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Fehrs Finance Co. v. Commissioner of Internal Revenue

filed: November 6, 1973.


Heaney, Stephenson and Webster, Circuit Judges.

Author: Stephenson

STEPHENSON, Circuit Judge.

The focal point of this controversy concerns the basis attributable to certain stock in the hands of the acquiring corporation in connection with a redemption of stock through the use of related corporations pursuant to 26 USC §§ 304(a) and 362(a) (2).

Our task is to review the decision of the United States Tax Court*fn1 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.*fn2 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. § 304(a).

According to § 304*fn3 the acquiring corporation (Finance) must treat the stock acquired as a contribution to its capital.

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.*fn4

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.*fn5 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 USC § 302(b) (1) and (3)*fn6 and will be discussed separately.


Dividend Equivalency

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, 25 L. Ed. 2d 323, 90 S. Ct. 1041 (1970). It is settled that the attribution rules of section 318(a)*fn7 apply to the stock ownership interest when 302(b) (1) dividend equivalency is in question. Davis, supra at 305-307.

Determination as to whether or not the redemption had a "business purpose" is no longer a relevant inquiry regarding dividend equivalency under 302(b) (1). Davis, supra at 312; Johnson v. United States, 434 F.2d 340, 343 (CA8 1970); Wright v. United States, 482 F.2d 600, 608-609 (CA8 1973).

The Tax Court recognized the above guidelines and concluded:

Thus, insofar as it is relevant in determining the question of dividend equivalence in this case, we conclude that the attribution rules require that Mr. Fehrs must be treated as continuing in actual control of Rental after the transaction here in issue. (citation omitted) We hold that the redemption cannot be treated as an exchange under section 302(b) (1). 58 T.C. at 188.

We agree. The judgment as to whether a redemption is "not essentially equivalent to a dividend" turns on the facts of each case. Wright, supra at 606. Viewing this case in the setting which the attribution rules dictate, the only stock which is not constructively owned by the Fehrs is the fifteen shares given by Mr. Fehrs to his son-in-law. See 58 T.C. at 176. Even after the resale of the Rental stock back to Rental, and the subsequent cancellation of that stock diminishing the Fehrs ownership interest from 98.2 to 88.69 percent, the proportionate interest of these stockholders in this corporation was not meaningfully reduced. Davis, supra at 313. It is not necessary for us to determine whether the Fehrs post-redemption ownership must be measured before or after cancellation of the stock. We agree with the Tax Court that even if we "assume for the sake of argument that the redemption reduced the Fehrs' ownership interest from 98.2 percent to 88.69 percent" the mandates of Davis would not be fulfilled. We are not convinced that the Tax Court findings are against the clear weight of evidence or induced by an erroneous view of the law. Commissioner of Int. Rev. v. Ironsport Mfg. and Equip. Co., 478 F.2d 731, 734 (CA8 1973); Riss v. Commissioner of Int. Rev., 478 F.2d 1160, 1164 (CA8 1973).

Complete Redemption

Finance strongly urges that this redemption qualifies as an exchange since there was a "complete redemption of all of the stock of the corporation owned by the shareholder." 26 USC § 302(b) (3). If Finance is to be successful on this point it must show that the provisions of 302(c) (2) (A)*fn8 have been fulfilled. That section frees a taxpayer from the application of the attribution rules to its redemption provided the three tests are fulfilled.

There is no question that the Fehrs themselves no longer own any Rental stock. Nevertheless, they constructively own those shares owned by their daughters and grandchildren.

Finance asserts that the Fehrs are protected from that constructive ownership in this instance because they have fully complied ...

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