United States v. Davis
1970 U.S. LEXIS 60, 397 U.S. 301, 25 L. Ed. 2d 323 (1970)
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Rule of Law:
To determine if a stock redemption is "not essentially equivalent to a dividend" under § 302(b)(1) of the Internal Revenue Code, the sole test is whether the redemption results in a meaningful reduction of the shareholder's proportionate interest in the corporation. The business purpose for the redemption is irrelevant, and the constructive ownership rules of § 318 apply in making this determination.
Facts:
- In 1945, Maclin P. Davis and E.B. Bradley organized a corporation.
- Davis and his wife each received 250 shares of common stock, while Bradley received 500 shares.
- To provide the company with working capital to qualify for a government loan, Davis purchased 1,000 shares of preferred stock for $25,000.
- It was understood that the corporation would redeem the preferred stock once the loan from the Reconstruction Finance Corporation (RFC) was repaid.
- Davis later acquired Bradley's 500 common shares and transferred them to his son and daughter.
- At the time of the redemption, Davis owned 250 common shares, his wife owned 250, and their children owned 500, making them the sole owners of the common stock.
- In 1963, after the loan was repaid, the corporation redeemed Davis's 1,000 shares of preferred stock for $25,000, as originally agreed.
Procedural Posture:
- Taxpayer Maclin P. Davis reported the $25,000 redemption as a capital transaction resulting in no tax.
- The Commissioner of Internal Revenue assessed a deficiency, treating the payment as a dividend taxable as ordinary income.
- Davis paid the deficiency and filed suit for a refund in the U.S. District Court for the Middle District of Tennessee (a federal trial court).
- The District Court ruled in favor of Davis, ordering a refund.
- The United States appealed to the U.S. Court of Appeals for the Sixth Circuit.
- The Court of Appeals affirmed the trial court's decision in favor of Davis.
- The United States petitioned the U.S. Supreme Court for a writ of certiorari, which was granted.
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Issue:
Does a stock redemption by a closely held corporation qualify as "not essentially equivalent to a dividend" under § 302(b)(1) if it is supported by a legitimate business purpose, even if the shareholder's proportionate interest in the corporation remains unchanged after applying attribution rules?
Opinions:
Majority - Mr. Justice Marshall
No. A stock redemption does not qualify as "not essentially equivalent to a dividend" under § 302(b)(1) based on a business purpose if the shareholder's proportionate interest remains unchanged. The court held that the stock ownership attribution rules of § 318(a) apply to § 302(b)(1), meaning Davis was the constructive owner of 100% of the corporation's common stock both before and after the redemption. The legislative history of the 1954 Code indicates that Congress sought to replace subjective inquiries into motive with objective tests. The proper test under § 302(b)(1) is whether the redemption resulted in a "meaningful reduction of the shareholder's proportionate interest in the corporation." A redemption from a sole shareholder, actual or constructive, can never result in such a reduction and is always equivalent to a dividend. Therefore, the business purpose for the redemption is irrelevant.
Dissenting - Mr. Justice Douglas
Yes. The redemption should qualify as not essentially equivalent to a dividend because it was motivated by a bona fide business purpose and was not a scheme to avoid taxes. The lower courts correctly found that the entire transaction, from the initial purchase of preferred stock to its redemption, was a legitimate corporate financing arrangement necessary to secure an RFC loan. The majority's holding allows mechanical attribution rules to transform a legitimate corporate transaction into a tax avoidance scheme. By ruling that a redemption by a sole shareholder is "always" a dividend, the Court effectively cancels § 302(b)(1) from the Internal Revenue Code for closely held corporations, a revision that should be left to Congress.
Analysis:
This decision resolved a significant circuit split by firmly rejecting the 'business purpose' test for determining dividend equivalency under IRC § 302(b)(1). It established the 'meaningful reduction of proportionate interest' as the sole standard, creating a more objective but stricter rule. The case significantly impacts tax planning for closely held corporations, making it much more difficult for shareholders in such entities to extract corporate earnings at favorable capital gains rates through redemptions, especially when family attribution rules consolidate ownership.
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