Substantially Disproportionate Redemptions

An individual can use a technique to sell stock within a corporate structure, retain absolute control of the corporation and still obtain preferential capital-gain treatment. The technique involves a majority shareholder selling a substantial amount of his stock to a controlled subsidiary. The shareholder must follow specific mathematical guidelines to receive preferential treatment.

Example: A owns a 70% interest in domestic corporation P, and shareholder B owns the remaining 30%. P is the 100% shareholder of corporation S. A sells a 35% interest in P to S. As a result, A reports the transaction as a capital gain, even though he retains control of P.

In the example, Secs. 304 and 302 would determine whether the stock redemption results in dividend or capital-gain treatment. There are four ways for a stock redemption to result in capital-gain treatment. In the example, the transaction qualifies as a "substantially disproportionate redemption."

Under Sec. 302(b)(2)(C), a substantially disproportionate redemption occurs if "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," and "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 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." (Emphasis added.) In the example, A must reduce his interest in P to under 56% for purposes of the 80% test, and he must reduce his interest to under 50% for the control test.

To apply these tests, a taxpayer uses Sec. 318 attribution rules. In the example, S attributes its 35% interest to P. P attributes the 35% interest to A and B, whose proportionate share of the attributed P stock is calculated as follows:

A: (35% attributed) x (35/100 ownership interest) = 12.25%

B: (35% attributed) x (30/100 ownership interest) = 10.50%

A's ownership for Sec. 302(b)(2) purposes is therefore 47.25%.

It is not intuitive to include the P shares that S owns when calculating the attribution of P to A and B. Two issues deserve consideration. First, is P's stock in S included in this calculation? The answer can be found in Regs. Sec. 1.302-3:

Section 318(a) shall apply both in making the disproportionate redemption test and in determining the percentage of stock ownership after the redemption. The requirements under section 302(b)(2) shall be applied to each shareholder separately and shall be applied only with respect to stock which is issued and outstanding in the hands of the shareholders. (Emphasis added.)

In the example, the stock is issued and outstanding in S's hands and therefore can be used for Sec. 318 calculation purposes.

Second, does the P stock that S owns flow through to P or does it "disappear" during the attribution process? By omission, Regs. Sec. 1.318-1(b)(1) answers this question. It states, "a corporation shall not be considered to own its own stock by reason of section 318(a)(3)(C)." This statement clearly identifies the flow of stock attribution from a shareholder to a corporation, but is silent on the flow of stock attribution from a corporation to a shareholder. This omission is substantial, because a few lines later, Regs. Sec. 1.318-1(b)(3) addresses both flows.

Conclusion

For Sec. 302(b)(2) purposes, A has a 47.25% interest in P after the transaction is completed. Therefore, A meets both the 80% and 50% tests and will receive capital-gain treatment while retaining absolute control of the corporate structure. For this technique to work mathematically, A must have approximately a 55.7% ownership in P and must be willing to sell a significant amount of P stock.

From Mark Flanigan, J.D., M.S., CPA, Ellin & Tucker, Chartered, Baltimore, MD (Not affiliated with Grant Thornton LLP)