Shareholder redemption rights and sec. 305.

Corporations often establish (stock buy-back plans allowing them to redeem a preset amount of their outstanding stock from shareholders. Often, the purpose of such plans is to increase the price of the company's shares. Once established, the plans generally remain in effect for a specified period or until a particular number of shares are redeemed. Such plans may create problems, however, if they are in effect when the corporation declares a stock dividend.

Sec. 305(a)(1), as amended, provides in relevant part that gross income does not include the amount of any distribution of a corporation's stock to its shareholders with respect to its stock. Sec. 305(b)(1) provides that a stock distribution shall be treated as a distribution of property to which Sec. 301 applies, if the distribution is, at the election of any of the shareholders, payable either in the corporation's stock or in property. Regs. Sec. 1.305-2(a) provides in part that if any shareholder has the right to elect to receive a distribution in money or other property, all shareholders are treated as receiving a distribution to which Sec. 301 applies, regardless of whether:

--the election or option is exercised or exercisable before or after the declaration of the distribution; or

--the election governing the nature of the distribution is provided in the declaration of the distribution or in the corporate charter or arises from the circumstances of the distribution.

If a corporation with a buy-back plan declares a stock dividend, a shareholder's redemption right under the plan might be viewed as an election by the shareholder to receive a stock split distribution in either stock or property under Sec. 305(b).

In Rev. Rul. 83-68, the IRS ruled that a distribution of a stock dividend by a Federal Home Loan Bank (FHLB) to its member banks would be treated as a Sec. 301 distribution pursuant to Sec. 305(b)(1), if at least one member of the bank had the right to have the distributed stock immediately redeemed. The Service reasoned that although the distribution was made in FHLB stock, at all times any member had a right to request the redemption of all or part of its stock in the FHLB (subject to Federal minimum requirements). The IRS noted that although the FHLB had discretion regarding whether to redeem the member's stock, it had established a policy to honor all redemption requests.

The Service modified Rev. Rul. 83-68 in Rev. Rul. 90-98, but only to the extent that Rev. Rul. 83-68 no longer represented the IRS's position on member banks receiving stock dividends from an FHLB. The Service ruled that, except in the case of an FHLB, it would continue to apply the principles underlying Rev. Rul. 83-68 and Sec. 305(b)(1) to a pattern of granting redemption requests in determining whether in substance the pattern gives a shareholder an election to receive stock or property. The IRS pointed out that Congress amended the statutory rules governing FHLBs by specifically providing that the FHLBs, not the member banks, had the discretion to approve or deny redemption requests. Rev. Rul. 90-89 is consistent with the Seventh Circuit's decision against the Service in Colonial Savings Ass'n, 854 F2d 1001 (1988).

Citing the Tax Court opinion in Frontier Savings, 87 TC 665,678 (1986), the IRS further noted in Rev. Rul. 90-98 that a pattern of approving redemption requests can in substance confer an election within the meaning of Sec. 305(b)(1), because the stock distribution can be a "mere subterfuge for a cash distribution." Moreover, the ruling quotes Tax Court Judge Hamblen's concurring opinion in Frontier, which notes that "[i]f a discretionary act of the board of directors of a shareholder corporation to redeem the stock dividends becomes a routine matter, it might . . . develop into an `option' that arises after the distribution or a distribution pursuant to a `plan.'"

In a further, more helpful, development, the Service recently issued Letter Ruling 9709044, ruling that a stock split by a corporation whose shareholders had existing redemption rights both before and after the distribution would not cause the stock distribution to be taxable under Sec. 305(b) or (c). In the letter ruling, Fund was a diversified, open-ended, management investment company registered under the Investment Company Act of 1940 (the "Act") that was taxable as a corporation. Since beginning operations, Fund had elected to operate as a regulated investment company. Under the Act, each share of Fund was redeemable at the shareholder's request for its net asset value. The Fund's Board of Directors wanted to reduce the Fund's net asset value per share to reduce the aggregate price required to purchase an incremental block of Fund shares. Fund proposed to declare a stock split in the form of a 100% share dividend, in which one new Fund share would be distributed to Fund shareholders for each share in existence immediately before the transaction. The IRS correctly concluded that the redemption policy and the stock split were separate transactions that should not be integrated to result in a distribution to which Sec. 305(b) applied.

Of note is that the ruling neither cited nor discussed the prior rulings or case law addressing stock dividends that take place when shareholders have a pre-existing outstanding right to require the redemption of their stock both before and after the distribution.

From Michele R. Gillette, J.D., LL.M., Washington, D.C.