Not for attribution.

Family relationships can affect the tax treatment of many transactions. One such transaction is the redemption of stock by a corporation. Normally, a shareholder wants a redemption to be treated as a sale or exchange; if it is treated as a dividend, all the proceeds are taxed as ordinary income.

Basically, the tax laws allow redemptions to be treated as exchanges if they are comparable to sales to outsiders. Redemptions that do not significantly change a shareholder's interest in a corporation, on the other hand, arc, similar to dividends.

EXCHANGE TREATMENT

To be treated as an exchange, a corporate redemption most be a complete termination of the shareholder's interest, a substantially disproportionate redemption or a redemption not essentially equivalent to a dividend.

Complete termination of I sharehholder's interest. If a shareholder sells all his or her stock and completely terminates ownership of the corporation, the redemption is treated as an exchange.

Substantially disproportionate redemption. A redemption in this category must meet certain mathematical tests. After the redemption, the shareholder must own less than 50% of the corporation's total voting stock. The shareholder's percentage of voting stock after the redemption also must be less than 80% of his or her percentage before the redemption.

Redemption not essentially equivalent to a dividend. There must be a "meaningful reduction" in the shareholder's corporate interest for a redemption to fall into this category. What exactly a "meaningful reduction" is, however, is not clear. Obviously, when a majority shareholder redeems sufficient stock so that he or she no longer holds a controlling interest, this criterion is fulfilled. It also has been considered satisfied when a shareholder's position of absolute control is reduced to one in which control is evenly balanced: for example, when a majority shareholder reduces ownership to exactly 50% (thereby giving up control).

ATTRIBUTION 

Indirect ownership of stock also must be considered in determining exchange treatment. In measuring a redeeming shareholder's ownership interest, shares owned by, or for the benefit of, related parties (such as certain relatives, trusts or estates) must be taken into account. This determination may involve family members, entities and their beneficiaries.

Family attribution. A shareholder is deemed to own stock held by his or her spouse, parents, children or grandchildren.

Entities and beneficiaries. There are different sets of rules for attributing ownership from an entity to a beneficiary and from a beneficiary back to the entity.

WAIVER 

Under certain conditions, the family attribution rules may be waived. The redemption must otherwise qualify as a complete termination of the shareholder's interest. After the distribution, the distributee must have no interest in the corporation except as a creditor. He or she must not acquire any other interest in the corporation within 10 years (except through bequest or inheritance). The shareholder also must file with the Internal Revenue Service an agreement to notify the service of the acquisition of any such interest within that 10-year period.

DISCORD 

When family members work together in a family corporation, the attribution rules may offer a reasonable way of determining who actually owns the corporation's stock. However, when the parties are hostile toward each other and unlikely to cooperate in exerting control over the corporation, these rules can be extremely harsh. Some courts therefore have held that the attribution rules may be ignored, or are only one factor to be considered, when there is hostility between related parties. However, the IRS (and some courts) steadfastly have adhered to the position that the attribution rules apply to related shareholders, regardless of the situation.

For a discussion of this situation and other developments, see the Tax Clinic department, edited by Stuart R. Josephs, in the May 1993 issue of The Tax Adviser.