Lynch v. C.I.R.
| Decision Date | 08 October 1986 |
| Docket Number | No. 85-7456,85-7456 |
| Citation | 801 F.2d 1176 |
| Parties | -5970, 55 USLW 2211, 86-2 USTC P 9731 William M. LYNCH and Mima W. Lynch, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant. |
| Court | U.S. Court of Appeals — Ninth Circuit |
Donald R. Share, Greene, Radovsky, Maloney, & Share, San Francisco, Cal., for petitioners-appellees.
Michael L. Paup, Bruce Ellisen, Jonathan S. Cohen, Attys., Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellant.
Petition to Review a Decision of the Tax Court of the United States.
Before FARRIS, HALL and KOZINSKI, Circuit Judges.
The Commissioner of the Internal Revenue Service (Commissioner) petitions for review of a Tax Court decision holding that a corporate redemption of a taxpayer's stock was a sale or exchange subject to capital gains treatment. The Commissioner argues that the taxpayer held a prohibited interest in the corporation after the redemption and therefore the transaction should be characterized as a dividend distribution taxable as ordinary income. We agree with the Commissioner and reverse the Tax Court.
Taxpayers, William and Mima Lynch, formed the W.M. Lynch Co. on April 1, 1960. The corporation issued all of its outstanding stock to William Lynch (taxpayer). The taxpayer specialized in leasing cast-in- place concrete pipe machines. 1 He owned the machines individually but leased them to the corporation which in turn subleased the equipment to independent contractors.
On December 17, 1975 the taxpayer sold 50 shares of the corporation's stock to his son, Gilbert Lynch (Gilbert), for $17,170. Gilbert paid for the stock with a $16,000 check given to him by the taxpayer and $1,170 from his own savings. The taxpayer and his wife also resigned as directors and officers of the corporation on the same day.
On December 31, 1975 the corporation redeemed all 2300 shares of the taxpayer's stock. In exchange for his stock, the taxpayer received $17,900 of property and a promissory note for $771,920. Gilbert, as the sole remaining shareholder, pledged his 50 shares as a guarantee for the note. In the event that the corporation defaulted on any of the note payments, the taxpayer would have the right to vote or sell Gilbert's 50 shares.
In the years immediately preceding the redemption, Gilbert had assumed greater managerial responsibility in the corporation. He wished, however, to retain the taxpayer's technical expertise with cast-in-place concrete pipe machines. On the date of the redemption, the taxpayer also entered into a consulting agreement with the corporation. The consulting agreement provided the taxpayer with payments of $500 per month for five years, plus reimbursement for business related travel, entertainment, and automobile expenses. 2 In February 1977, the corporation and the taxpayer mutually agreed to reduce the monthly payments to $250. The corporation never withheld payroll taxes from payments made to the taxpayer.
After the redemption, the taxpayer shared his former office with Gilbert. The taxpayer came to the office daily for approximately one year; thereafter his appearances dwindled to about once or twice per week. When the corporation moved to a new building in 1979, the taxpayer received a private office.
In addition to the consulting agreement, the taxpayer had other ties to the corporation. He remained covered by the corporation's group medical insurance policy until 1980. When his coverage ended, the taxpayer had received the benefit of $4,487.54 in premiums paid by the corporation. He was also covered by a medical reimbursement plan, created the day of the redemption, which provided a maximum annual payment of $1,000 per member. Payments to the taxpayer under the plan totaled $96.05.
We must decide whether the redemption of the taxpayer's stock in this case is taxable as a dividend distribution under 26 U.S.C. Sec. 301 or as long-term capital gain under 26 U.S.C. Sec. 302(a). 3 Section 302(a) provides that a corporate distribution of property in redemption of a shareholder's stock is treated as a sale or exchange of such stock if the redemption falls within one of four categories described in section 302(b). If the redemption falls outside of these categories, then it is treated as a dividend distribution under section 301 to the extent of the corporation's earnings and profits. 4
Section 302(b)(3) provides that a shareholder is entitled to sale or exchange treatment if the corporation redeems all of the shareholder's stock. In order to determine whether there is a complete redemption for purposes of section 302(b)(3), the family attribution rules of section 318(a) must be applied unless the requirements of section 302(c)(2) are satisfied. Here, if the family attribution rules apply, the taxpayer will be deemed to own constructively the 50 shares held by Gilbert (100% of the corporation's stock) and the transaction would not qualify as a complete redemption within the meaning of section 302(b)(3).
Section 302(c)(2)(A) states in relevant part:
In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if--
(i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor....
The Commissioner argues that in every case the performance of post-redemption services is a prohibited interest under section 302(c)(2)(A)(i), regardless of whether the taxpayer is an officer, director, employee, or independent contractor.
The Tax Court rejected the Commissioner's argument, finding that the services rendered by the taxpayer did not amount to a prohibited interest in the corporation. In reaching this conclusion, the Tax Court relied on a test derived from Lewis v. Commissioner, 47 T.C. 129, 136 (1966) (Simpson, J., concurring):
Immediately after the enactment of the 1954 Code, it was recognized that section 302(c)(2)(A)(i) did not prohibit office holding per se, but was concerned with a retained financial stake in the corporation, such as a profit-sharing plan, or in the creation of an ostensible sale that really changed nothing so far as corporate management was concerned. Thus, in determining whether a prohibited interest has been retained under section 302(c)(2)(A)(i), we must look to whether the former stockholder has either retained a financial stake in the corporation or continued to control the corporation and benefit by its operations. In particular, where the interest retained is not that of an officer, director, or employee, we must examine the facts and circumstances to determine whether a prohibited interest has been retained under section 302(c)(2)(A)(i).
Lynch v. Commissioner, 83 T.C. 597, 605 (1984) (citations omitted).
After citing the "control or financial stake" standard, the Tax Court engaged in a two-step analysis. First, the court concluded that the taxpayer was an independent contractor rather than an employee because the corporation had no right under the consulting agreement to control his actions. 5 Id. at 606. Second, the court undertook a "facts and circumstances" analysis to determine whether the taxpayer had a financial stake in the corporation or managerial control after the redemption. Because the consulting agreement was not linked to the future profitability of the corporation, the court found that the taxpayer had no financial stake. Id. at 606-07. The court also found no evidence that the taxpayer exerted control over the corporation. Id. at 607. Thus, the Tax Court determined that the taxpayer held no interest prohibited by section 302(c)(2)(A)(i).
We review the decisions of the Tax Court on the same basis as decisions in civil bench trials in district courts, Mayors v. Commissioner, 785 F.2d 757, 759 (9th Cir.1986), with no special deference paid to the Tax Court's conclusions of law. Vukasovich, Inc. v. Commissioner, 790 F.2d 1409, 1413 (9th Cir.1986). The Tax Court's interpretation of what constitutes a prohibited interest under section 302(c)(2)(A)(i) is a question of law reviewed de novo. Orvis v. Commissioner, 788 F.2d 1406, 1407 (9th Cir.1986); Ebben v. Commissioner, 783 F.2d 906, 909 (9th Cir.1986).
We reject the Tax Court's interpretation of section 302(c)(2)(A)(i). An individualized determination of whether a taxpayer has retained a financial stake or continued to control the corporation after the redemption is inconsistent with Congress' desire to bring a measure of certainty to the tax consequences of a corporate redemption. We hold that a taxpayer who provides post-redemption services, either as an employee or an independent contractor, holds a prohibited interest in the corporation because he is not a creditor.
The legislative history of section 302 states that Congress intended to provide "definite standards in order to provide certainty in specific instances." S.Rep. No. 1622, 83d Cong.2d Sess. 233, reprinted in 1954 U.S.Code Cong. & Ad.News 4017, 4621, 4870. "In lieu of a factual inquiry in every case, [section 302] is intended to prescribe specific conditions from which the taxpayer may ascertain whether a given redemption" will qualify as a sale or be treated as a dividend distribution. H.R.Rep. No. 1337, 83d Cong.2d Sess. 35, reprinted in 1954 U.S.Code Cong. & Ad.News 4017, 4210. The facts and circumstances approach created by the Tax Court undermines the ability of taxpayers to execute a redemption and know the tax consequences with certainty.
The taxpayer's claim that the Senate rejected the mechanical operation of the House's version of section 302 is misleading. The Senate did reject the House bill because the "definitive conditions" were "unnecessarily restrictive." S.Rep. No. 1622, 83d Cong., 2d Sess. 44, reprinted in 1954 U.S.Code...
To continue reading
Request your trial
-
Pacific First Federal Sav. Bank v. C.I.R.
...in general, no special deference should be given the tax court when reviewing a pure question of law. See also Lynch v. Commissioner, 801 F.2d 1176, 1178-79 (9th Cir.1986) (no deference to tax court's conclusions of law). This interpretation of our circuit's case law history was followed in......
-
Hurst v. Comm'r of Internal Revenue
...retention of control by Mr. Hurst. But in Lynch v. Commissioner, 83 T.C. 597, 1984 WL 15621 (1984), revd. on other grounds 801 F.2d 1176 (9th Cir.1986), we held that a security interest in redeemed stock does not constitute a prohibited interest under section 302. We noted that “The holding......
-
IRS discusses possible prohibited transactions of redeemed shareholder.
...amount of spousal fringe benefits might not be economically different, depending on the circumstances. In Lynch, 83 TC 597 (1984), rev'd, 801 F2d 1176 (9th Cir. 1986), a redeemed shareholder had a post-redemption consulting agreement with the redeeming corporation. That former shareholder w......