Internal Revenue Service
Revenue Ruling
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smRev. Rul. 77-19
1977-1 C.B. 83
Section 305
IRS Headnote
Redemption; proportionate interest increased; merger. Isolated redemptions of stock over the previous 3 years from retiring employee-shareholders or estates of deceased shareholders and redemptions under a merger whereby numerous minority shareholders were eliminated and received only cash in the transactions are not deemed under section 305(c) of the Code to result in distributions to which sections 305(b)(2) and 301 apply.
Full Text
Rev. Rul. 77-19
Advice has been requested whether under the circumstances described below, past redemptions and a current redemption by a corporation constitute a periodic redemption plan the effect of which is to increase the proportionate interests of certain shareholders within the meaning of section 305(b)(2) and (c) of the Internal Revenue Code of 1954.
Corporation X is a publicly held corporation with 450,000 shares of common stock outstanding. Its stock has been traded over-the-counter, but no active market for X stock currently exists.
Although no formal plan or resolution has been adopted calling for X to redeem shares of its stock, X, over the previous 36 months, has redeemed 20,000 shares of its common stock in 20 separate transactions. The redeeming shareholders have consisted principally of retiring employees of X or the estates of deceased shareholders. Eighteen of these transactions were distributions in redemption of stock within the meaning of section 302(a) of the Code. The remaining two were distributions to which section 301 applied.
The management of X has now determined that it would be beneficial to eliminate shareholders who do not own a significant amount of X stock.
Accordingly, pursuant to a merger under section 368(a)(1)(A) of the Code, X corporation was merged with and into Y corporation, a corporation newly formed by X for the purpose of effecting the merger. In the merger, Y issued shares of its common stock and cash to the exchanging shareholders of X corporation. The exchange ratio called for the exchange of one share of Y's common stock for 200 shares of X's common stock. Shareholders with less than 200 shares of X common stock received 20x dollars in cash for each share of X stock surrendered. In the transaction, Y issued 2,000 shares of its common stock to former X shareholders; and, numerous shareholders of X who owned in the aggregate 50,000 shares of X common stock received only cash. As a result, corporation Y has 81 percent fewer shareholders than X. As provided in Rev. Rul. 74-515, 1974-2 C.B. 118, those X shareholders who received only cash in exchange for their X stock are treated as having their X stock redeemed under section 302.
Section 305(b)(2) of the Code provides that subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies if the distribution (or a series of distributions of which such distribution is one) has the result of the receipt of property by some shareholders and an increase in the proportionate interests of the other shareholders in the assets or earnings and profits of the corporation.
Section 305(c) of the Code provides, in part, that the Secretary of the Treasury or the Secretary's delegate shall prescribe the circumstances under which a redemption that is treated as a distribution to which section 301 applies, or any transaction, that has the effect of a distribution described in section 305(b), will be treated as a distribution under section 301 with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by the transaction.
Section 1.305-7(a) of the Income Tax Regulations provides, in part, that a transaction, including a redemption which is treated as a distribution to which section 301 of the Code applies, described in section 305(c) will be treated as a distribution to which sections 305(b) and 301 apply if (1) the proportionate interest of any shareholder in the earnings and profits or assets of the corporation deemed to have made such distribution is increased by such transaction, and (2) such distribution has the result described in section 305(b)(2), (3), (4), or (5).
Section 1.305-3(b)(3) of the regulations provides, in part, that a distribution of property incident to an isolated redemption of stock (for example, pursuant to a tender offer) will not cause section 305(b)(2) to apply even though the redemption distribution is treated as a distribution of property to which section 301, 871(a)(1)(A), 881(a)(1), or 356(a)(2) applies.
Section 1.305-3(b)(4) of the regulations provides, in part, that where the receipt of cash or property occurs more than 36 months following a distribution or series of distributions of stock, or where a distribution or series of distributions of stock is made more than 36 months following the receipt of cash or property, such distribution or distributions will be presumed not to result in the receipt of cash or property by some shareholders and an increase in the proportionate interest of other shareholders, unless the receipt of cash or property and the distribution or series of distributions of stock are made pursuant to a plan.
Example (10) of section 1.305-3(e) of the regulations involves a situation where corporation P has 1,000 shares of stock outstanding. T owns 700 shares of the P stock and G owns 300 shares of the P stock. In a single and isolated redemption to which section 301 of the Code applies, the corporation redeems 150 shares of T's stock. Since this is an isolated redemption and is not part of a periodic redemption plan, G is not treated as having received a deemed distribution under section 305(c) to which sections 305(b)(2) and 301 apply even though G has an increased proportionate interest in the assets and earnings and profits of the corporation.
Sections 305(c) and 305(b)(2) of the Code are intended to apply to corporate stock redemptions that are in pursuance of a plan to periodically redeem the interest of some of a corporations shareholders. See S. Rep. No. 522, 91st Cong., 1st Sess. (1969), 1969-3 C.B. 423, 521, which provides, in part, as follows:
A periodic redemption plan may exist, for example, where a corporation agrees to redeem a small percentage of each common shareholders stock annually at the election of the shareholder. The shareholders whose stock is redeemed receive cash, and the shareholders whose stock is not redeemed receive an automatic increase in their proportionate interests. However, the committee does not intend that this regulatory authority is to be used to bring isolated redemptions of stock under the disproportionate distribution rule (of sec. 305(b)(2)).
In the instant case, all of the redemptions that occurred in the past 36 months were principally from retiring employees of X or the estates of deceased shareholders. Also, the redemptions completely terminated the direct ownership of the redeemed shareholders. The circumstances surrounding the prior redemptions indicate there was no direct relation between the prior redemptions and the redemptions that were effected pursuant to the merger agreement. Furthermore, the magnitude of the latter is of such a nature that it should be considered as an isolated redemption. The redemptions were not distributions to which section 305(b)(2) of the Code applies by reason of application of section 1.305-3(b)(3) of the regulations even though the redemption had the effect of transactions described in that section since one group of shareholders increased their proportionate interest in the assets and earnings and profits of the corporation while other shareholders may have received cash in a transaction to which section 301 applied. See section 356.
This is consistent with the conclusion reached in example (10) of section 1.305-3(e) of the regulations where isolated redemptions do not cause section 305(b)(2) of the Code to apply even though there are increased proportionate interests in the assets and earnings and profits of the corporation by some shareholders and receipts of property by other shareholders.
Accordingly, in the instant case the redemptions are not deemed, under section 305(c) of the Code, to result in distributions to which sections 305(b)(2) and 301 apply.