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A dominant shareholder who voluntarily surrenders a portion of his shares to the corporation, but retains control, does not sustain an immediate loss deductible from taxable income. Rather, the surrendering shareholder must reallocate his basis in the surrendered shares to the shares he retains. The shareholder's loss, if any, will be recognized when he disposes of his remaining shares.
A husband and wife, who were the dominant shareholders of a closely held corporation, voluntarily surrendered some of their shares to the corporation in an effort to increase its attractiveness to outside investors. As a result, their combined percentage ownership was reduced from 72.5% to 68.5%. They received no consideration for their stock, and no other shareholder surrendered any stock. The effort to attract new investors was not successful, and the corporation was eventually liquidated. On their joint federal income tax returns, the husband and wife claimed as ordinary loss deductions the full amount of their adjusted basis in the surrendered shares. The Commissioner of Internal Revenue disallowed the deductions and concluded that (1) the stock surrendered was a contribution to capital and resulted in no immediate tax consequences, and (2) their basis in the surrendered shares should be added to the basis of their remaining shares of stock in the corporation. The Tax Court sustained the Commissioner's determination, but the United States Court of Appeals for the Sixth Circuit reversed, holding that the taxpayers were entitled to deduct their basis in the surrendered shares immediately as an ordinary loss, except to the extent that the surrender had increased the value of their remaining shares.
Were the taxpayers entitled to deduct their basis in the surrendered shares immediately as an ordinary loss?
On certiorari, the United States Supreme Court reversed, holding that a dominant shareholder who voluntarily surrendered a portion of his shares to the corporation but retained control did not sustain an ordinary loss immediately deductible from taxable income, but the surrender of shares closely resembled an investment or contribution to capital and, under the applicable rule governing contributions to capital, he must reallocate his basis in the surrendered shares to the shares he retains, and loss, if any, will be recognized when he disposes of his remaining shares, because the stock surrender in this case did not meet the requirement that an immediately deductible loss must be actually sustained during the taxable year, since the corporation was closely held and its shares therefore were not traded on the open market, so that there was no reliable method of determining whether the surrender would result in a loss until the shareholders disposed of their remaining shares. Moreover, the treating stock surrenders as ordinary losses might encourage shareholders in failing corporations to convert potential capital losses to ordinary losses by voluntarily surrendering their shares before the corporation fails. The Court further held that the shareholders may be encouraged to transfer corporate stock rather than other property to the corporation in order to realize a current loss.