Rev. Rul. 75-502

Advice has been requested whether, under the circumstances described below, a redemption of common stock will qualify as an exchange under section 302(a) of the Internal Revenue Code of 1954.

X corporation had outstanding one class of stock consisting of 1,750 shares of common stock. An estate owned 250 shares of the common stock and individual A, the sole beneficiary of the estate, owned 750 shares of the common stock. Individual B, who was not related to individual A within the meaning of section 318(a)(1) of the Code, owned the remaining 750 shares of X common stock. Through the application of the attribution rules of section 318(a)(3)(A), the estate owned A's common stock. Thus, prior to the redemption described below, the estate owned, actually and constructively, approximately 57 percent of the total voting rights of the outstanding common stock of X.

X redeemed for cash all of the common stock held by the estate. After the redemption, the common stock held by A represented 50 percent of the total voting rights of the then outstanding stock of X. Such stock continued to be owned by the estate through the application of section 318(a)(3)(A). Thus, the redemption reduced the estate's voting rights in X from 57 percent to 50 percent.

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock, and if section 302(b)(1), (2), or (3) applies, such redemption will be treated as a distribution in part or full payment in exchange for the stock.

Section 302(b)(1) of the Code provides that section 302(a) will apply if the redemption is not essentially equivalent to a dividend. Section 302(b)(2) provides that section 302(a) will apply if the redemption substantially reduces the voting power of the shareholder, but that section 302(b)(2) will not apply unless 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. Section 302(b)(3) provides that section 302(a) will apply if the redemption completely terminates the shareholder's interest in the corporation. Section 302(c)(1) provides, with an exception not here relevant, that the constructive ownership rules of section 318(a) apply in determining the ownership of stock for purposes of section 302.

In the instant case the redemption of the estate's common stock did not qualify as a substantially disproportionate redemption under section 302(b)(2) of the Code because the estate owned 50 percent of the voting rights of X after the redemption. Moreover, the estate's constructive ownership of the X stock also prevented the redemption from qualifying as a complete termination of interest under section 302(b)(3). The question, therefore, is whether the redemption was not essentially equivalent to a dividend within the meaning of section 302(b)(1).

Section 1.302-2(b) of the Income Tax Regulations relating to section 302(b)(1) of the Code provides, in part, as follows:

The question whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a dividend under section 302(b)(1) depends upon the facts and circumstances of each case.

In United States v. Davis, 397 U.S. 301 (1970), rehearing denied, 397 U.S. 1071 (1970), 1970-1 C.B. 62, the Supreme Court of the United States held that a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation in order to qualify as not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Code and that the business purpose of the redemption is irrelevant to this determination. The Supreme Court further held that section 318(a) applies for the purpose of determining whether a distribution is "not essentially equivalent to a dividend" under section 302(b)(1).

The Supreme Court in Davis did not indicate what constitutes an "interest" and what constitutes a "meaningful reduction" in situations different from the factual pattern contained in Davis wherein the shareholder owned 100 percent of the redeeming corporation before and after the transaction. The Court of Appeals for the Second Circuit has defined the rights inherent in a shareholder's interest. In Himmel v. Commissioner, 338 F. 2d 815 (2d Cir. 1964) the court defined a shareholder's interest to include: (1) the right to vote and thereby exercise control; (2) the right to participate in current earnings and accumulated surplus; and (3) the right to share in net assets on liquidation. A redemption which reduces these rights may result in a meaningful reduction in a shareholder's proportionate interest in a corporation within the meaning of Davis and, thus, qualify such redemption as not essentially equivalent to a dividend under section 302(b)(1) of the Code. Therefore, A's interest in X before and after the redemption must be examined in determining whether the redemption resulted in a meaningful reduction of A's interest under the facts and circumstances of the instant case.

In applying the above principles to the instant case, it is significant that the redemption reduced the estate's voting rights in X from 57 percent to 50 percent and also correspondingly reduced the estate's right to participate in current earnings and accumulated surplus and the estate's right to share in net assets on liquidation. Moreover, the reduction of the estate's voting rights from 57 percent to 50 percent produced a situation in which the other 50 percent of the voting rights of X were held by a single unrelated shareholder. Thus, under the facts and circumstances of the instant case, the redemption constituted a meaningful reduction of the estate's interest in X within the meaning of Davis.

Accordingly, the redemption was not essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Code and, therefore, qualified as an exchange under section 302(a).

If in the instant case, the stock of X held by the estate was reduced by less than 7 percentage points the redemption would not qualify under section 302(b)(1) because the estate would continue to have dominant voting rights in X by virtue of its ownership of more than 50 percent of the X stock.