Stock redemption pitfalls.

• Author: Lebovits, Philip
• Position: Taxation

When a corporation redeems a shareholder's stock, there is no assurance that it will be treated as a capital transaction; the redemption may be treated as a dividend distribution. The tests for a capital transaction are found in Sec. 302(b). The most elusive is in Sec. 302(b)(1).

Sec. 302(b)(1) provides that a redemption will be treated as a sale or exchange subject to capital gain treatment when a distribution is "not essentially equivalent to a dividend." This is based on the facts and circumstances of each case (Regs. Sec. 1.302-2(b)).

For a distribution to be considered "not essentially equivalent to a dividend," the transaction must result in a "meaningful reduction" of the shareholder's proportionate ownership interest in the company (Davis, 397 US 301 (1970), reh'g den., 397 US 1071 (1970)).

In determining whether a reduction in a minority shareholder's proportionate ownership interest is "meaningful" for tax purposes, three basic attributes of stock ownership were examined in Rev. Rul. 76-385:

1. Reduction in voting power;

2. Reduction in rights to current earnings; and

3. Reduction in rights to assets on liquidation.

A fourth test, effect on corporate control, has also been applied. Letter Ruling 9829008 held there was a meaningful reduction when a shareholder (1) with 1.72% of voting power and 5.91% of value of publicly traded stock reduced his interest to 1.56% of voting power and 5.10% of value and (2) was isolated from corporate management and control. In Letter Ruling 8134148, the IRS held that a distribution was not essentially equivalent to a dividend when the seventh largest shareholder, owning 4.12% of the shares outstanding, was reduced to ninth largest shareholder (3.54% shares) and exercised no control over the corporation's affairs.

In Rev. Rul. 76-385, a reduction in the interest of minority shareholders as small as 0.0000037 percentage points was held to be meaningful, based largely on the fact that the interest was relatively...