340 Planning and Forecasting
were not a subchapter S corporation at the time) and would be fully taxable to
him. But Morris had another idea. He would embark on a strategy of turning in
small amounts of his stock on a regular basis in exchange for the stock’s value.
Although not a perfect solution, the distributions to him would no longer be
dividends but payments in redemption of stock. Thus, they would be taxable
only to the extent they exceeded his basis in the stock and, even then, only at
long-term capital gain rates (not as ordinary income). Best of all, if such re-
demptions were small enough, he would retain his control over the company for
as long as he retained over 50% of its outstanding stock.
However, the benefits of this type of plan have attracted the attention of
Congress and the IRS over the years. If an individual can draw monies out of a
corporation, without affecting the control he asserts through the ownership of
his stock, is he really redeeming his stock or simply engaging in a disguised div-
idend? Congress has answered this question with a series of Code sections pur-
porting to define a redemption.
Substantially Disproportionate Distributions
Most relevant to Morris is Section 302(b)(2), which provides that a distribution
in respect of stock is a redemption (and thus taxable as a capital gain after sub-
traction of basis), only if it is substantially disproportionate. This is further de-
fined by requiring that the stockholder hold, after the distribution, less than
half of the total combined voting power of all classes of stock and less than
80% of the percentage of the company’s total stock that he owned prior to the
distr ibution.
Thus, if Morris intended to redeem 5 shares of the company’s stock at a
time when he owned 85 of the company’s outstanding 100 shares, he would be
required to report the entire distribution as a dividend. His percentage of
ownership would still be 50% or more (80 of 95, or 84%), which in itself dooms
the transaction. In addition, his percentage of ownership will still be 80% or
more than his percentage before the distribution (dropping only from 85% to
84%—99% of his percentage prior to the distribution).
To qualify, Morris would have to redeem 71 shares, since only that
amount would drop his control percentage below 50% (14 of 29, or 48%). And
since his percentage of control would have dropped from 85% to 48%, he
would retain only 56% of the percentage he previously had (less than 80%).
Yet, even such a draconian sell-off as thus described would not be suffi-
cient for the Code. Congress has taken the position that the stock ownership of
persons other than oneself must be taken into account in determining one’s
control of a corporation. Under these so-called attribution rules, a stockholder
is deemed to control stock owned not only by himself but also by his spouse,
children, grandchildren, and parents. Furthermore, stock owned by partner-
ships, estates, trusts, and corporations affiliated with the stockholder may also
be attributed to him. Thus, assuming that Lisa and Victor owned 10 of the re-
maining 15 shares of stock (with Brad owning the rest), Morris begins with