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The effect of sec. 318 on exchange treatment under sec. 302(b)(1).

For stock redemption proceeds to qualify for exchange treatment under Sec. 302(b)(1), a shareholder must experience a "meaningful reduction" in his interest in a corporation (Davis, 397 US 301 (1970)). However, Sec. 318 attribution can hinder qualification for exchange treatment. In measuring a shareholder's ownership in a corporation, shares owned by or for the benefit of related parties (such as parents, trusts, estates, etc.) are considered owned by the redeeming shareholder. The application of these attribution rules often prevents a meaningful reduction in a shareholder's corporate ownership, resulting in dividend treatment for the entire redemption proceeds. The following are examples of the effect that Sec. 318 attribution can have on redeeming shareholders.

Family and entity attribution

The purchase of stock in a family-owned corporation by another related corporation resulted in denial of exchange treatment to a redeeming trust in Rev. Rul. 77-218. Because family corporation X could not redeem 20 shares of common stock held by a family trust, another family corporation (Y) purchased those shares from the trust. Sec. 304(a)(1) classified this transaction as a distribution in redemption of the stock of the acquiring corporation (Y). Sec. 318 then applied in determining the effect of the distribution under Sec. 302(b).

In this particular situation, the family trust's income beneficiary was considered to own both the X shares owned by her child and the Y shares owned by her children and grandchildren. Hence, under Sec. 318(a)(3)(B)(i), stock in both family corporations owned by the trust beneficiary, directly and indirectly, was attributed to the trust. Because of this direct and indirect ownership, the trust had an ownership reduction of only 5% (from 60% to 55%). The IRS did not consider this reduction meaningful because - although the trust experienced a 100% reduction in its direct ownership, it retained an indirect interest in the X stock exceeding 50%; - most of the remaining X stock was held, directly or indirectly, by shareholders related to the trust under Sec. 318, and - an individual, the beneficiary's child who also owned X and Y stock, managed and controlled both X's and Y's affairs and served as a co-trustee of the trust.

Therefore, the entire proceeds from the sale of X stock to Y was treated as dividend income to the redeeming trust.

In contrast, Rev. Rul. 75-502 allowed exchange treatment when a 7% reduction in an estate's ownership of a closely held corporation reduced its ownership to exactly 50%. In granting this favorable treatment, the Service pointed not only to the estate's loss of financial benefits in viewing the reduction as "meaningful" but also to the estate's loss of control. After the redemption, the estate held only 50% of the voting rights with the remaining 50% held by a single unrelated shareholder.

Option attribution

In addition to family and entity attribution, option attribution under Sec. 318(a)(4) can treat a nonshareholder as owning shares or treat a shareholder as owning more shares than he actually owns. Therefore, a shareholder's ability to obtain exchange treatment on redemption of his shares under Sec. 302(b)(1)'s meaningful reduction standard may be affected.

In Henry T. Patterson Trust, 729 F2d 1089 (6th Cir. 1984), aff'g unreported Ohio DC decision, a testamentary trust redeemed 200 shares in a family-owned corporation. In addition to these shares, the trust was also treated as owning shares owned by the trust's beneficiary and her children through the family attribution rules. Before the redemption, the trust was deemed to own 345 out of 356 shares. After the redemption, it was deemed to own 145 out of 156 shares.

On audit, the IRS denied exchange treatment for this transaction because the reduction in the trust's stock ownership was only 4% - which was not considered meaningful. The Service's position was that an option to acquire 75 shares in the corporation, held by the trust creator's son-in-law, was included in the total number of outstanding shares.

However, the district court decided that the corporation's ownership decreased from 80% to 62.8%, a reduction of 17.2%. By including the 75 optioned shares in the fraction measuring the trust's stock ownership before and after the redemption, the reduction was considered meaningful. In holding for exchange treatment on the redemption proceeds, the court also noted that the trust" no longer controlled the company after the redemption (holding less than two-thirds of the stock) . . . ." This loss of control led the court to conclude that the "meaningful reduction" test was satisfied.

The Sixth Circuit held: "In this case, the redemption effected |a change in the relative economic interests or rights' of all the stockholders of the ... company. Therefore, despite the fact that - excluding operation of [sections]318(a)(4) - the Trust's relative holdings fell only 4% after redemption, under the unique facts and circumstances of this case, such was a |meaningfuly [sic] reduction' and the distribution was therefore not a dividentd"

Redemptions and attribution in

hostile environments

The application of the attribution rules to parties who are hostile towards each other and unlikely to cooperate in exerting control over a corporation is unnecessarily harsh. However, there is division among the courts as to whether the Sec. 318 attribution rules can be ignored if there is hostility between related parties.

Regs. Sec. 1.302-1(a) states that Sec. 318(a) "applies to all redemptions under section 302 except that in the termination of a share-holder's interest certain limitations are placed on the application of section 318(a)(1) by section 302(c)(2)." (Emphasis added.) Regs. Sec. 1.302-2(b) further states that the determination of whether a redemption is essentially equivalent to a dividend under Sec. 302(b)(1) "depends upon the facts and circumstances of each case. One of the facts to be considered in making this determination is the constructive stock ownership of such share-holder under section 318(a)." (Emphasis added.)

These two regulation apparently conflict. If the determination depends on the facts and circumstances of each redemption and Sec. 318 constructive ownership is only one of the facts to be considered, there appears to be some support for ignoring Sec. 318 attribution if warranted by the facts.

Disregarding attribution

under Haft

After the Davis decision, a number of courts held that Sec. 318 attribution must be applied in measuring the effects of a redemption on a shareholder. However, Haft Trust, 510 F2d 43 (1st Cir. 1975), rem'g 61 TC 398 (1973), supplemental opinion, 62 TC 145 (1974), held that Sec. 318 attribution could be disregarded when testing Sec. 302(b)(1) redemptions - depending on the facts involved.

Haft involved the redemption of stock by four family trusts, all minority shareholders in a family corporation as a result of divorce negotiations between Mr. and Mrs. Haft. Although the property settlement called for the complete termination of the trust's interest in the corporation, the trusts were treated as owning slightly more of the corporation after the redemption through Sec. 318 attribution.

The shares in the corporation owned directly by Mr. Haft were attributed to his children and then reattributed to each of the four children's trusts. Also attributed to the redeeming trusts were shares in the corporation owned by a trusts of which Mr. Haft was a beneficiary.

The Tax Court held that dividend treatment applied because the trusts did not have a meaningful reduction in their direct and indirect ownership in the corporation. However, the First Circuit held that the Davis language" certainly seems to permit, if it does not mandate, an examination of the facts and circumstances to determine the effect of the transaction transcending a mere mechanical application of the attribution rules." Therefore, the Appeals Court concluded:

Since the court below made no finding on the hostility question, we remand to the Tax Court to reconsider taxpayers' claims in the light of the facts and circumstances of the case, including the existence of family discord tending to negate the presumption that taxpayers would exert continuing control over the corporation despite the redemption. We intimate no opinion as to the validity of these claims.

In Rev. Rul. 80-26, shares in a family corporation were redeemed by four trusts created for the benefit of the taxpayer's children by their maternal grand-parent. As a result of divorce between the taxpayer and his wife, the trusts redeemed their shares in the corporation as part of the settlement. Before the redemption, the trusts directly and indirectly owned 31% of the stock. After the redemption, the trusts indirectly owned 33% of the stock (through attribution of the father's shares to the children which were reattributed to the trusts). Even though the trusts did not exercise any control over the corporation, Sec. 318 attribution was applied. The resulting increase in stock ownership by the trusts precluded exchange treatment for the redemption proceeds.

In citing Haft, the IRS found the court's interpretation of Sec. 318's legislative history to be erroneous:

The purpose of the attribution rules under section 318 was to replace the confusion of prior law with clear and objective standards for attribution of stock ownership among related shareholders. The facts and circumstances of a particular case cannot contradict the mechanical determination under section 318 of how much stock a shareholder owns.

Consequently, Rev. Rul. 80-26 further stated that the Service would not follow Haft. In contrast to this decision, and in response to Rev. Rul. 80-26, other cases have held that family hostility cannot mitigate Sec. 318 attribution in measuring a shareholder's interest in a corporation. (See Metzger Trust, 76 TC 42 (1981), aff'd, 693 F2d 459 (5th Cir. 1982), cert. denied; and Cerone, 87 TC 1 (1986).)

A discussed, qualifying redemption proceeds for exchange treatment is even more difficult if there is attribution under Sec. 318. If stock in a corporation is held by a number of related parties, Sec. 318 can prevent a share-holders from obtaining exchange treatment for a redemption under Sec. 302(b)(1). Therefore, share-holders in this situation should consider completely terminating their interests in the corporation. In this event, Sec. 302(c)(2) may limit attribution and avoid dividend treatment for the redemption proceeds. Otherwise, it may be wise to avoid such a redemption.
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Author:Roemer, Kimberly C.
Publication:The Tax Adviser
Date:May 1, 1993
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