Rev. Rul. 76-364

Advice has been requested whether, under the circumstances described below, a redemption of stock was a redemption that was not essentially equivalent to a dividend under section 302(b)(1) of the Internal Revenue Code of 1954.

Corporation X had outstanding one class of stock consisting of 200,000 shares of common stock each of which was entitled to one vote. A, an individual, owned 54,000 shares of X common stock (27 percent), each of which was entitled to one vote. Because A was retired from business, A took no active part in the management of X. The remaining 146,000 shares of outstanding X common stock (73 percent) were held in equal portions by individuals B, C, and D. None of the X shareholders were related within the meaning of section 318(a)(1) of the Code.

X redeemed for cash 12,160 shares of its stock held by A. After the redemption, A owned 41,840 shares of the outstanding stock of X which represented 22.27 percent of the 187,840 shares then outstanding. The redemption reduced A's percentage of ownership and voting rights in X from 27 percent to 22.27 percent. This reduction in A's percentage ownership in X failed to meet the percentage requirement of section 302(b)(2)(C) of the Code.

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock, and if section 302(b)(1), (2), or (3), applies, such redemption will be treated as a distribution in part or full payment in exchange for the stock.

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)(5) provides, in part, that in determining whether a redemption meets the requirements of section 302(b)(1), the fact that such redemption fails to meet the requirements of section 302(b)(2) will not be taken into account.

In the case of 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 in order to qualify under section 302(b)(1) of the Code a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.

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 on liquidation.

In the instant case, the fact that A failed to meet the requirements of section 302(b)(2) of the Code is not to be taken into consideration in determining whether the redemption meets the requirements of section 302(b)(1) as provided in section 302(b)(5). In determining whether the redemption meets the requirements of section 302(b)(1), it is significant that the redemption, in reducing A's interest from 27 percent to 22.27 percent, correspondingly reduced A's right to vote, A's right to earnings, and A's right to share in net assets on liquidation. Moreover, the reduction of A's voting rights from 27 percent to 22.27 percent is meaningful in itself in that it caused A to go from a position of holding a block of X stock that afforded A control of X if A acted in concert with only one other stockholder, to a position where such action was not possible. Thus, under the facts and circumstances of the instant case, the reduction constitutes a meaningful reduction of A's interest in X within the meaning of Davis.

Accordingly, the redemption was not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Code and, therefore, qualified as an exchange under section 302(a).