The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 6, January 2003, Panel Publishers, New York, NY.


By Robert W. Wood

Okay, so we're not starting with the happiest premise for a tax story. Much of the lore of stock redemptions focuses on how to avoid dividend treatment. In the traditional corporate tax planning literature, everyone seeks the nirvana of redemption treatment. They seek to reach this goal by structuring transactions that qualify as substantially disproportionate (thus securing redemption treatment), or by satisfying the more nebulous standard of having the consideration not be essentially equivalent to a dividend. Either way, the capital treatment associated with stock redemptions is attractive.

Avenues to Redemption Valhalla

There are several distinct avenues to redemption treatment. Perhaps most straightforward (and closest to te model of a redemptions as merely a specialized type of stock sale) is a redemption in termination of the shareholder's interest. If the shareholder is being bought out, the theory goes, then it should not matter whether it is the company that buys out the shareholder or some third party.

The second approach is a substantially disproportionate redemption. In other words, even though the shareholder will remain a shareholder of the company, if his stock ownership is reduced substantially in relationship to other shareholders, the sale analog is appropriate. The distribution in such a case, by definition, is not pro rata.

Finally, and most dishearteningly, a redemption transaction will be treated as a redemption if it is "not essentially equivalent to a dividend." This is one of the classic tautologies of the federal income tax. It is the most like "we know it when we see it" that you are likely to find.

Termination of Interest

The complete termination of interest wing of the redemption provision requires just what it's name would suggest: a shareholder can no longer hold any stock in the corporation. This obviously limits the practical value of this provision to circumstances in which a complete buyout of the shareholder's interest is economically feasible. Even so, a fundamental problem is the definition of "entire interest" for purposes of such redemptions.

Apart from attribution of stock ownership (based on familial relationship, etc.), one does not have to be overly creative to imagine a shareholder attempting to maintain his position in the corporation through equity instruments disguised as debt instruments. Then, too, other roles with the company (such as a role as a director) arguably should be taken into account.

One ameliorating possibility concerns installment sales. A redemption can qualify for sale or exchange treatment if it is in complete redemption of all of the stock owned by the shareholder, even if payments for the stock are made over time under an installment contract. This makes the complete termination of interest redemption of significantly more practical value to closely held corporations than it otherwise might be. Nevertheless, some care is needed. Such redemptions on credit (where the redemption payments are made in installments despite a current transfer of shares), have not been well received by the IRS. One IRS concern is that, under most installment sale arrangements, if the installment payments stop, the seller will have the right to take back all or a portion of the transferred property. This problem is particularly acute where any other continuing interests maintained by the shareholder whose shares were redeemed. For example, continuing interests in the form of debt may appear to be disguised equity.

Often, it is not clear whether an interest in a corporation ought properly to be considered stock or debt. If debt is recharacterized as equity, it would preclude complete termination of interest treatment. Here, the same types of factors that apply in determining debt vs. equity status in other areas are used. Thus, relevant factors would include the voting rights, if any, of the debtholder, whether the corporation is thinly capitalized, the convertibility of debt, etc.

Apart from general debt/equity principles, however, the regulations under Section 302 contain special cautionary language about debt instruments following a redemption. For purposes of the termination of interest redemption rule, if the shareholder whose stock interest is totally redeemed is a creditor after the transaction, the regulations indicate that the acquisition of assets of the corporation to enforce the rights of a creditor will not be considered the acquisition of an interest in the corporation which would preclude complete termination of interest treatment, unless the creditor acquires stock in the corporation, its parent, or a subsidiary. Reg. §1.302-4(e).

Because of the extensive attribution rules included within Section 318 (which import stock ownership) and the applicability of these rules to stock redemptions, in the context of most closely held corporations, it will be difficult (if not impossible) to successfully run the gauntlet of a complete termination of interest. Unless the shares held by an entire family are redeemed, in most cases there will be attribution that would result in the redeemed shareholder being treated as retaining an interest in the equity position of the company.

Fortunately, a waiver of family attribution rules for the limited purpose of a redemption in complete termination of a shareholder's interest is available. If all of the stock actually owned by a shareholder is redeemed, and the waiver is affected, the redemption will still qualify as one in complete termination of the shareholder's interest. To qualify for this waiver, the distributee must have no interest in the corporation other than as a creditor immediately after the redemption.

An interest as an officer, director or employee of the corporation is also prohibited. Moreover, the distributee must not acquire any interest in the corporation (other than stock acquired by bequest or inheritance) within ten years from the date of the distribution. Finally, the distributee must file an agreement with the IRS to notify the IRS if he acquires an interest in the company within this ten year period.

What Is "Substantially Disproportionate?"

If a redemption is not in complete termination of a shareholder's interest, it will still qualify for capital treatment if it is substantially disproportionate. This test has as its primary advantage a mathematical certainty of result. It operates as a safe harbor to assure sale or exchange treatment. It was designed to provide a purely mechanical test for determining disproportionality. A pro rata distribution in redemption to shareholders looks like a dividend, and therefore is so treated.

In contrast, a redemption resulting in a complete termination of a shareholder's interest ought to be treated as a sale or exchange. The substantially disproportionate redemption, where some shareholders have a significant portion (but not all) of their shares redeemed, falls somewhere in between these extremes. Since the substantially disproportionate test is applied shareholder by shareholder, it may apply to some shareholders, but not to others.

For a redemption to be treated as substantially disproportionate, the shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote immediately after the redemption. The shareholder may own a majority of the stock (even 100%) before the redemption. After the redemption, though, the shareholder must own less than 50% of the total combined voting power. The manner of determining the voting power of the stock, relevant for purposes of this provision as well as many other purposes under the redemption provisions, is relatively straightforward.

The requisite percentage reduction the redemption must achieve is determined according to a ratio. The distribution is substantially disproportionate if, immediately after the redemption, the ratio of the redeemed shareholder's voting stock in the corporation in relation to the corporation's total voting stock has decreased by more than 20%.

Stated differently, the ratio of the shareholder's voting stock to the total voting stock must be measured both before and after the redemption, and the ratio between these two ratios must be less than 100:80.

Example: Sam Shareholder owns 40% of the voting stock of Widget Co. A redemption occurs under which Sam gives up 10% of his stock. His percentage ownership will be reduced from 40% to 30%. This would satisfy the percentage test because before the redemption, Sam owns 40% and after the redemption, Sam owns less than 80% of his pre-redemption 40% interest (80% of 40% equals 32%). Any redemption resulting in Sam owning less than 32% of the outstanding stock after the redemption would qualify as substantially disproportionate.

Since the percentage formula for a substantially disproportionate redemption focuses upon the voting power of the corporation, if the corporation redeems only nonvoting stock, the redemption by definition cannot qualify as substantially disproportionate. Indeed, even though the corporation redeems all the nonvoting stock held by a shareholder, and that nonvoting stock constitutes 90% of the total shares (both voting and nonvoting) held by that shareholder, no substantially disproportionate redemption can occur.

The percentage requirements for a substantially disproportionate redemption are measured at the shareholder level, and each shareholder is considered separately. Each shareholder must own less than 50% of the total combined voting power, and each must separately meet the 80% reduction requirement. However, a series of redemptions involving shareholders, each of whose percentage interest in the company was reduced by more than 20% of his interest before the redemption, must be aggregated.

Not Essentially Equivalent

If a redemption does not qualify as substantially disproportionate, and is not in complete termination of interest, what's left? The only possibility for redemption treatment is the gauntlet of "not essentially equivalent to a dividend." It is commonly asserted that this puzzling phrase is of relatively little importance from a planning perspective. True, one rarely wants to rely upon this enigmatic standard, as opposed to one of the more objective criteria of substantially disproportionate redemptions or those in complete termination of a shareholder's interest.

Nonetheless, many redemptions, for one reason or another, cannot be structured to comply with either of the two sets of rules that would provide more certainty. Although it is not an area of absolute certainty, it is possible to chart a course through the authorities interpreting the meaning of dividend nonequivalency.

The seminal case on stock redemptions not essentially equivalent to a dividend is U.S. v. Davis, 397 U.S. 301 (1970), reh'g denied, 397 U.S. 1071.

In Davis, the Supreme Court determined that the primary focus of this standard should be whether there has been a "meaningful reduction" in the interest of the redeemed shareholder. The business purpose is not necessary for the redemption to be not essentially equivalent to a dividend. Indeed, a business purpose is irrelevant. The Davis court also determined that the attribution rules of Section 318 would apply in determining dividend equivalency. Unfortunately, the Supreme Court did not resolve whether other factors (such as family hostility) may negate otherwise applicable attribution.

Much ink has been spilled over the question of what constitutes a "meaningful reduction" in the proportionate interest of a shareholder, thus entitling that shareholder to redemption treatment.

The Dreaded Dividend

Dividend treatment, obviously, is much less attractive than sale or exchange treatment. Indeed, with a dividend, taxpayers receive ordinary income measured by the amount of the dividend, and there is no offset for basis recovery. In short, there is no sale or exchange. Here at The M&A Tax Report, we are sensitive to the fact that many taxpayers these days are corporate taxpayers that are affirmatively seeking dividend treatment.

After all, corporations would generally prefer the dividends received deduction to sale or exchange treatment, unless their basis is sufficiently high to preclude any amount being taxed. Subject to certain requirements and limits, the general dividends received deduction allows the recipient corporation to deduct a percentage of dividends received from domestic corporations. For the deduction to be available, the paying corporation must be subject to federal income tax. The percentage amount of the dividends received deduction varies depending on the percentage of the corporation's stock that the dividend receiving company holds. The dividends received deduction applies not only to cash dividends, but also to dividends paid in property, the property being valued at its fair market value.

Some of the more interesting issues involving the dividends received deduction involve distributions intended as one type of payment, but treated as another. For example, if a distribution is not intended as a dividend by the distributing corporation, but is required to be so treated to the distributee (such as a constructive dividend), should the dividends received deduction be available?

Under one theory, any distribution that is not treated as a dividend to both payor and recipient when paid should not qualify for the dividends received deduction. See Waterman Steamship Corporation, 430 F.2d 1185 (5th Cir. 1970), cert. denied, 401 U.S. 939 (1971). However, this argument has been rejected. For example amounts taxable as dividends as the result of boot in a reorganization have been held to qualify for the dividends received deduction. See King Enterprises, Inc. v. U.S., 418 F.2d 511 (Ct. Cl. 1969). Amounts not initially characterized as dividends, but constructively required to be so treated by the distributee, should therefore also qualify for the dividends received deduction.

So, What Happens to Basis?

If a distribution that under corporate law looks like a redemption (for example, in cancellation of outstanding stock), is treated as a dividend for tax purposes, what happens to the basis of the stock? The IRS has issued proposed regulations (REG-150313-01) dealing with the treatment of the basis of redeemed stock when a distribution as redemption is treated as a dividend. These proposed regs would amend a variety of regulations, issued under Section 302, 304, 704, 861, 1371, 1374 and 1502 (that's a mouthful). They would provide guidance not only on the dividends issue, but also on stock acquisitions by related corporations that are treated as distributions and redemption of stock.

When Redemptions Are Treated as Dividends: Whither Basis?, Vol. 11, No. 6, The M&A Tax Report (January 2003), p. 3.