Rev. Rul. 88-55

1988-2 C.B. 45, 1988-27 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

       STOCK REDEMPTION; TERMINATION OF SHAREHOLDER INTEREST FOLLOWED BY

      PURCHASE FROM THE FORMER SHAREHOLDER OF STOCK IN RELATED CORPORATION

                            Published: July 5, 1988

SECTION 302. - DISTRIBUTIONS IN REDEMPTION OF STOCK, 26 CFR 1.302-4: Termination of shareholder's interest

(Also Sections 304, 318; 1.304-2, 1.318-1.)

  Stock redemption; termination of shareholder interest followed by purchase from the former shareholder of stock in related corporation. A former shareholder of a redeeming corporation who had entered into an agreement under section 302(c)(2)(A)(iii) of the Code not to reacquire an interest in the redeeming corporation does not violate this (iii) agreement when the applicability of section 304(a)(1) to a subsequent sale of stock in a related corporation results in the subsequent transaction being treated as if the former shareholder received a distribution in redemption of stock in the redeeming corporation.

  An individual and the individual's child owned all the stock of two domestic corporations, X and Y. In 1985, X redeemed from the parent all of the parent's stock in X for cash. To invoke the complete termination of shareholder interest rule in sections 302(a) and (b)(3) and treat the cash as received in full payment in exchange for the stock, the parent filed a section 302(c)(2)(A)(iii) agreement with the Service and otherwise complied with section 302(c)(2)(A). In 1987, to complete the process of transferring control of the family business to the child, the parent sold all of his stock in Y to X for cash. The sales price was the fair market value of Y stock.

  Although the parent had complied with section 302(c)(2)(A) in connection with the 1985 transaction, that compliance did not affect the parent's actual or constructive stock ownership for purposes of section 304. Therefore, the parent, for purposes of the 1987 transaction, continued to own all of Y stock (directly and by virtue of section 318(a)(1)(A) family attribution) and all of the X stock (by virtue of family attribution). Because the parent was thus considered to control both corporations, section 304(a)(1) treated the parent's sale to X of the Y stock as a distribution by X to the parent in redemption of X stock for purposes of section 302.

  ISSUE. At issue is whether the parent's having been treated under section 304(a)(1) as receiving a distribution in redemption of the X stock means that a prohibited interest in the corporation was reacquired in violation of section 302(c)(2)(A)(ii).

  HOLDING. The Service has held that the parent does not violate the section 302(c)(2)(A)(iii) agreement when the applicability of section 304(a)(1) to the subsequent sale of stock in the related second corporation results in the subsequent transaction being treated as if the former shareholder received a distribution in redemption of stock in the redeeming corporation.

  ANALYSIS. The Service found that, prior to the 1987 transaction and for purposes of the 1985 transaction, the parent had complied with the requirements of section 302(c)(2). Since the parent complied, the Service said, section 318(c)(2) 'does not apply in the case of the 1985 transaction' and that the 1985 transaction is treated as a distribution in exchange for stock, provided that section 302(c)(2)(A)(ii) is not violated. Continuing, the Service noted that section 304(a)(1) treats the amount received by the parent from X for Y's stock as a distribution in redemption of X stock. Nevertheless, the Service said, the parent is not thereby treated as if he had owned stock in X immediately before the redemption for purposes of section 302(c).

  Citing Rev. Rul. 71-562, 1971-2 C.B. 173, the Service held that family attribution 'is waived in determinations not only of whether there was a termination of a shareholder's interest for purposes of section 302(b)(3), but also of whether there was a reacquisition in violation of section 302(c)(2)(A)(ii). Accordingly, since no prohibited reacquisition occurred, the parent is not required to notify the Service of the 1987 sale under the 1985 section 302(c)(2)(A)(iii) agreement.

                                     ISSUE

  If, in connection with a redemption, an agreement is filed in accordance with section 302(c)(2)(A)(iii) of the Internal Revenue Code ('(iii) agreement ') regarding the reacquisition of a prohibited interest in the redeeming corporation and if, in a subsequent transaction, the shareholder is treated under section 304(a)(1) as receiving a distribution in redemption of stock in that same corporation, does this treatment of the latter transaction mean that a prohibited interest in the corporation was reacquired in violation of section 302(c)(2)(A)(ii)?

                                     FACTS

  Prior to 1985, A and A's child, B, owned all the stock of both corporation X and corporation Y. In 1985, X redeemed from A all A's stock for cash. To invoke section 302(a) and (b)(3) of the Code and treat the cash as received in full payment in exchange for the X stock, A filed the (iii) agreement and otherwise complied with the requirements of section 302(c)(2)(A).

  In 1987, in order to complete the process of transferring control of the family business to B, A sold all A's Y stock to X for cash. The sales price was the fair market value of A's Y stock, and the terms of the sale were in all respects terms that would have been agreed to by parties dealing at arm's length. Both corporations are domestic corporations.

                                LAW AND ANALYSIS

  Section 302(a) of the Code provides that a redemption of stock is treated as a distribution in part of full payment in exchange for the stock, provided that paragraph (1), (2), (3), or (4) of section 302(b) applies.

  Section 302(b)(3) of the Code provides that section 302(a) applies if the distribution is in complete redemption of all the stock of the corporation owned by the shareholder. Section 302(c)(1) provides generally that the constructive stock ownership rules of section 318(a) apply in determining the ownership of stock for section 302 purposes.

  Under section 318(a)(1)(A) of the Code, an individual is considered as owning the stock owned by his or her children. However, section 302(c)(2)(A) provides that, in the case of a distribution described in section 302(b)(3), section 318(a)(1) does not apply if: (i) immediately after the distribution the redeemed shareholder has no interest in the corporation (including an interest as officer, director, or employee) other than as a creditor, (ii) the redeemed shareholder does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of the distribution, and (iii) the redeemed shareholder timely files an agreement to notify the Secretary of any acquisition described in (ii) and to retain certain records.

  Section 304(a)(1) of the Code deals with acquisitions of stock between related corporations (commonly controlled corporations other than those in a parent-subsidiary relationship). Section 304(a)(1) provides that, for purposes of section 302, if a person is in control of each of two corporations and in return for property one of the corporations acquires stock in the other corporation from that person, then the property is treated as a distribution in redemption of the stock of the corporation acquiring the stock.

  Section 304(c)(1) of the Code provides that control, for purposes of section 304, means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock. Section 304(c)(3) provides that, for purposes of determining control under section 304, section 318(a) applies, with modifications not relevant here.

  Although A complied with section 302(c)(2)(A) of the Code in connection with the 1985 transaction, that compliance does not affect A's actual or constructive stock ownership for purposes of section 304. Therefore, for those purposes in connection with the 1987 transaction, A continues to own all of the Y stock (directly and by virtue of family attribution under 318(a)(1)) and all of the X stock (by virtue of family attribution). Because A is thus considered to control both X and Y, section 304(a)(1) treats A's sale to X of the Y stock as a distribution by X to A in redemption of X stock for purposes of section 302.

  The question is thus presented whether this treatment of the 1987 transaction results in an acquisition by A of an interest in X contrary to the requirements in section 302(c)(2)(A)(ii) of the Code.

  Prior to the 1987 transaction, for purposes of the 1985 transaction, A had complied with the requirements of section 302(c)(2) of the Code. As a result of that compliance, section 318(a)(1) (family attribution) does not apply in the case of the 1985 transaction. The 1985 transaction is therefore treated as a distribution in exchange for stock, provided that section 302(c)(2)(A)(ii) (barring certain reacquisitions) is not violated. Although section 304(a)(1) treats the amount received by A from X for the Y stock as a distribution in redemption of X stock, A is not thereby treated as if A had owned stock in X immediately before the redemption for purposes of section 302(c). Under section 302(c)(2)(A), family attribution is waived in determinations not only of whether there was a termination of a shareholder's interest for purposes of section 302(b)(3), but also of whether there was a reacquisition in violation of section 302(c)(2)(A)(ii). See Rev. Rul.. 71-562, 1971-2 C.B. 173. In the present situation, but for application under section 304 of family attribution, the 1987 transaction would not have been treated as a redemption of X stock deemed to have been held by A. But family attribution does not apply for purposes of determining whether there has been a prohibited reacquisition in connection with the 1985 transaction. Thus, the 1987 transaction is not treated as a redemption of X stock that had been acquired in a prohibited reacquisition for purposes of determining whether there was a prohibited reacquisition that violated section 302(c)(2)(A)(ii).

                                    HOLDING

  The application of section 304(a)(1) of the Code to the 1987 sale of the Y stock to X does not result in the reacquisition of an interest in X by A for purposes of the requirement of section 302(c)(2)(A)(ii) applicable to the 1985 redemption. Accordingly, A is not required to notify the Secretary of the 1987 sale under the agreement filed pursuant to section 302(c)(2)(A)(iii) with respect to the 1985 redemption.

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Michael Danbury of the Corporation Tax Division. For further information regarding this revenue ruling contact Barry Isaacs on (202) 566-6407 (not a toll-free call).

Rev. Rul. 88-55, 1988-2 C.B. 45, 1988-27 I.R.B. 5.