Rev. Rul. 56-584

Advice has been requested as to the tax consequences of a redemption by a closely held corporation of part of its capital stock, under the circumstances described below.

The corporation was engaged in the business of manufacturing and selling certain products. Its capitalization consisted only of common stock. The stockholders of the corporation were eight in number, the first six being brothers and the last two being sons of two of the brothers.

One son acquired a seven percent stock interest in the corporation five years ago by gift from his father. The father, the president and major shareholder of the corporation, made the gift to encourage his son's interest in the business. The son was 28 years of age at the time of the gift and had been employed in various capacities by the corporation for five years. By the time of the gift, he had gained sufficient experience to act as assistant buyer for one of its products. He carried increasing responsibilities as a buyer and became the supervisor of that line until three years ago when the corporation completely discontinued the business of this product. Thereafter, the corporation's activities were limited to acting as a jobber, the son being confined to the selling, advertising, and promotion activities of the business. The reduced scale of activity of the corporation did not furnish sufficient opportunity for him. Therefore a year ago, he left the employ of the corporation and has since been engaged in another business unrelated to that of the corporation. Accordingly, the son requested the corporation to purchase his stock and in the current year the corporation redeemed such stock.

The question presented is whether the redemption was substantially equivalent to a dividend to the son.

For the purposes of section 302 of the Internal Revenue Code of 1954, relative to distributions in redemption of stock, the provisions of section 318(a) are applicable in determining the ownership of stock. Under section 318(a)(1) the son is considered as owning all of the stock owned by his father. In view of this constructive ownership of the stock of the corporation, the question arises whether the distribution to the son might be treated as being in exchange for his stock under section 302(b)(3) and (c)(2) of the Code.

Section 302(c)(2) of the Code states that under certain conditions (section 302(c)(2)(A)(i), (ii) and (iii)) the son will not be considered to own his father's stock so that the redemption may qualify as a termination of his interest as provided in section 302(b)(3) of the Code. However, in view of the fact that the son acquired his stock less than ten years ago from his father, the provisions of section 302(c)(2) are not applicable unless the acquisition by the son of stock from his father did not have as one of its principal purposes the avoidance of Federal income tax. See section 302(c)(2)(B) of the Code.

In the instant case, because the gift of stock from father to son was made for bona fide business reasons and there was at the time of the gift no plan to effect a redemption of the stock, the avoidance of income tax was not a principal purpose of the gift.

Accordingly, it is held that (1) the acquisition of the stock by the son from his father in 1950 did not have as one of its principal purposes the avoidance of Federal income tax; (2) provided that the son filed the agreement described in section 302(c)(2)(A)(iii) of the Code, then, to the extent that the consideration received by the son on the redemption of all of his shares of stock of the corporation was no greater than the fair market value of the shares so redeemed, such redemption is treated as a distribution in full payment in exchange for the stock under section 302(a) and (b)(3) of the Code, but subject to the condition stated in section 302(c)(2)(A)(ii) of the Code; and (3) gain or loss is realized by the son in the amount of the difference between the basis of the stock redeemed and the consideration received therefor, to the extent that the consideration received is not greater than the fair market value of the stock at the date of redemption. Such gain or loss constitutes capital gain or loss subject to the provisions and limitations of subchapter P of chapter 1 of the Code.