Himmel v. Commissioner

United States Court of Appeals for the Second Circuit · 1964 · Corporations

CorporationsTaxationStock redemptionDividend equivalenceIRC § 302(b)(1)redemption not essentially equivalent to a dividendpreferred stocknonvoting stock

Facts

H. A. Leed Co. had a multi-class capital structure consisting of common stock, Class A nonvoting cumulative preferred, and Class B voting cumulative preferred. Taxpayer had originally advanced money to the corporation, and in a 1948 recapitalization he received 266 shares of Class A preferred and 110 shares of Class B preferred in cancellation of the corporation's indebtedness to him; later he transferred his common stock to his two sons. In 1957 and 1958 the corporation redeemed 50 and then 70 shares of the taxpayer's Class A nonvoting preferred for $5,000 and $7,000, and no other shareholders received distributions. Earnings and profits exceeded the distributed amounts, but if the same sums had been paid as dividends on common stock the taxpayer, even with attribution, would have received materially less than he received in the redemption.

Issue

Were the 1957 and 1958 redemptions of the taxpayer's Class A nonvoting preferred stock by the corporation "essentially equivalent to a dividend" under IRC § 302(b)(1), so that the payments should be taxed as ordinary income rather than as exchanges?

Rule

A stock redemption is essentially equivalent to a dividend if, by its net effect, it resembles a dividend rather than a sale. The hallmarks of a dividend are a pro rata distribution of earnings and profits and no change in basic shareholder relationships; in a multi-class capital structure, courts must examine separately the effects on voting rights, rights to current and accumulated earnings, and rights on liquidation, rather than casually lumping different classes of stock together.

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Lakeview Tooling, Inc., a closely held Ohio corporation, has 100 shares of common owned equally by Nora Pike and Eli Moran. Nora alone also owns 200 shares of nonvoting cumulative preferred. In 2025, the corporation redeems 40 of Nora's preferred shares for $40,000; no one else receives anything. If the same $40,000 had instead been distributed on the common, Nora would have been treated as receiving only $20,000.

How should the redemption most likely be characterized under the majority's approach?

Explanation. The majority asks whether the redemption's net effect resembles a dividend. The hallmarks of a dividend are a pro rata distribution of earnings and profits and no change in basic shareholder relationships. In a multi-class structure, the court compares the redemption with a plausible dividend pattern and separately examines voting, earnings, and liquidation rights. Here, Nora received twice what she would have received in a common-stock dividend, so the distribution is not substantially pro rata. Unchanged voting power is of limited importance because the redeemed stock is nonvoting preferred.