Substantially disproportionate redemptions.

• Author: Goldberg, Michael J.
• Position: Corporate stock sale by majority shareholder; capital gains

An individual can use a technique to sell stock within a corporate structure, retain absolute control of the corporation and still obtain preferential capital-gain treatment. The technique involves a majority shareholder selling a substantial amount of his stock to a controlled subsidiary. The shareholder must follow specific mathematical guidelines to receive preferential treatment.

Example: A owns a 70% interest in domestic corporation P, and shareholder B owns the remaining 30%. P is the 100% shareholder of corporation S. A sells a 35% interest in P to S. As a result, A reports the transaction as a capital gain, even though he retains control of P.

In the example, Secs. 304 and 302 would determine whether the stock redemption results in dividend or capital-gain treatment. There are four ways for a stock redemption to result in capital-gain treatment. In the example, the transaction qualifies as a "substantially disproportionate redemption."

Under Sec. 302(b)(2)(C), a substantially disproportionate redemption occurs if "immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote;' and "the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time is less than 80 percent of the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time." (Emphasis added.) In the example, A must reduce his interest in P to under 56% for purposes of the 80% test, and he must reduce his interest to under 50% for the control test.

To apply these tests, a taxpayer uses Sec. 318 attribution rules. In the example, S attributes its 35% interest to P. P attributes the 35% interest to A and B, whose proportionate share of the attributed P stock is calculated as follows:

A: (35% attributed) x (35/100 ownership interest) = 12.25%

B: (35% attributed) x (30/100 ownership interest) = 10.50%

A's ownership for Sec. 302(b)(2) purposes is therefore 47.25%.

It is not intuitive to include the P shares that S owns...