Rev. Rul. 77-226

Advice has been requested whether a redemption of stock of a corporation should be treated as a distribution of a dividend under the circumstances described below.

X corporation has outstanding approximately 200,000x shares of voting common stock, which is widely held and publicly traded. On April 4, 1976, X offered to purchase shares of its common stock at the rate of $250 per share. On April 5, 1976, Y corporation, which owned no X common stock either actually or constructively under section 318 of the Internal Revenue Code of 1954 prior to the tender offer, purchased 4,000 shares of X stock on the market for a total price of $1,000,000, and immediately tendered 800 shares to X for redemption. On April 21, 1976, Y sold the remaining 3,200 shares of X stock on the market for $800,000.

On its Federal income tax return for its fiscal year ended September 30, 1976, Y reported the $200,000 redemption proceeds as a dividend, claimed the 85 percent dividends received deduction of section 243 of the Code and paid a tax of $14,400. Y claimed a $200,000 short-term capital loss on the sale of the 3,200 shares of X stock and applied this loss against short-term capital gains of $200,000 from other sources, realizing a tax saving of $96,000. The net effect of the entire transaction, as reported by Y, was a tax saving of $81,600.

Section 243(a) of the Code provides, in part, that a corporation may deduct 85 percent of the dividends it receives from a domestic corporation taxable under Chapter 1. For purposes of section 243(a), the term "dividend" means any distribution of property made by a corporation to its shareholders out of either current or accumulated earnings and profits. Section 316(a). A distribution will be treated as a distribution of property for this purpose to the extent the distribution is, under any provision of Subchapter C of Chapter 1, treated as a distribution of property to which section 301 applies. Section 316(a).

A redemption of stock of a corporation will be treated as a distribution of property to which section 301 of the Code applies (except as otherwise provided in Subchapter C of Chapter 1) if section 302(a) does not apply. Section 302(d). Section 302(a) provides that a redemption of stock will be treated as a distribution in part or full payment in exchange for the stock redeemed if section 302(b)(1), (2), (3) or (4) applies. Section 302(b)(3) provides that section 302(a) will apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.

In Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), the 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. The Government contended the redemption was a dividend because 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 court rejected the Government's contention and held that the redemption of the stock was not a dividend to the shareholder because the redemption, coupled with the earlier sale, extinguished the shareholder's interest in the corporation.

In Rev. Rul. 55-745, 1955-2 C.B. 223, the Internal Revenue Service agreed to follow Zenz in cases that present similar facts and circumstances. In Rev. Rul. 75-447, 1975-2 C.B. 113, the Service held that if the sale and the redemption are undertaken pursuant to an integrated plan, then the two steps will be treated as a unit for the purpose of making the computations under section 302(b)(2) of the Code, regardless of whether the redemption or sale occurs first.

Section 1.302-2(c) of the Income Tax Regulations provides that if the redemption of part of a shareholder's stock of a corporation is treated as a distribution of a dividend, the shareholder's basis in its remaining stock of the corporation will be increased by the basis of the stock redeemed.

In this case, the redemption and the sale were undertaken pursuant to an integrated plan. Therefore, even assuming the redemption distribution, standing by itself, would have been essentially equivalent to a dividend, the redemption and sale combined completely terminated Y's interest in X within the meaning of section 302(b)(3) of the Code. That the redemption occurred before the sale is irrelevant.

Accordingly, the redemption by X of the 800 shares of X stock held by Y should have been treated as an exchange under section 302(a) of the Code rather than as the distribution of a dividend. Y was not entitled to a deduction for dividends received. Y's basis in the 3,200 shares of X stock sold should not have been increased by the basis of the 800 shares of X stock redeemed. Y recognized no loss on the later sale of the remaining 3,200 shares of X stock because the amount realized ($800,000) was equal to the adjusted basis of the stock sold.