## Facts

- Puritan Laundry and Dry Cleaning Company was a closely held family corporation controlled by Henry Patterson, Sr.
- In 1969, Henry Sr. gave 40 shares each to three children (John, Hank, and Ellen) and retained 200 shares.
- After Henry Sr.’s illness and later death, Ellen’s husband, Bill Hicks, served as president/general manager amid family conflict and management instability.
- As part of Hicks’s return to management, Puritan granted him an option to purchase 80 newly issued shares; Hicks purchased 5 shares and left 75 shares unexercised.
- Henry Sr.’s 200 shares were held through the Henry T. Patterson Trust (trustee: Reeves Banking & Trust Company); Puritan later redeemed the Trust’s 200 shares for $190,000 in 1976.
- The Trust reported the redemption proceeds as capital gain (sale or exchange treatment).
- The IRS applied constructive ownership rules to attribute related-family shares to the Trust and concluded the redemption did not meaningfully reduce the Trust’s interest; it treated the payment as a dividend taxable as ordinary income.
- In measuring percentage ownership, the IRS excluded Hicks’s 75 unexercised option shares from the total outstanding shares and calculated a reduction from about 97% to about 93%.
- The district court included the 75 option shares in the outstanding-share total and found a larger proportional drop (about 80% to 62.8%), awarding the Trust a tax refund.
- The United States appealed.

## Issues

1. Whether the 1976 redemption of the Trust’s stock was “not essentially equivalent to a dividend” under I.R.C. § 302(b)(1) because it produced a meaningful reduction in the Trust’s proportionate interest after applying constructive ownership rules.
2. Whether unexercised stock option shares should be treated as outstanding shares when computing the shareholder’s percentage ownership for § 302(b)(1)’s meaningful-reduction analysis.

## Decision

- The Sixth Circuit reversed the district court.
- The court held that unexercised option shares are not outstanding stock for purposes of computing percentage ownership in a § 302(b)(1) analysis.
- Excluding the 75 option shares, the Trust’s constructive ownership decreased only from about 97% to about 93%, which was not a meaningful reduction.
- The redemption proceeds were essentially equivalent to a dividend and taxable as ordinary income; the Trust was not entitled to the requested refund.

## Legal Principles

- Under I.R.C. § 302(b)(1), a redemption receives sale-or-exchange (capital gain) treatment only if it results in a meaningful reduction in the shareholder’s proportionate interest, considering applicable constructive ownership rules.
- The meaningful-reduction inquiry focuses on actual changes in ownership/control rather than corporate purpose for the redemption.
- Unexercised options to acquire shares do not constitute outstanding stock and generally may not be used to inflate the share base to create an apparent reduction in ownership.
- A small reduction in a controlling shareholder’s constructive ownership percentage (here, roughly 97% to 93%) is insufficient to avoid dividend-equivalent treatment.

## Conclusion

The Sixth Circuit held that the Trust’s stock redemption was dividend-equivalent under § 302(b)(1) because, after applying constructive ownership and excluding unexercised option shares from outstanding stock, the Trust’s control was not meaningfully reduced, making the proceeds taxable as ordinary income rather than capital gain.


Henry T. Patterson Tr. v. United States, 729 F.2d 1089 (6th Cir. 1984)