The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 5, December 1999, Panel Publishers, New York, NY.


By Robert W. Wood

The corporate objectives of a stock buyback are often well-publicized. A redemption can get rid of troublesome shareholders, rachet up remaining shareholders' positions or any one of a number of business goals. Yet, the tax results to each redeeming shareholder is a topic that is often confused, or more dangerous still, simply assumed to be capital. On the surface, the redeeming shareholder would appear always to be eligible for capital gains treatment. An individual shareholder is simply selling capital assets for an amount in excess of their basis. Unfortunately, a redemption can be treated as a dividend. Section 301 provides the dreaded dividend rules, while Section 302, a mere digit away, provides the nirvana of capital treatment.

Routes to Capitalism

In determining whether a redemption qualifies as an exchange, we look solely to the effect of the redemption on the shareholder's proportionate interest in the corporation. A redemption is eligible for the coveted exchange treatment only if it results in a sufficient reduction in that proportionate interest. If not, the redemption is treated as a Section 301 distribution because it resembles a dividend.

Under Section 302(b)(1), a redemption is treated as an exchange if it is not essentially equivalent to a dividend, an enigmatic phrase. The U.S. Supreme Court has said that the redemption must result in a "meaningful reduction" of the shareholder's proportionate interest (see U.S. v. Davis, 370 U.S. 65 (1962)). A redemption by a public corporation is different, as it ordinarily involves miniscule reductions in the proportionate interests of the participating shareholders. The IRS long ago ruled that any reduction is meaningful, as long as the shareholder is neither an officer nor a director of the corporation, and is not in a position to exercise control over corporate affairs. (See Revenue Ruling 76-385, 1976-2 C.B. 92.)

Even in these cases, exchange treatment for the redemption will be available only if there is some reduction in proportionate interest. If there is no reduction at all, the redemption will be a dividend, no matter how small the shareholder's percentage interest is in the corporation. (See Revenue Ruling 81-289, 1981-2 C.B. 82).

Substantially Disproportionate Nirvana

A surer route to exchange treatment is compliance with the provisions of Section 302(b)(2) under which a redemption is "substantially disproportionate." Immediately after the redemption, the redeeming shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote, and the shareholder's percentage ownership of voting stock and common stock must be less than 80% of the shareholder's percentage ownership immediately before the redemption. (I.R.C. §302(B)(2).)

For a shareholder who has a significant stake in a corporation undertaking a self-tender offer, the ability to participate in the offer can actually be scuttled by the tax consequences that would result. Self tender offers are usually greeted enthusiastically by shareholders. Consequently, the corporation may end up buying nearly a pro-rata amount of stock from each subscribing shareholder. If that happens, the shareholder in question would not have the necessary degree of reduction in his proportionate interest.

As one recent example, take the Oshkosh B' Gosh tender offer. The members of the Wyman and Hyde families evidently do not intend to tender any shares. Why? As a result of the substantial percentage of Class B shares owned by the members of these families, their sales would probably be taxed as dividends. That means all ordinary income, plus no credit for their basis in their shares, surely a very bad result. In fact, depending on one's basis in his shares, it is hard to say whether the rate differential or the deprivation of basis is a bigger body blow.

Still, in many of these cases, large shareholders can participate in the redemption and secure capital gain treatment. Achieving this result requires jumping through a few hoops, nimble footing that is a good deal more taxing (pun intended) than merely tendering shares in the redemption.

Capital Gain Strategies

A couple of possibilities are worth considering for the large shareholder. One is the Zenz doctrine. Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), was the seminal case in which a bootstrap acquisition, a simultaneous sale of stock and redemption, was approved with capital gain treatment to the seller on the shares sold as well as those redeemed. Capital gain treatment can be achieved through combining a redemption of part of one's stock and a sale of additional stock to third persons. In determining whether the redemption is substantially disproportionate, the effect on the shareholder's proportionate interest of the shares sold is taken into account as long as the redemption and sales are parts of a single transaction. That will almost be certainly be the case where the events occur close to contemporaneously, especially where the shareholder make a convincing record of the fact that he is availing himself of the Zenz doctrine.

Not creative enough? A bolder strategy was developed — but apparently never implemented — by Leslie Wexner, the CEO and principal shareholder of The Limited. A few years back, the company effected a substantial redemption and Wexner was unable to participate. Wexner had exactly the type of problem discussed above — the less consequential shareholders were entitled to capital gain treatment, but Wexner would have been walloped with a dividend.

Wexner's strategy to eliminate this dilemma was quite clever. He executed an agreement with the company that amounted to a collar. He sold the company a call option and, simultaneously, purchased a put option (granted by the company) on a large amount of his personal holdings. The put and call could be exercised only after several years had elapsed.

The idea was that the exercise of the put and call would give rise to a sufficient reduction in his proportionate interest to enable him to enjoy capital gains nirvana on the sale. The key would depend on whether his percentage ownership of the common stock after the exercise would be compared with the ownership immediately before the exercise, or before the buyback that precipitated the collar.

As you might suspect, which of these comparisons was appropriate depended on whether the redemptions were considered parts of a plan that contemplated a series of redemptions that in the aggregate were not substantially disproportionate with respect to Wexner. (Sounds like the step transaction doctrine again.) Although it was a clever idea, it was never implemented.

Final Thoughts

Although the Limited's Leslie Wexner may not have followed through with it, his collar arrangement probably had stood a good chance of success. Of course, the Service may have disagreed, given its search for the presence of nefarious plans. (See Revenue Ruling 85-14, 1985-1 C.B. 92, suggesting that a plan need be nothing more than a "design" by a single shareholder to arrange a redemption as part of a sequence of events.)

Fortunately, for those cases that do eventually go to court, the courts generally require that redemptions sought to be aggregated by the IRS must have been undertaken pursuant to a binding agreement. The exercise of the options that formed the basis of Wexner's arrangement was not certain to occur — not contractually anyway. But who wants to have to go to court?

Redemptions: Gaining a Capital Gain, Vol. 8, No. 5, M&A Tax Report (December 1999), p. 1.