When stock is redeemed (i.e., repurchased by the issuing corporation), the redemption can be taxed, with respect to the redeeming shareholder, as either a distribution to which Sec. 301 applies (a dividend) or as a “sale or exchange.”
Exchange treatment is proper in cases where the redemption is “properly characterized” as a sale. It is in cases where, after taking into account certain rules regarding “attribution” of stock, the redemption resembles a sale because it results in a sufficient reduction in the redeemed shareholder’s “proportionate interest” in the redeeming corporation. In instances where the redemption is treated as an exchange, the shareholder, in calculating the gain or loss from such exchange, offsets his or her basis in the redeemed stock against the redemption proceeds.
However, where the redemption is treated as a distribution, no such offset is permitted (the full proceeds are treated as a dividend) and the basis of the redeemed stock is transferred to, and allocated among, the shares of the redeeming corporation retained by the shareholder. See Rev. Rul. 66-37. More specifically, where the redemption is a dividend, Reg. Sec. 1.302-2(c) provides that “proper adjustment” of the basis of the remaining stock will be made with respect to the stock redeemed.
In Notice 2001-45, there was a redemption of stock from a person not subject to U.S. tax. The redemption was treated as a dividend as a result of the application of the aforementioned attribution rules—After applying such attribution rules, to gauge the shareholder’s ownership of stock after the redemption, such redemption did not result in a sufficient reduction in the redeeming shareholder’s proportionate interest in the corporation.
In this case, under Reg. Sec. 1.302-2(c), the basis of the redeemed stock was added to the basis of the stock in the redeeming corporation that was owned by the person whose relationship with the redeeming shareholder (via the attribution rules) caused the redemption to be classified as a dividend. This “basis shift” enabled such related person to claim a loss from the sale of the stock in the redeeming corporation and this loss, presumably, was used to offset unrelated capital gains enjoyed by the related person.
Support for this basis shift was, purportedly, found in Example 2 of Reg. Sec. 1.302-2(c). There, the basis of the stock redeemed from a spouse was transferred to the basis of the stock in the redeeming corporation held by her husband; the person whose ownership of stock caused the redemption to be classified as a dividend.
However, the Service noted, the example in the regulations (which supported the taxpayer’s basis shift) is premised on the conclusion that an adjustment is only appropriate where the redeemed shareholder is required to include the redemption proceeds in gross income subject to U.S. tax and such redeemed shareholder retains no stock to which the basis (of the redeemed shares) could, properly, attach.
Here, of course, the first condition was not satisfied and, accordingly, no basis adjustment was permitted. The Service admonished that it would disallows losses in cases where, as here, the taxpayer derives a benefit from what we now know is an unauthorized basis shift.
Accordingly, this particular “tax shelter” has been rendered ineffectual and, in the process, we are fully apprised regarding the proper scope of Reg. Sec. 1.302-2(c)—Where a redemption is a dividend, and the redeeming shareholder retains no stock in the corporation, the basis of the redeemed shares can be shifted to the person whose ownership of stock caused the redemption to be treated as a dividend in cases where, and only where, the redeemed shareholder includes the redemption proceeds in gross income subject, in full, to U.S. taxation.
Robert Willens is a Managing Director and Tax & Accounting Analyst at Lehman Brothers.