Law School Case Brief
United States v. Davis - 397 U.S. 301, 90 S. Ct. 1041 (1970)
If a corporation distributes property as a simple dividend, the effect is to transfer the property from the company to its shareholders without a change in the relative economic interests or rights of the stockholders. Where a redemption has that same effect, it cannot be said to have satisfied the "not essentially equivalent to a dividend" requirement of 26 U.S.C.S. § 302 (b)(1). Rather, to qualify for preferred treatment under that section, a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.
Brown, a, taxpayer who owned common stock in a closely held corporation purchased $25,000 worth of preferred stock in the corporation in order to increase the corporation's working capital and thereby enable it to obtain a loan. It was understood that the preferred stock would be redeemed after the loan was repaid, and the preferred stock was later redeemed in accordance with this understanding. Brown reported the redemption as a capital gains transaction resulting in no tax, since his basis in the stock equaled the amount he received for it, but the Commissioner of Internal Revenue claimed that the redemption was essentially equivalent to a dividend and was thus, taxable as ordinary income. After paying the resulting deficiency, Brown sued for a refund in the United States District Court for the Middle District of Tennessee. The District Court ruled in favor of the taxpayer, the judgment of which was affirmed by the Court of Appeals for the Sixth Circuit. The United States sought further appellate review.
Did the court of appeals err in holding that redemption of stock qualified as a capital gain?
The order of the court of appeals was reversed and remanded to the district court for dismissal. The United States Supreme Court found that to qualify as a capital gain, the redemption must not be essentially equivalent to a dividend and must result in a meaningful reduction of the shareholder's proportionate interest in the corporation. The business purpose of a transaction was irrelevant in determining dividend equivalence.
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