Editor: Mark G. Cook, CPA, CGMA
In Letter Ruling 201918009, published May 3, 2019, the IRS addressed the tax consequences of a redemption of a shareholder's stock. The letter ruling deviates from prior judicial and IRS guidance on how to determine whether a stock redemption is a capital gain transaction. Specifically, it fails to evaluate whether the redemption resulted in a "meaningful reduction" of the shareholder's interest.
Sec. 302 affords a shareholder the advantage of sale or exchange (capital gain transaction) treatment on redeemed stock but only if the redemption meets one of several tests. The first of these tests, under subsection (b)(1), is that the redemption is "not essentially equivalent to a dividend." The regulations provide little insight into what this phrase means but instead state that the determination of dividend equivalence depends on the facts and circumstances of each case, without regard to the redeeming corporation's earnings and profits (Regs. Sec. 1.302-2).
The courts have elaborated on the details of the facts-and-circumstances test, and that is precisely how the meaningful-reduction standard was established five decades ago. In holding that a redemption was essentially equivalent to a dividend (and thus taxable as ordinary income), the U.S. Supreme Court in Davis, 397 U.S. 301 (1970), focused on the fact that there was no meaningful reduction in the shareholder's interest. Because the redeemed shareholder held 100% of the stock both before and after the redemption, the Court denied the sole shareholder beneficial tax treatment. The Court also made clear that the business purpose of pro rata distributions is irrelevant in this determination.
The Court in Davis did not elaborate on what constitutes a meaningful reduction in a shareholder's interest. In Rev. Rul. 75-502, the IRS picked up where Davis left off and, by reference to Himmel, 338 F.2d 815 (2d Cir. 1964), defined a shareholder's interest to include: (1) the right to vote and thereby exercise control; (2) the right to participate in current earnings and accumulated surplus; and (3) the right to share in net assets on liquidation. A proper determination under Sec. 302(b)(1) thus requires an examination of the shareholder's interest in the corporation both before and after the redemption.
Most, if not all, rulings and cases after Davis and Rev. Rul. 75-502 discuss the before-and-after stock percentages held by the redeemed shareholder in their analyses. However, in Letter Ruling 201918009 the IRS merely states that the shareholder's ownership was reduced, with no explicit reference to whether the reduction was meaningful. Instead, taxpayers are left to ponder the significance of a diverse list of facts surrounding the transaction itself, none of which have much to do with the shareholder's economic interest in the redeeming corporation.
First, the IRS makes two key points: The redemption was an isolated transaction, and no other shareholder is obligated to purchase any of the redeemed stock. These factors imply that the redemption was not made pursuant to an overall plan, and no other shareholders were redeemed simultaneously. If the opposite were true, then each shareholder's interest would have to be calculated before and after the redemptions occurred to determine if there was a meaningful reduction in interest. The letter ruling does not explain why a meaningful-reduction analysis is inapplicable in the case of an isolated transaction.
Second, the IRS noted the redeemed shareholder received fair market value for his stock and will not receive notes or other obligations from the redeeming corporation. By including these factors in its analysis, the IRS indicated that the type of consideration received by the redeemed shareholder is important in determining whether a redemption is essentially equivalent to a dividend. In Rev. Proc. 2019-3, the IRS stated that it will no longer issue rulings concerning whether Sec. 302(b) applies when the consideration received by a redeemed shareholder consists of the redeeming corporation's promise to pay that is based either on future earnings or notes payable secured by the shareholder's stock.
Finally, the IRS noted that the redeemed stock is not Sec. 306 stock, there are no declared unpaid dividends, and the redemption will not result in a loss on the stock. The significance of these factors is even more ambiguous than the others, but one can surmise that they are an attempt to separate the "good apples" from the bad ones, so to speak, in searching for disguised-dividend distributions. If the stock were tainted under Sec. 306, the shareholder would have to treat the sale as a dividend received to the extent that it realized ordinary income. If there were declared but unpaid dividends, the transaction might scream of tax avoidance, even though Regs. Sec. 1.302-2 states that the Sec. 302(b)(1) determination is made without regard to the corporation's earnings and profits. If the redemption would result in a loss on the stock, it is a capital loss, so the IRS may consider recharacterizing the transaction as essentially equivalent to a dividend to reach its desired result: the less tax-favorable ordinary loss.
Considering the above, one of the effects of Letter Ruling 201918009, whether intended or not, is to shift the focus away from the Supreme Court's meaningful-reduction-in-interest standard and back toward Treasury's expansive facts-and-circumstances test. While a letter ruling has no precedential effect, it remains to be seen whether the shift this one seems to exemplify will continue and whether the business purpose of a redemption transaction will become a more important consideration in future Sec. 302(b)(1) analyses. In the meantime, shareholders contemplating the tax effects of redeeming their stock should look beyond whether the transaction reduces their economic interest in the corporation and into the murky world of facts and circumstances.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or email@example.com.
All contributors are members of SingerLewak LLP.