Rev. Rul. 75-447

Advice has been requested as to the Federal income tax consequences, in the situations described below, of the redemption by a corporation of part of its stock.

Situation 1

Corporation X had outstanding 100 shares of voting common stock of which A and B each owned 50 shares. In order to bring C into the business with an equal stock interest, and pursuant to an integrated plan, A and B caused X to issue, at fair market value, 25 new shares of voting common stock to C. Immediately thereafter, as part of the same plan, A and B caused X to redeem 25 shares of X voting common stock from each of them. Neither A, B, nor C owned any stock of X indirectly under section 318 of the Internal Revenue Code of 1954.

Situation 2

Corporation X had outstanding 100 shares of voting common stock of which A and B each owned 50 shares. In order to bring C into the business with an equal stock interest, and pursuant to an integrated plan, A and B each sold 15 shares of X voting common stock to C at fair market value and then caused X to redeem five shares from both A and B. Neither A, B, nor C owned any stock of X indirectly under section 318 of the Code.

Section 302(b)(2) of the Code states that section 302(a), which provides for treating a redemption of stock as a distribution in part or full payment in exchange for the stock, will apply if the distribution is substantially disproportionate with respect to the shareholder. Section 302(b)(2) provides, in part:

(2) SUBSTANTIALLY DISPROPORTIONATE REDEMPTION OF STOCK.-- (A) IN GENERAL.--Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder.

(B) LIMITATION.--This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.

(C) DEFINITIONS.--For purposes of this paragraph, the distribution is substantially disproportionate if--

(i) the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time, is less than 80 percent of--

(ii) the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time.

In Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), a sole shareholder of a corporation, desiring to dispose of her entire interest therein, sold part of her stock to a competitor and shortly thereafter sold the remainder of her stock to the corporation for an amount of cash and property approximately equal to its earned surplus. The Government contended that the redemption was a dividend on the grounds that the result was the same as if the steps had been reversed, that is, as if the stock had been redeemed first and the sale of stock to the competitor had followed. The United States Court of Appeals rejected the Government's contention and held that the purchase of the stock by the corporation (when coupled with the sale of stock to the competitor) was not a dividend to the selling shareholder and that the proceeds should be treated as payment for the stock surrendered under the provisions of the Internal Revenue Code of 1939.

Rev. Rul. 55-745, 1955-2 C.B. 223, states that in situations similar to that in Zenz, the amount received by the shareholder from the corporation will be treated as received in payment for the stock surrendered under section 302(a) of the Code since the transaction when viewed as a whole results in the shareholder terminating his interest in the corporation within the meaning of section 302(b)(3).

In determining whether the "substantially disproportionate" provisions of section 302(b)(2) of the Code have been satisfied in Situation 1 and in Situation 2, it is proper to rely upon the holding in Zenz that the sequence in which the events (that is, the redemption and sale) occur is irrelevant as long as both events are clearly part of an overall plan. Therefore, in situations where the redemption is accompanied by an issuance of new stock (as in Situation 1), or a sale of stock (as in Situation 2), and both steps (the sale, or issuance, of stock, as the case may be, and the redemption) are clearly part of an integrated plan to reduce a shareholder's interest, effect will be given only to the overall result for purposes of section 302(b)(2) and the sequence in which the events occur will be disregarded.

Since the Zenz holding requires that effect be given only to the overall result and proscribes the fragmenting of the whole transaction into its component parts, the computation of the voting stock of the corporation owned by the shareholder immediately before the redemption for purposes of section 302(b)(2)(C)(ii) of the Code should be made before any part of the transaction occurs. Likewise, the computation of the voting stock of the corporation owned by the shareholder immediately after the redemption for purposes of section 302(b)(2)(C)(i) should be made after the whole transaction is consummated. Making the immediately before and the immediately after computations in this manner properly reflects the extent to which the shareholder involved in each situation actually reduces his stock holdings as a result of the whole transaction.

Therefore, for purposes of the computations required by section 302(b)(2)(C) of the Code, A and B, in Situation 1, will each be viewed as having owned 50 percent (50/100 shares) of X before the transaction and 331/2 percent (25/75 shares) immediately thereafter. In Situation 2, A and B will each be viewed as having owned 50 percent (50/100 shares) of X before the transaction and 331/3 percent (30/90 shares) immediately thereafter. Furthermore, in each situation, the result would be the same if the redemption had preceded the issuance, or sale, of stock.

Accordingly, in both Situations 1 and 2, the requirements of section 302(b)(2) of the Code are satisfied. Therefore, the amounts distributed to A and B in both situations are distributions in full payment in exchange for the stock redeemed pursuant to section 302(a).