William M. Lynch and Mima W. Lynch v. Commissioner of Internal Revenue
1986 U.S. App. LEXIS 31851, 58 A.F.T.R.2d (RIA) 5970, 801 F.2d 1176 (1986)
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Rule of Law:
A taxpayer who provides post-redemption services to a corporation, whether as an employee or an independent contractor, retains a prohibited 'interest in the corporation' other than as a creditor under I.R.C. § 302(c)(2)(A)(i). Such an interest prevents the waiver of family attribution rules, and the redemption is therefore treated as a dividend distribution taxable as ordinary income.
Facts:
- William Lynch, the sole shareholder of W.M. Lynch Co., sold 50 shares of the corporation's stock to his son, Gilbert Lynch, on December 17, 1975.
- On the same day, William Lynch and his wife resigned as directors and officers of the corporation.
- On December 31, 1975, the corporation redeemed all of William Lynch's remaining 2300 shares in exchange for property and a promissory note.
- As part of the redemption, Gilbert Lynch pledged his 50 shares as a guarantee for the note, giving his father the right to vote or sell the shares upon default.
- Simultaneously with the redemption, William Lynch entered into a five-year consulting agreement with the corporation, agreeing to provide services for $500 per month.
- Following the redemption, William Lynch continued to come to the office daily for a year, shared an office with his son, and was later given a private office.
- William Lynch also remained covered by the corporation's group medical insurance policy and a medical reimbursement plan after the redemption.
Procedural Posture:
- The Commissioner of Internal Revenue determined a tax deficiency against William and Mima Lynch, characterizing their stock redemption proceeds as a dividend.
- The Lynches challenged the deficiency in the U.S. Tax Court.
- The Tax Court ruled in favor of the Lynches, holding that William Lynch's post-redemption consulting did not constitute a prohibited interest and the redemption qualified for capital gains treatment.
- The Commissioner (petitioner/appellant) appealed the Tax Court's decision to the U.S. Court of Appeals for the Ninth Circuit, with the Lynches as respondents/appellees.
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Issue:
Does a taxpayer who provides post-redemption consulting services to a corporation as an independent contractor retain a prohibited interest under I.R.C. § 302(c)(2)(A)(i), thereby preventing the waiver of family attribution rules and disqualifying the stock redemption from capital gains treatment?
Opinions:
Majority - Judge Cynthia Holcomb Hall
Yes, a taxpayer who provides post-redemption services as an independent contractor retains a prohibited interest under § 302(c)(2)(A)(i). The court rejected the Tax Court's flexible 'facts and circumstances' test, which analyzed whether a former shareholder retained a 'financial stake' or 'control' over the corporation. Instead, the court established a bright-line rule, holding that Congress intended to create certainty for taxpayers. Any provision of services, whether by an employee or an independent contractor, is a non-creditor interest that is prohibited by the statute. The parenthetical language in the statute listing 'officer, director, or employee' is a non-exclusive list of examples. Allowing a case-by-case inquiry into the level of control or financial stake would create the same uncertainty that the specific safe harbor rules of § 302 were designed to prevent. Therefore, because William Lynch provided consulting services, he retained a prohibited interest, the family attribution rules apply, the redemption was not 'complete,' and the proceeds must be taxed as a dividend.
Analysis:
This decision establishes a strict, bright-line rule in the Ninth Circuit for what constitutes a 'prohibited interest' under I.R.C. § 302(c)(2)(A)(i), rejecting the more flexible, fact-intensive analysis previously used by the Tax Court. It significantly narrows the ability of a shareholder in a family-owned corporation to continue any service relationship post-redemption if they want to ensure capital gains treatment. The ruling prioritizes certainty and predictability in tax planning by creating a clear, mechanical test, forcing taxpayers to make a complete and total severance of all non-creditor ties to the business to qualify for the statutory safe harbor.
