Buyer beware of Zenz transactions.

• Author: O'Connor, Mike

Rev. Rul. 75-447 addresses the tax treatment of two situations: an issuance of stock to a new shareholder followed by a redemption of stock from old shareholders, as well as the partial sale of stock by old shareholders to a new shareholder, followed by a redemption of some (but not all) of the remaining shares of the old shareholders. Typically, the tax consequences of a transaction in which property is distributed to a shareholder are determined under Sec. 301. Under Sec. 301, a distribution of property is treated as a dividend to the extent of the distributing corporation's current or accumulated earnings and profits (E&P). Any amount exceeding the corporation's E&P is treated as a reduction in the stock's adjusted tax basis. The remaining amount is treated as gain from a sale or exchange of property.

In Rev. Rul. 75-447, the IRS said that, regardless of the order of the steps, the redemption of shares (when combined with an issuance of stock or sale of stock by the shareholders) as part of an integrated plan should not be treated as a dividend to the shareholder, but rather should be treated as a sale or exchange under Sec. 302(b). Specifically, the ruling addresses whether the stock redemption (when combined with an issuance or partial disposition as part of an overall integrated plan) qualifies under Sec. 302(b) (2) as a "substantially disproportionate" redemption. However, as discussed below, this rule also applies in cases where a plan involves a redemption and an issuance or sale of stock that results in a termination of the old shareholder's interest in the corporation under Sec. 302(b)(3).

Zenz v. Quinlivan

Rev. Rul. 75-447 is based on Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954). In Zenz, the IRS argued that a redemption should be treated as a dividend; however, the Sixth Circuit disagreed, finding that the shareholder did not retain any ownership post-redemption, and therefore she was treated as if she had disposed of all of the interest as part of one transaction. Thus, the court held that the transaction qualified for Sec. 302(b)(3) treatment as a termination of the shareholder's interest. That the two transactions took place as part of one integrated plan was key to the Sixth Circuit's ruling. The order of the transactions does not have any effect on the treatment, as long as it results in a complete liquidation of the former shareholder's interest within a short period of time. The treatment of the stock redemption is...