Rev. Rul. 77-467

Advice has been requested whether under the circumstances described below, the taxpayer whose stock in a corporation will be redeemed will retain a prohibited "interest" within the meaning of section 302(c)(2)(A)(i) of the Internal Revenue Code of 1954 so that the taxpayer cannot waive application of the constructive stock ownership rules of section 318(a)(1) and qualify the redemption for exchange treatment under section 302(a) and (b)(3).

Individual A and A's children own all of the stock of Corporation X. A plans to retire from X and all of the X stock owned by A will be redeemed by X for an amount of cash equal to the fair market value of the stock. A's positions of president and chairman of the board of directors of X will be terminated and A will no longer be employed by X in any capacity.

Five years ago, A and X entered into a contract under which A agreed to permit X to use an office building owned by A in X's business for a period of 10 years. In return, X agreed to pay 600x dollars, at the rate of 5x dollars per month, which is an arm's length charge for the use of the building. The payments are not subordinate to the claims of X's general creditors. Under the agreement, A pays all taxes, assessments, and charges for utilities, services and insurance, and maintains both the interior and exterior of the building.

Section 302(a) of the Code provides that a redemption of stock of a corporation will be treated as a distribution in part or full payment in exchange for the stock redeemed if section 302(b)(1), (2), (3), or (4) applies. Section 302(b)(3) provides that section 302(a) will apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. If section 302(a) does not apply, a redemption of stock will be treated as a distribution of property to which section 301 applies (except as otherwise provided in subchapter C of chapter 1). Section 302(d).

Section 318(a)(1)(A)(ii) of the Code provides that for purposes of provisions of subchapter C to which the rules of section 318 are expressly made applicable, an individual will be considered as owning the stock owned, directly or indirectly, by or for the individual's children. Except as provided in section 302(c)(2), the constructive stock ownership rules of section 318(a) apply in determining ownership for purposes of section 302. Section 302(c)(1). Unless section 302(c)(2) applies, therefore, A's redemption will not qualify as a complete redemption because after the redemption A will be treated as owning the X stock actually owned by A's children.

Section 302(c)(2)(A) of the Code provides that section 318(a)(1) will not apply to section 302(b)(3) if (1) immediately after the distribution the distributee has no interest in the corporation (including an interest as an officer, director, or employee), other than an interest as a creditor, (2) the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of the distribution, and (3) the distributee files an agreement to notify the district director of any acquisition of a prohibited interest during the 10-year period.

In this case, the only relationship between A and X after the stock redemption will be the agreement under which X will continue to use A's building for an arm's length charge. The payments under the agreement will not be dependent upon X's future earnings and will not be subordinate to the claims of X's general creditors. This relationship will not provide A with an interest in X greater than that of a creditor. See section 1.302-4(d) of the Income Tax Regulations.

Accordingly, immediately after the redemption A will not have a prohibited "interest" in X within the meaning of section 302(c)(2)(A)(i) of the Code. Therefore, if A complies with all of the other requirements of section 302(c)(2)(A), the redemption will qualify for exchange treatment under section 302(a) and (b)(3).

If under the terms of an agreement for the use of property the payments to the person whose stock was redeemed are dependent on the corporation's future earnings or subordinate to the claims of the corporation's general creditors, the arrangement may be a prohibited proprietary interest. See section 1.302-4(d) of the regulations and Rev. Proc. 77-45, page 579 of this Bulletin.