The effect of sec. 318 on exchange treatment under sec. 302(b) (1).

• Author: Roemer, Kimberly C.

For stock redemption proceeds to qualify for exchange treatment under Sec. 302(b)(1), a shareholder must experience a "meaningful reduction" in his interest in a corporation (Davis, 397 US 301 (1970)). However, Sec. 318 attribution can hinder qualification for exchange treatment. In measuring a shareholder's ownership in a corporation, shares owned by or for the benefit of related parties (such as parents, trusts, estates, etc.) are considered owned by the redeeming shareholder. The application of these attribution rules often prevents a meaningful reduction in a shareholder's corporate ownership, resulting in dividend treatment for the entire redemption proceeds. The following are examples of the effect that Sec. 318 attribution can have on redeeming shareholders.

Family and entity attribution

The purchase of stock in a family-owned corporation by another related corporation resulted in denial of exchange treatment to a redeeming trust in Rev. Rul. 77-218. Because family corporation X could not redeem 20 shares of common stock held by a family trust, another family corporation (Y) purchased those shares from the trust. Sec. 304(a)(1) classified this transaction as a distribution in redemption of the stock of the acquiring corporation (Y). Sec. 318 then applied in determining the effect of the distribution under Sec. 302(b).

In this particular situation, the family trust's income beneficiary was considered to own both the X shares owned by her child and the Y shares owned by her children and grandchildren. Hence, under Sec. 318(a)(3)(B)(i), stock in both family corporations owned by the trust beneficiary, directly and indirectly, was attributed to the trust. Because of this direct and indirect ownership, the trust had an ownership reduction of only 5% (from 60% to 55%). The IRS did not consider this reduction meaningful because - although the trust experienced a 100% reduction in its direct ownership, it retained an indirect interest in the X stock exceeding 50%; - most of the remaining X stock was held, directly or indirectly, by shareholders related to the trust under Sec. 318, and - an individual, the beneficiary's child who also owned X and Y stock, managed and controlled both X's and Y's affairs and served as a co-trustee of the trust.

Therefore, the entire proceeds from the sale of X stock to Y was treated as dividend income to the redeeming trust.

In contrast, Rev. Rul. 75-502 allowed exchange treatment when a 7% reduction in an...