Rev. Rul. 78-401

ISSUE

Does the redemption of stock described below qualify as a distribution not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Internal Revenue Code of 1954?

FACTS X corporation, incorporated under the laws of state D, had outstanding one class of stock consisting of 1,000 shares of voting common stock. A, an individual, owned 900 shares (90 percent of the total voting rights) and B, an individual unrelated to A within the meaning of section 318 of the Code, owned the remaining 100 shares (10 percent of the total voting rights). A and B were both active in the management of X.

X redeemed 750 shares of its stock held by A. After the redemption, the common stock held by A (150 shares) represented 60 percent of the total voting rights of the then 250 outstanding shares of X stock. Thus, the redemption reduced A's voting rights in X from 90 percent to 60 percent. A and B both continued to be active in the management of X after the redemption.

Pursuant to the articles of incorporation of X and the laws of state D, a holder of over 50 percent of the X stock controlled X's day to day affairs through the board of directors, and a holder of 66.67 percent of the X stock controlled broader corporate decisions such as those regarding corporate liquidation, merger, or disposition of substantial amounts of operating assets.

LAW AND ANALYSIS

The applicable sections of the Code and Income Tax Regulations thereunder are 302(b)(1) and 1.302-2, relating to redemptions not equivalent to dividends; and 302(d), 301, 1.302-1 and 1.301-1, relating to redemptions treated as distributions of property.

Pursuant to section 1.302-2(b) of the regulations, the question whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a dividend under section 302(b)(1) of the Code 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.

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 applying the above factors to the instant case, it is most significant that the redemption did not reduce A's voting rights in X to 50 percent or less, even though there was a reduction in A's right to participate in current earnings and accumulated surplus and A's right to share in net assets in liquidation. Although A has surrendered the ability to individually control those corporate decisions requiring a 66.67 percent vote, A has retained control of the day to day affairs of X. Since A is in control of the day to day affairs of X and because there is no indication that the type of corporate action requiring a 66.67 percent shareholder vote is imminent, the retention by A of 60 percent of the voting rights in X becomes a predominatnt factor in determining whether the redemption results in a meaningful reduction of A's interest in X.

In Rev. Rul. 75-502 the reduction in a shareholder's interest from 57 percent to 50 percent indirectly (with the remaining 50 percent held by a single unrelated individual) was regarded to be meaningful within the meaning of Davis. However, that Rev. Rul. points out that if the redeeming shareholder had retained more than 50 percent of the voting rights the redemption would not qualify under section 302(b)(1) of the Code because the redeeming shareholder would continue to have dominant voting rights in the corporation.

In Rev. Rul. 77-218, 1977-1 C.B. 81, a shareholder indirectly retained 55 percent of the voting rights of the corporation after having all of its stock redeemed. It was held that the redemption did not constitute a meaningful reduction within the meaning of Davis, part of the justification for this result being the shareholder's retention of an indirect interest in the corporation in excess of 50 percent.

HOLDING

Under the facts and circumstances, the redemption by X of A's stock did not constitute a meaningful reduction in A's interest in X within the meaning of Davis despite the fact that A's voting rights were reduced below 66.67 percent. Accordingly, the redemption does not qualify as a distribution not essentially equivalent to a dividend under section 302(b)(1) of the Code 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 is a distribution of property to which section 301 applies.