Cerone v. Commissioner
87 T.C. 1, 1986 U.S. Tax Ct. LEXIS 86, 87 T.C. No. 1 (1986)
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Rule of Law:
Family hostility does not negate the mandatory application of the family stock attribution rules under IRC § 318. For a stock redemption to qualify as a complete termination of interest under § 302(b)(3) and thereby waive family attribution, the redeeming shareholder must not retain any prohibited interest in the corporation, including that of an employee.
Facts:
- Michael N. Cerone ('Mike') and his son, Michael L. Cerone ('Mick'), each owned 50% of the stock in Stockade Cafe, Inc. and jointly managed the business.
- Over the years, the relationship between Mike and Mick deteriorated, marked by frequent and intense disagreements over business management and operations.
- The primary source of conflict was Mike's illegal gambling activities conducted on the business premises, which prompted two police raids.
- Following the raids, a representative from the Nebraska Liquor Control Commission warned Mick that his father's activities could cause the corporation to lose its essential liquor license.
- Faced with this threat and their inability to work together, Mick informed his father that one of them must buy out the other's interest in the corporation.
- After nearly a year of contentious negotiations, the corporation redeemed all of Mike's stock on January 16, 1975, for $125,000, leaving Mick as the sole actual shareholder.
- Following the redemption, Mike resigned as president and director but, at his son's request, returned approximately one month later to work as a paid employee, primarily operating the cash register.
- Mike continued to work for the corporation as a salaried employee for at least five years, though he held no managerial authority.
Procedural Posture:
- The Commissioner of Internal Revenue determined deficiencies in the federal income taxes of Michael and Helen Cerone, as well as Stockade Cafe, Inc., for several tax years.
- The Cerones and Stockade Cafe, Inc. (petitioners) filed separate petitions in the United States Tax Court to challenge the Commissioner's determinations.
- The Tax Court consolidated the cases for trial, briefing, and opinion.
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Issue:
Do payments from a corporation to a shareholder in redemption of all of his stock qualify for capital gains treatment under IRC § 302 when, due to family attribution rules, he is treated as the sole shareholder post-redemption and continues his relationship with the corporation as a paid employee, despite severe hostility between him and the remaining family shareholder?
Opinions:
Majority - Parker, Judge
No. The payments must be treated as dividends taxable as ordinary income because the redemption failed to qualify for exchange treatment under either § 302(b)(1) or § 302(b)(3). The family attribution rules of § 318 are mandatory and are not negated by family hostility. Under § 318, Mike is considered the constructive owner of the shares held by his son, Mick, making him a 100% shareholder both before and after the redemption. Since there was no reduction in his proportionate interest, the redemption is 'essentially equivalent to a dividend' under § 302(b)(1) as interpreted by United States v. Davis. Furthermore, the redemption does not qualify as a 'complete termination of interest' under § 302(b)(3) because Mike retained a prohibited interest in the corporation by continuing as a paid employee for several years after the redemption. This employment relationship constitutes a 'financial stake' that violates the requirements of § 302(c)(2)(A)(i) for waiving the family attribution rules.
Analysis:
This case solidifies the Tax Court's strict, non-discretionary application of the IRC § 318 family attribution rules, affirming that interpersonal relationships, however hostile, cannot override the statute's plain language. It reinforces the precedent set in United States v. Davis that a redemption from a sole shareholder (including a constructive one) is always equivalent to a dividend. The decision provides a clear warning for tax planning in family business buyouts: to qualify for capital gains treatment under the complete redemption safe harbor, the departing shareholder must make a clean break and cannot remain as an employee, even in a non-managerial capacity.
