## Facts

- Michael N. Cerone and his son each owned 50% of Stockade Cafe, Inc., a closely held corporation.
- Because of a hostile father–son relationship, the corporation redeemed all of Michael N. Cerone’s shares, leaving the son as sole record shareholder.
- The corporation made payments over time and labeled portions as principal and interest.
- After the redemption, Michael N. Cerone continued to work for the corporation as an employee for several years but did not participate in management or control.
- The Commissioner determined that the redemption payments were dividend distributions (not exchange treatment) due to constructive ownership under the family attribution rules.
- The corporation sought to deduct the labeled “interest” portion under I.R.C. § 163; the parties agreed the deduction issue turned on the redemption’s characterization.

## Issues

1. Whether the stock redemption payments were treated as an exchange under I.R.C. § 302(a) or as dividends under §§ 302(d), 301, and 316, including whether the redemption satisfied § 302(b)(1) (not essentially equivalent to a dividend) or § 302(b)(3) (complete termination).
2. Whether family hostility between a parent and child prevents application of the family attribution rules of § 318(a)(1) when applying § 302(b)(1) and § 302(b)(3).
3. Whether post-redemption employment is a “prohibited interest” under § 302(c)(2)(A)(i) that bars the waiver of family attribution under § 302(c)(2) for a claimed complete termination under § 302(b)(3).
4. Whether the corporation could deduct amounts designated as interest under § 163 if the payments were treated as dividends.

## Decision

- The Tax Court upheld the Commissioner’s deficiency determinations.
- Family hostility did not prevent application of § 318(a)(1) family attribution.
- Applying § 318(a)(1)(A)(ii), Michael N. Cerone was treated as owning 100% of the corporation both before and after the redemption, so there was no meaningful reduction in ownership and the redemption was essentially equivalent to a dividend under § 302(b)(1).
- Because Cerone continued as an employee, he held a prohibited interest under § 302(c)(2)(A)(i) and could not use the § 302(c)(2) waiver to avoid attribution; therefore, the redemption was not a complete termination under § 302(b)(3).
- The redemption payments were taxable as dividends under §§ 301 and 316 rather than as exchange proceeds under § 302(a).
- The corporation was not entitled to deduct the labeled “interest” amounts under § 163 given the dividend characterization.

## Legal Principles

- Section 318(a)(1) family attribution rules apply as written; intra-family hostility does not create an exception.
- For § 302(b)(1), dividend equivalence turns on whether there is a meaningful reduction in the shareholder’s interest measured using actual and constructive ownership; absent such reduction, redemption payments are treated as dividends.
- For § 302(b)(3), the § 302(c)(2) waiver of family attribution is unavailable if the redeemed shareholder retains a prohibited interest, including continued employment, as defined in § 302(c)(2)(A)(i).
- When attribution causes the shareholder’s constructive ownership to remain unchanged after redemption, both § 302(b)(1) and § 302(b)(3) relief fail, and § 302(d) directs dividend treatment under §§ 301 and 316.
- A corporation cannot claim an interest deduction under § 163 for payments that are, in substance, dividend distributions rather than debt-service obligations.

## Conclusion

The Tax Court treated the corporation’s redemption payments to the father-shareholder as dividends because § 318 family attribution applied despite family hostility and the father’s continued employment barred any waiver of attribution, defeating both dividend-equivalency and complete-termination exchange treatment and eliminating the related corporate interest deduction.


Cerone v. Commissioner, 87 T.C. 1 (1986)