Lynch v. Commissioner

United States Tax Court
83 T.C. 597; 1984 U.S. Tax Ct. LEXIS 21; 83 T.C. No. 32 (1984)

ELI5:

Rule of Law:

A complete redemption of a shareholder's stock will be treated as a sale qualifying for capital gains treatment, rather than a dividend, if the former shareholder's subsequent relationship with the corporation is as an independent contractor and a true creditor, without retaining a financial stake or continued control over the corporation.

Facts:

William M. Lynch was the founder and sole shareholder of W.M. Lynch Co. (the corporation), which was primarily in the business of leasing concrete pipe machines.
Lynch's son, Gilbert, worked for the corporation and wanted to expand its business into construction, a move Lynch opposed.
On December 17, 1975, Lynch sold 50 shares of the corporation's stock to Gilbert, making him a shareholder.
On December 31, 1975, the corporation redeemed Lynch's remaining 2,300 shares for cash and a $771,920 installment promissory note.
On the same day as the redemption, Lynch entered into a five-year written consulting agreement with the corporation for $500 per month.
Following the redemption, Lynch continued to be covered by the corporation's group medical policy, was covered by its medical reimbursement plan, and was provided with a company vehicle.
Gilbert assumed control of the corporation after the redemption.
In May 1976, Lynch agreed to subordinate his promissory note to a $350,000 bank loan so the corporation could purchase new equipment.

Procedural Posture:

William and Mima Lynch filed their 1975 joint federal income tax return, reporting the redemption proceeds as a long-term capital gain.
The Commissioner of the Internal Revenue Service audited the return and determined a deficiency, asserting the redemption proceeds should be taxed as a dividend at ordinary income rates.
The Lynches (petitioners) challenged the Commissioner's determination by filing a petition in the United States Tax Court.

Premium Content

Subscribe to Lexplug to view the complete brief

You're viewing a preview with Rule of Law, Facts, and Procedural Posture

Issue:

Does a former shareholder's post-redemption consulting agreement and creditor relationship constitute a prohibited interest under I.R.C. § 302(c)(2)(A), thereby treating the stock redemption as a dividend distribution instead of a capital gain?

Opinions:

Majority - Simpson, Judge

No, a former shareholder's post-redemption consulting agreement as an independent contractor and a standard creditor relationship do not constitute a prohibited interest under I.R.C. § 302(c)(2)(A). To waive family attribution rules and qualify for capital gains treatment after a complete redemption, a former shareholder must not retain an 'interest' in the corporation beyond that of a creditor. The court determined Lynch's role as a consultant was that of an independent contractor, not an employee, because the corporation did not control the means and manner of his work. Furthermore, his compensation was not contingent on the corporation's profitability, and the benefits he received were not substantial enough to constitute a continued financial stake. The court also found that Lynch's interest as a noteholder was a true creditor relationship, not a disguised equity interest, despite subordinating his note to a single bank loan, as the payments were fixed and not dependent on corporate earnings.

Analysis:

This case clarifies the 'prohibited interest' rule under I.R.C. § 302(c)(2), providing a crucial framework for shareholders of closely-held family businesses seeking to structure a complete redemption for capital gains treatment. The court's distinction between an employee and an independent contractor based on control is pivotal, signaling that providing post-redemption services is permissible if structured correctly. By examining the substance of the relationship rather than just the form, the decision allows for a practical transition of power and knowledge between generations without triggering punitive dividend tax treatment. This ruling serves as a guide for tax planning, emphasizing that a former shareholder can retain a creditor interest and provide consulting services without violating the statute, so long as they do not maintain a financial stake or control.

Gunnerbot

AI-powered case assistant

Loaded: Lynch v. Commissioner (1984)

Try: "What was the holding?" or "Explain the dissent"

Premium Feature