IRS discusses possible prohibited transactions of redeemed shareholder.

Individual A was the sole shareholder of Corp. X from its inception. On a specified date, X redeemed 90% of A's stock with a note, to be paid in installments over a 15-year period, secured by a pledge of the redeemed stock. A resigned as a director, officer and employee of X as of that date. Also on that date, A sold 51% of the remaining X stock to his son, S, and the other 49% to two unrelated X employees, for 15-year installment notes with provisions (including a pledge) similar to the redemption note.

At the same time, X entered into a new lease of its business premises from A, and a new employment agreement with A's spouse B. (The lease provides for arm's-length lease payments.) It is unclear whether the employment contract provides excessive compensation for the services provided. X had leased the same property from A and employed B before the redemption.

A had spousal benefits in B's health insurance plan provided by X. X prepared A and B's joint Federal income tax return. X also provided a pickup truck for B's use, but it was used primarily by A.

In addition, under the stock-pledge agreement, the redeemed X stock is pledged to A as security for his installment note. The agreement assigns the dividend and voting rights on the pledged stock to the pledgor (not A), as long as there is no default on the note. The agreement provides that, if there is a default on the note, A might elect, subject to state law Y, to foreclose on the pledged stock by causing it to be sold at a public or private sale at a price that A might determine. A may purchase all or part of the pledged shares at the sale. Under Y, A may not obtain more than the unpaid balance on the note plus reasonable related expenses; any surplus over that amount must be accounted for to the debtor. It also appears that, under Y, a debtor is responsible for any deficiency after the sale of collateral.

The installment notes provide that, if X breaches either the employment agreement or the lease, the remaining principal on the note would become immediately due and payable. Not paying the full amount due may trigger the default provisions of the stock-pledge agreement.

Notwithstanding the agreements among A, X and the unrelated individuals, there is some question as to whether the stock was actually registered in the names of the new shareholders (as is contemplated by the agreements) and a sale actually occurred, or whether the parties' rights vis-a-vis the stock are simply determined by the agreements and common law. Moreover, at least one business decision of X (whether to exercise an option to buy X's business premises from A) was influenced by A'S wishes.

Analysis

Sec. 302(a) provides that if a corporation redeems its stock and if Sec. 302(b)(1), (2), (3) or (4) applies, the redemption would be treated as a distribution in part or full payment in exchange for the stock. However, under Sec. 302(d), a redemption to which Sec. 302(a) does not apply is treated as a distribution to which Sec. 301 applies.

Sec. 302(b)(3) applies if the redemption is in complete termination of all the stock owned by the shareholder. In determining whether there is such a complete termination of interest, Sec. 302(c)(1) generally provides that the Sec. 318 attribution rules apply. Under Sec. 318(a)(1)(A)(ii), stock owned by a shareholder's child is considered owned by the shareholder. However, Sec. 302(c) (2)(A) (i) provides that the family attribution rules of Sec. 318(a)(1) will not apply if, immediately after the distribution, the distributee has no interest in the corporation (including an interest as an officer, director or employee) other than as a creditor.

The Service's interpretation of Sec. 302(c) (2) (A) (i) generally asks whether the distributee is a creditor. The Tax Court's approach, on the other hand, generally asks whether the distributee has a financial stake in the corporation Or continued to control the corporation after the redemption.

Under Regs. Sec. 1.302-4(d), a person would be considered a creditor for Sec. 302(c)(2) (A) (i) purposes "only if the rights of such person with respect to the corporation are not greater or broader in scope than are necessary for the enforcement of his claim. Such claim must not in any sense be proprietary and must not be subordinate to the claims of general creditors." For example, claims that may be repaid only out of (or by reference to) earnings do not constitute a creditor interest. Kegs. Sec. 1.302-4(e) provides that, as to the distributee in a Sec. 302(b)(3) redemption who is a creditor after the transaction, the acquisition of the corporation's assets in the enforcement of the creditor's rights is not a prohibited interest for Sec. 302(c)(2) purposes, unless stock of the corporation or certain related corporations is acquired.

Rev. Rul. 84-135 held that a redeemed shareholder's right to receive payments under an unfunded pension agreement after the redemption relating to his pre-redemption employment with the corporation was not a prohibited interest under Sec. 302(c) (2) (A) (i); the payments did not depend on the corporation's earnings and the ex-shareholder's pension claim was not subordinate to general creditors. Rev. Rul. 77-467 held that a redeemed shareholder's continuing lease of real estate to the corporation that redeemed his stock was a creditor interest and not a prohibited interest as to the redeemed shareholder. Rev. Rul. 71-562 held that the acquisition of a stock interest by the son of a redeemed shareholder was not a prohibited interest as to the redeemed shareholder. That ruling suggested that a Sec. 318(a)(1) relative may acquire what would be a prohibited interest in the hands of the redeemed shareholder without causing such shareholder to have a prohibited interest.

Spouse's fringe benefits enjoyed by redeemed shareholder. There is no authority addressing whether a redeemed shareholder's participation in a spouse's fringe benefits is a prohibited interest. A taxpayer might be able to argue that, if Rev. Rul. 84-135 were broad enough to permit spousal employment, a reasonable amount of spousal fringe benefits might not be economically different, depending on the circumstances.

In Lynch, 83 TC 597 (1984), rev'd, 801 F2d 1176 (9th Cir. 1986), a redeemed shareholder had a post-redemption consulting agreement with the redeeming corporation. That former shareholder was also covered by the corporation's medical plan and had the use of a pickup truck provided by the corporation. The Tax Court held that the redeemed shareholder's consultancy, even when combined with the fringe benefits (and a stock pledge), was not a prohibited interest; it was not a significant interest in the business's success and such shareholder did not exercise control. The Ninth Circuit reversed on the grounds that performing services (either as an employee or an independent contractor) was a prohibited interest, but did not rule on whether the fringe benefits, by themselves, were prohibited interests.

The fringe benefits enjoyed by A in this case are comparable to those enjoyed by the redeemed shareholder in Lynch. Because it is not known whether A performed services for X after the redemption, one of the grounds used by the Ninth Circuit to reverse Lynch does not apply.

Acceleration provisions of installment note. There is no authority on whether a redeemed shareholder's rights are greater or broader in scope than necessary for the enforcement of his claim under Regs. Sec. 1.302-4(d). In this case, the conditions in the installment note, which impose a default if X breaches the spouse's employment agreement or the lease agreement, are not necessary to protect A's claim. These conditions also give A some continuing influence and a continuing financial stake in X. This argument might be even more compelling if the employment contract were not for fair market value.

It appears that, under the "greater or broader in scope" rule, A's interest does not constitute a creditor interest for Sec. 302(c)(2) purposes and is therefore a prohibited interest. Note: Even if a distributee has run afoul of Regs. Sec. 1.302-4(d), the Tax Court has ruled that the distributee was nevertheless a creditor. In Estate of Lennard, 61 TC 554 (1974), even though the distributee failed the non-subordination rule, satisfaction of the nonproprietary requirement (and the other indicia of creditor status) rendered the distributee a creditor under Sec. 302(c)(2).

Pledge of redeemed stock to redeemed shareholder. We have not found a case in which the redeemed stock was pledged by the corporation to the redeemed shareholder. However, in Lynch, when the stock of the redeemed shareholder's son was pledged to the redeemed shareholder to secure the corporation's installment note to the redeemed shareholder, the Tax Court held that the pledge was a security interest common in sales agreements and was not inconsistent with an interest as a creditor. The Second Circuit has also noted that a pledge would constitute a prohibited interest; see Dunn, 615 F2d 578 (1980).

In this case, the pledge agreement does not directly return the stock to A, but allows him to sell the stock at public or private sale and to buy all (or part of) the stock at that sale. More importantly, under the controlling state law, A may not obtain, under this pledge, more than the unpaid balance on the note plus reasonable sale expenses. Any surplus over that amount must be accounted for to the debtor.

If the pledge allowed A to recover more than the unpaid balance on the note (or the note was not likely to be paid), the IRS could argue more forcefully that the pledge gave A more than a creditor interest under Regs. Sec. 1.302-4(d) and that A had a "proprietary interest."

Continuing influence by redeemed shareholder. There is some indication that the wishes of the redeemed shareholder are being honored as far as the corporation's decisionmaking. If the redeemed shareholder were exercising continuing control over X, such interest would constitute a prohibited non-creditor interest under Sec. 302(c)(2)(A).

IRS LETTER RULING (FSA) 200203021 (10/18/01)