Rev. Rul. 77-426

Advice has been requested whether a redemption of preferred stock under the circumstances described below qualifies as not essentially equivalent to a dividend under section 302(b)(1) of the Internal Revenue Code of 1954.

A corporation had voting common stock and nonvoting preferred stock outstanding. The preferred stock is not convertible into common stock. The preferred stock is limited and preferred as to dividends and in liquidation and has a stated redemption price. The preferred stock, which is not "section 306 stock," is all owned by one shareholder who owns no common stock of the corporation either directly or by application of the constructive ownership of stock rules of section 318 of the Code. The difference between the issue price of the preferred stock and the redemption price represented a reasonable redemption premium within the meaning of section 1.305-5(b) of the Income Tax Regulations. The corporation redeemed 5 percent of the preferred stock.

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock and if section 302(b)(1), (2), or (3) applies, such redemption is treated as a distribution in part or full payment in exchange for the stock. The redemption did not qualify as substantially disproportionate within the meaning of section 302(b)(2) because that provision only relates to redemptions of voting stock and common stock, nor did it qualify as a complete termination of interest within the meaning of section 302(b)(3) because not all of the shareholder's preferred stock was redeemed.

Section 302(b)(1) of the Code provides that section 302(a) shall apply if the redemption is not essentially equivalent to a dividend.

Section 1.302-2(a) of the regulations provides that the fact that a redemption fails to meet the requirements of section 302(b)(2) or (3) of the Code is not taken into account in determining whether the redemption is not essentially equivalent to a dividend under section 302(b)(1). To illustrate this provision, section 1.302-2(a) states that if a shareholder owns only nonvoting stock of a corporation that is not section 306 stock and that is limited and preferred as to dividends and in liquidation, and one-half of such stock is redeemed, the distribution will ordinarily meet the requirements of section 302(b)(1). However, if the shareholder in the above example were considered to own stock by reason of the application of the constructive ownership rules of section 318(a), the redemption might have been treated as a distribution under section 301. See section 1.302-2(b) and United States v. Davis, 397 U.S. 301 (1969), rehearing denied, 397 U.S. 1071 (1970), 1970-1 C.B. 62.

In explaining the reason for adding the "not essentially equivalent to a dividend" provision of section 302(b)(1) of the Code, the Senate Committee on Finance stated that the House provisions "appeared unnecessarily restrictive, particularly, in the case of redemptions of preferred stock which might be called by the corporation without the shareholder having any control over when the redemption may take place." S. Rep. No. 1622, 83d Cong., 2d Sess. 44 (1954).

In Davis, the Supreme Court of the United States stated that if the effect of a redemption is the same as the distribution of a dividend (a transfer of property by a corporation to its shareholders that does not cause a change in the relative economic interests or rights of the shareholders), the redemption does not satisfy the requirement of section 302(b)(1) of the Code. The Court concluded that in order for a redemption to qualify under section 302(b)(1) it must result in a "meaningful reduction of the shareholder's proportionate interest in the corporation."

Here, the preferred stock was nonvoting, nonconvertible, and limited and preferred as to dividends and in liquidation. The taxpayer did not own any of the common stock of the corporation. Under these circumstances, the rights represented by the redeemed shares were yielded to the common shareholders of the corporation and could not be recovered through the taxpayer's continued stock ownership. Thus, the redemption here is properly characterized as a sale rather than as a dividend. See S. Rep. No. 1622, 83d Cong., 2d Sess. 234 (1954), wherein the Senate Committee on Finance said that the section 302(b)(1) inquiry is to be devoted solely to the question of whether or not the transaction by its nature may properly be characterized as a sale of stock.

Accordingly, the redemption of any amount of stock that is nonvoting, nonconvertible, and limited and preferred as to dividends and in liquidation represents a meaningful reduction of the shareholder's proportionate interest in the corporation if the shareholder does not own stock of any other class, either directly or indirectly. Therefore, the redemption in this case qualifies as not essentially equivalent to a dividend under section 302(b)(1) of the Code.