WHEN TRUST HOLDS COMMON & PREFERRED STOCK AND IS ONE OF THREE OWNERS WHO CAN FORM CONTROL GROUP, REDEMPTION OF TRUST'S NONVOTING PREFERRED STOCK IS PROPERTY DISTRIBUTION

Rev. Rul. 85-106

ISSUE

Is a redemption of nonvoting preferred stock not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Internal Revenue Code when there is no reduction in the percentage of voting and nonvoting common stock owned by the redeemed shareholder, and when the redeemed shareholder continues to have an undiminished opportunity to act in concert with other shareholders as a control group, under the circumstances described below?

FACTS

Corporation X has outstanding three classes of stock consisting of 100 shares of voting common stock, 100 shares of nonvoting common stock, and 50 shares of nonvoting 9 percent cumulative preferred stock. The fair market value of each share of common stock was approximately half the fair market value of each share of preferred stock. The voting common stock was held as follows:

  Shareholders Shares

The nonvoting common stock and the preferred stock were held (directly and indirectly) in approximately the same proportions as the common stock. C held no nonvoting common stock or preferred stock directly, but was the sole remaining beneficiary of a trust, T, which owned 18 percent of both the nonvoting common stock and the preferred stock.

The trustees of T decided that it would be in the best interests of that trust if most of the X preferred stock held by T could be converted into cash. After negotiation, X redeemed six shares of preferred stock for its fair market value of 6x dollars. Following this redemption, T continued to hold three shares of preferred stock, and 18 percent of the nonvoting common stock. Under section 318(a)(3)(B) of the Code, T is also considered to own the voting common stock owned by its sole beneficiary, C.

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 for 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)(2) provides that section 302(a) will apply if (in addition to other requirements) the redemption substantially reduces the voting power of 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) does not deal with the type of redemption under consideration. Section 302(c)(1) provides, with an exception not here relevant, that the constructive ownership rules of section 318(a) apply in determining the ownership of stock for purposes of section 302.

The lack of any reduction in T's 18 percent vote prevented this redemption from qualifying under section 302(b)(2) of the Code, and the lack of complete termination of interest prevented it from qualifying under section 302(b)(3). The question remains whether the redemption should be considered not essentially equivalent to a dividend so as to qualify under section 302(b)(1). Under section 1.302-2(b) of the Income Tax Regulations, this determination depends upon the facts and circumstances of each case.

In United States v. Davis, 397 U.S. 301 (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, and that, for this purpose, the attribution rules of section 318 apply.

In determining whether a reduction in interest is "meaningful", the rights inherent in a shareholder's interest must be examined. The three elements of a shareholder's interest that are generally considered most significant are: (1) the right to vote and thereby exercise control; (2) the right to participate in current earnings and accumulated surplus; and (3) the right to share in net assets on liquidation. Rev. Rul. 81-289, 1981-2 C.B. 82.

In applying the above principles, it is significant that (as a result of section 318(a)(3)(B) of the Code) the redemption did not reduce T's percentage of the vote in X. It is true that T reduced its percentage interest in current earnings, accumulated surplus, and net assets upon liquidation, and reduced the fair market value of its ownership in X. However, when the redeemed shareholder has a voting interest (either directly or by attribution), a reduction in voting power is a key factor in determining the applicability of section 302(b)(1) of the Code. Johnson Trust v. Commissioner, 71 T.C. 941, 947, 948 (1979); Rev. Rul. 78-401, 1978-2 C.B. 127; Rev. Rul. 77-218, 1977-1 C.B. 81; Rev. Rul. 7-502, 1975-2 C.B. 111; Rev. Rul. 75-512, 1975-2 C.B. 112.

It is also true that T was not the largest shareholder. A and B each held slightly larger voting interests, and larger interests measured by fair market value. T, however, was not in the position of a minority shareholder isolated from corporate management and control. Compare Rev. Rul. 75-512, where the majority of the redeeming corporation's voting stock was held by a shareholder unrelated (within the meaning of section 318(a)) to the redeemed trust. Also compare Rev. Rul. 76-385, 1976-2 C.B. 92, where the redeemed shareholder's total interest was de minimis.

In the present situation, a significant aspect of T's failure to reduce voting power is the fact that the redemption leaves unchanged T's potential (by attribution from C) for participating in a control group by acting in concert with A and B. Compare Rev. Rul. 76-364, 1976-2 C.B. 91, where a reduction in voting interest was found meaningful in itself when it caused the redeemed shareholder to give up a potential for control by acting in concert with one other shareholder. In addition, the Tax Court has indicated significance for this factor of potential group control (Johnson Trust, at 947). See also Bloch v. United States, 261 F. Supp. 597, 611-612 (S.D. Tex. 1966), aff'd per curiam, 386 F.2d 839 (5th Cir. 1967), where, in finding that "the distributions in question were essentially equivalent to a dividend," the court noted that there was no change in the redeemed shareholder's potential for exercising control "by aligning himself with one or more of the other stockholders."

Although there was a reduction of T's economic interest in X, such reduction was not sufficiently large to result in a meaningful reduction of T's interest. The absence of any reduction of T's voting interest in X (through C) and T's potential (through C) for control group participation are compelling factors in this situation.

In Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964), dealing with a similar question, a decision was reached permitting the applicability of section 302(b)(1) of the Code. That case, however, was decided prior to the decision of the Supreme Court in Davis. Thus, Himmel fails to reflect the development in the law represented by the Davis limitation on section 302(b)(1) applicability where there is no meaningful reduction of the shareholder's proportionate interest in the corporation. Thus, pursuant to David, it is proper to view Himmel as incorrect to the extent it conflicts with the position contained in this revenue ruling.

HOLDING

The redemption of nonvoting preferred stock held by T does not qualify as a redemption under section 302(b)(1) of the Code, under the facts of this ruling when there is no reduction in the percentage of voting and nonvoting common stock owned by T, and when T continues to have a undiminished opportunity to act in concert with other shareholders as a control group. Since the redemption does not otherwise qualify under section 302(b), it is not a distribution in part or full payment for the stock under section 302(a). Consequently, under section 302(d), the redemption will be treated as a distribution of property to which section 301 applies.