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An individualized determination of whether a taxpayer has retained a financial stake or continued to control the corporation after the redemption is inconsistent with Congress' desire to bring a measure of certainty to the tax consequences of a corporate redemption. A taxpayer who provides post-redemption services, either as an employee or an independent contractor, holds a prohibited interest in the corporation because he is not a creditor.
Taxpayers, William and Mima Lynch, formed the W.M. Lynch Co. on April 1, 1960. The corporation issued all of its outstanding stock to William Lynch (taxpayer), then to the corporation which in turn subleased the equipment to independent contractors. On December 17, 1975, the taxpayer sold 50 shares of the corporation's stock to his son, Gilbert Lynch (Gilbert), for $17,170. Gilbert paid for the stock with a $16,000 check given to him by the taxpayer and $1,170 from his own savings. The taxpayer and his wife also resigned as directors and officers of the corporation on the same day. On December 31, 1975 the corporation redeemed all 2,300 shares of the taxpayer's stock. In exchange for his stock, the taxpayer received $17,900 of property and a promissory note for $771,920. Gilbert, as the sole remaining shareholder, pledged his 50 shares as a guarantee for the note. In the event that the corporation defaulted on any of the note payments, the taxpayer would have the right to vote or sell Gilbert's 50 shares. In the years immediately preceding the redemption, Gilbert had assumed greater managerial responsibility in the corporation. He wished, however, to retain the taxpayer's technical expertise with cast-in-place concrete pipe machines. On the date of the redemption, the taxpayer also entered into a consulting agreement with the corporation. The consulting agreement provided the taxpayer with payments of $500 per month for five years, plus reimbursement for business related travel, entertainment, and automobile expenses. In February 1977, the corporation and the taxpayer mutually agreed to reduce the monthly payments to $250. The corporation never withheld payroll taxes from payments made to the taxpayer. After the redemption, the taxpayer shared his former office with Gilbert. The taxpayer came to the office daily for approximately one year; thereafter, his appearances dwindled to about once or twice per week. When the corporation moved to a new building in 1979, the taxpayer received a private office. In addition to the consulting agreement, the taxpayer had other ties to the corporation. He remained covered by the corporation's group medical insurance policy until 1980. When his coverage ended, the taxpayer had received the benefit of $4,487.54 in premiums paid by the corporation. He was also covered by a medical reimbursement plan, created the day of the redemption, which provided a maximum annual payment of $1,000 per member. Payments to the taxpayer under the plan totaled $96.05.
Did the taxpayer hold a prohibited interest in the corporation after the redemption and therefore the transaction should be characterized as a dividend distribution taxable as ordinary income?
The appellate court reversed the decision of the tax court because taxpayer provided post-redemption services and, under 26 U.S.C.S. § 302(c)(2)(A), held a prohibited interest in the corporation because he was not a creditor. The appellate court found that the distribution was taxable as ordinary income.