed I shares of Class C stock for cash at a cost of $J. After the redemption, the number of Class C shares held by the ESOP represented OO% of voting power of the Corp X equity and PP% of the value of the Corp X equity.

                          LAW AND ANALYSIS

[11] Section 404(k), as it existed prior to amendments made by the Omnibus Reconciliation Act of 1989, provided that a deduction shall be allowed to a corporation in the amount of any dividend paid in cash by such corporation during the taxable year with respect to the stock of such corporation if --

     (1) such stock is held on the record date for the dividend by

[13] Section 302(d) treats a redemption as a distribution of property to which section 301 applies if section 302(a) does not apply. Section 302(a) applies to a redemption if any of sections 302(b)(1) (redemptions not essentially equivalent to dividends), 302(b)(2) (substantially disproportionate redemption of stock), 302(b)(3) (termination of shareholder's interest), or 302(b)(4) (redemption from noncorporate shareholder in partial liquidation) apply. If section 302(a) applies, the redemption will be treated as a distribution in part or full payment in exchange for stock. Thus, if a redemption does not satisfy the requirements of any of sections 302(b)(1), 302(b)(2), 302(b)(3), or 302(b)(4), section 302(d) treats the redemption as a distribution of property to which section 301 applies and, to the extent the distribution is out of accumulated or current earnings and profits of the corporation, the distribution is a dividend within the meaning of section 316.

[14] In order to determine whether a redemption is treated as a distribution in part or full payment in exchange for stock under section 302(a) or as a distribution of property to which section 301 applies (and thus, potentially, as a dividend under section 316), the tests under sections 302(b)(1), (2), (3), and (4) must be applied with respect to the owner of the redeemed stock. Corp X bases its position on the premise that the ESOP is the owner of the Class C stock at the time of the redemption. This memorandum addresses first whether the ESOP or the Participant is the owner of the Class C stock at the time of the redemption and then addresses whether the redemption is treated as a distribution in part or full payment in exchange for Class C stock within the meaning of section 302(a) or as a distribution of property to which section 301 applies.

                           OWNER OF STOCK

[16] Under the common law, the beneficial owner of stock is deemed to be the owner of such stock for tax purposes. Wilson v. Commissioner, 560 F.2d 687 (5th Cir. 1977) (beneficial, not mere record, ownership of a share is a prerequisite to shareholder status); Ragghianti v. Commissioner, 71 T.C. 346 (1978), aff'd 652 F.2d 65 (beneficial ownership is the controlling factor in determining who must include in gross income any dividends attributable to such stock). The question of whether an individual satisfies the requirements and qualifies as a beneficial owner is one of fact. Wilson at 690.

[17] In Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964), the Second Circuit was called upon to decide whether a redemption of stock was not essentially equivalent to a dividend under section 302(b)(1). The court determined whether the redemption of stock was not essentially equivalent to a dividend by examining the redemption's effect on the taxpayer's particular capital structure. In discussing the taxpayer's capital structure, the court discussed the ownership of stock. The court noted that:

     Ownership of stock can involve three important rights: (1) to

[19] In addition, in U.S. v. Davis, 397 U.S. 301 (1970), the Supreme Court held that the constructive ownership rules of section 318 were relevant for purposes of applying section 302(b)(1) to determine whether a redemption was not essentially equivalent to a dividend. Under the Davis standard, it may be relevant to apply the constructive ownership rules of section 318(a)(2)(B)(i) for attribution of stock owned by a trust to its beneficiaries even though the parenthetical prohibits attribution through an employer's trust described in section 401(a) which is exempt from tax under section 501(a). Ignoring the prohibition would be consistent with the intent of Congress in enacting section 302(b)(1) because the redemption affects the Participant's interest in the corporation and not the ESOP's interest in the corporation.

[20] In order to determine whether the redemption constitutes a sale or exchange under section 302(a) or a distribution of property under section 301, the redemption must [sic] tested under sections 302(b)(1), (2), (3), and (4). On the facts presented, the redemptions in the present case constitute a complete termination of each Participant's interest within the meaning of section 302(b)(3). Thus, the redemptions are treated as a distribution in full payment in exchange for stock within the meaning of section 302(a).

[21] The taxpayer argues that the Participant cannot be the beneficial owner of the Class C stock since Congress amended section 402(a) to eliminate the constructive receipt doctrine. Prior to 1981, section 402 provided for recognition of amounts "made available" within a plan for distribution to employees, but this concept was abolished by the Economic Recovery Tax Act of 1981. Economic Recovery Tax Act of 1981, P.L. 97-34, section 314(c)(1). The effect of the amendment is that Participants are not taxed on amounts added to or earned by their accounts. The doctrine of constructive receipt is not relevant to the determination of who is the owner of stock for purposes of applying section 302. Moreover, the redemption in the present case goes beyond the concept of constructive receipt because the stock is not just "made available" to the Participant, but has actually been redeemed pursuant to an affirmative act of the Participant.

[22] The taxpayer cites Rev. Rul. 82-75, 1982-1 C.B. 116 for the proposition that an employee's holding period for capital assets distributed from a qualified plan begins on the date of distribution, not on the date the assets were placed in the employee's account, or on the date that the participant requests a distribution. By making this assertion, the taxpayer implies that distribution occurs on the date that the participant actually receives the stock certificates. In fact, the Service in Rev. Rul. 82-75 states that distribution occurs on the date the plan trustee delivers the stock to the transfer agent with instructions to reissue the stock in the participant's name. The ruling goes on to hold that the participant's holding period with respect to the stock begins the day after the stock is deemed to be "distributed" to the participant, regardless of when the participant actually receives the stock. In contrast to the taxpayer's assertion, Rev. Rul. 82-75 reiterates the Service's position that the participant can be the owner of the stock allocated to his account prior to actual receipt of the stock. Additionally, when the holding period commences is not relevant for determining beneficial ownership for purposes of section 302 since the holding period is deemed to begin the day after the capital asset is acquired. Rev. Rul. 54-607, 1954-2 C.B. 177 (in determining the holding period of property, the date the property is acquired is excluded and the date the property is disposed of is included).

                             CONCLUSION