Rev. Rul. 56-556

Advice has been requested as to the tax effect of a redemption of part of the stock of a corporation under the circumstances described below.

The holder of an automobile dealer franchise and his wife owned 255 shares of the stock of the corporation created to exercise this franchise. Their son owned all of the 80 remaining shares, having received them as a gift from the father in 1947. At the time of the gift, the father did not intend to retire from the business or have his son acquire the franchise.

Early in 1955 the franchise holder and his wife advised the manufacturer that they wished to retire from the business. Because the franchise was nonassignable, it was necessary to find a purchaser acceptable to the manufacturer. After refusing to approve several persons interested in the purchase of the franchise, the manufacturer indicated that it would be willing to approve a transfer to the franchise holder's son if suitable financial arrangements could be made. The son had been active in the business from 1945 and was sales manager for the past three years.

Under the plan agreed upon, the son purchased 50 shares of stock from his father at their fair market value, paying half the price on delivery of the stock and agreeing to pay the balance with five percent interest in installments over a period of ten years. In addition, the father and mother surrendered all their remaining stock in the corporation to it in exchange for cash, securities and improved real property, the sum of the cash and fair market value of the securities and property being equal to the fair market value of the stock surrendered. At the same time, they resigned as officers, directors and employees of the corporation. In accordance with the requirements of section 302(c)(2)(A) of the Code and section 1.302-4(a) of the Income Tax Regulations, they agreed in writing to notify the Internal Revenue Service if they should re-acquire any interest in the assets or business of the corporation, or if they should render any services to it within ten years of the date of the redemption.

In view of the facts presented, the Service holds as follows:

(1) Capital gain or loss is recognized to the father upon the sale of the 50 shares of the corporation to the son. Such gain or loss is subject to the provisions and limitations of Chapter 1, Subchapter P, of the Code.

(2) The disposition by the father of the shares of the corporation's stock by gift to the son in previous years did not have as one of its principal purposes the avoidance of Federal income tax and consequently the limitation of section 302(c)(2)(B) is not applicable.

(3a) If neither of the former majority shareholders re-acquires any interest in the assets or business of the corporation and if neither of them renders any services to the corporation for ten years from the date of the redemption, the redemption of the stock owned by them qualifies as a termination of their interests under section 302(b)(3), provided that each of them complies with the requirements in section 302(c)(2)(A) of the Code. Under section 302(a) of the Code, the redemption is treated as a distribution in full payment for the stock, and gain or loss is realized by the majority shareholders measured by the difference between the redemption price and the adjusted basis of the stock. Such gain or loss is a capital gain or loss subject to the provisions and limitations of Chapter 1, Subchapter P, of the 1954 Code.

(3b) If either of the former majority shareholders re-acquires an interest in the assets or business of the corporation, or renders services to it (with or without compensation) within ten years from the date of the redemption, then, because of section 302(d) of the Code, the redemption of his or her stock is treated as a distribution to which section 301 applies.