Our task is to review the decision of the United States Tax Court wherein, after an extensive examination of the facts and the several sub-issues, the court determined that the basis of the stock in question was zero since the transferors had recognized no gain on the transfer for the tax year in question.
We affirm the Tax Court in all respects and set out only those facts that become necessary to a determination and explanation of the issues.
The transaction which began this case is not complex. Mr. and Mrs. Fehrs owned all of the stock of Fehrs Rental Corporation (Rental). Mr. Fehrs gave a small portion of his stock to his wife, son-in-law, daughters and grandchildren. Approximately two months thereafter Fehrs Finance Company (Finance) was newly incorporated with two of the Fehrs' daughters as sole shareholders. Mr. and Mrs. Fehrs then transferred all of the remaining Rental stock to Finance in return for Finance's promise to pay to the Fehrs annuities totaling $70,000 per year for their lives. Finance immediately resold the Rental stock to Rental in exchange for $100,000 in cash and an unsecured promissory note in the sum of $625,000.
The Tax Court held that Finance realized a taxable gain of $100,000 in 1965 (the cash received in 1965) since its basis was zero. The parties stipulated that the basis of the stock in the hands of Mr. and Mrs. Fehrs was zero. Finance (taxpayer) contends that Mr. and Mrs. Fehrs realized a capital gain on the transfer which, in turn, increased the basis of the stock in the hands of taxpayer, Finance. The Tax Court disagreed. We agree with the Tax Court.
The parties do not quarrel with the Tax Court's characterization of the foregoing transaction as a redemption through the use of related corporations. 26 U.S.C. Sec. 304(a).
According to Sec. 304 the acquiring corporation (Finance) must treat the stock acquired as a contribution to its capital.
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When the stock in question has been treated as a contribution to capital, the basis of that stock in the hands of the transferee (Finance) is the same as it would be in the hands of the transferor (the Fehrs), increased by the amount of gain recognized to the transferor on the transfer.
It becomes necessary due to the interworkings of sections 304 and 362 of the Internal Revenue Code to determine whether or not the Fehrs realized any gain on the redemption. If they did not, the basis of the Rental stock in the hands of Finance would be zero; i. e., the substituted basis of Mr. and Mrs. Fehrs. If they realized a gain, the basis of the Rental stock to Finance would be increased by the amount of that gain. Hence, Finance's gain on resale would be less.
Only gain realized by the Fehrs on a sale or exchange (capital gain) will allow Finance to receive the "stepped-up" basis for which it argues. If the transaction gave rise to dividend or ordinary income to the Fehrs it would not affect Finance's basis.
Finance advances two theories, either of which it says will support the assertion that the transaction was an exchange giving rise to capital gain to the Fehrs, and therefore increasing Finance's basis in the stock. The two theories are found in 26 U.S.C. Sec. 302(b)(1) and (3) and will be discussed separately.
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The essence of 302(b)(1) is that a redemption will be treated as an exchange if it "is not essentially equivalent to a dividend." Paramount to the dividend equivalency test are several preliminary rules which we must consider.
To qualify for the preferred treatment of 302(b)(1) the redemption "must result in a meaningful reduction of the shareholder's proportionate interest in the corporation." United States v. Davis, 397 U.S. 301, 313, 90 S.Ct.
Jurisdiction: U.S. Court of Appeals, Eighth Circuit
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