## Facts

- Richard E. Hurst and Mary Ann Hurst owned an HVAC business operated through Hurst Mechanical, Inc. (HMI) and also owned R.H., Inc. (RHI); they personally owned the building used by the businesses.
- In 1997, as retirement planning, the Hursts sold their RHI stock to HMI.
- In the same year, HMI redeemed 90% of Richard’s HMI stock, and Richard sold his remaining 10% to his son and two other employees.
- The redemption and the stock sale were structured as 15-year installment obligations secured by the shares involved; the agreements were cross-collateralized and contained cross-default provisions.
- After the transactions, the Hursts continued leasing the building to HMI under a long-term lease, and Mary Ann continued as an HMI employee receiving salary and fringe benefits, including health insurance and a company car.
- The Hursts reported the stock transactions as long-term capital gains reported under the installment method.
- The IRS determined deficiencies, contending the redemption proceeds should be treated as dividends (not exchange treatment) because Richard allegedly retained an interest in HMI beyond that of a creditor.
- In post-trial briefing, the IRS also sought to analyze the RHI sale under § 304 (related-corporation stock sale rules).
- The IRS treated HMI’s payment of Mary Ann’s health insurance premiums as taxable income, asserting she was a “2-percent shareholder” under § 1372 through § 318 attribution.

## Issues

1. Whether the HMI stock redemption and related stock sale produced exchange treatment as a “complete termination” of Richard’s interest under I.R.C. § 302(b)(3), or dividend treatment under § 301 because he retained an interest other than as a creditor.
2. Whether the IRS could apply I.R.C. § 304 to the RHI stock sale when that theory was first raised in post-trial briefing.
3. Whether Mary Ann was a “2-percent shareholder” of HMI under I.R.C. § 1372 by § 318 attribution, requiring inclusion of employer-paid health insurance premiums in income (with any allowable § 162(l) deduction).

## Decision

- The court held the HMI redemption and related stock sale qualified as a complete termination under § 302(b)(3); the cross-default and cross-collateralization provisions did not create an interest beyond that of a creditor.
- The court rejected the IRS’s § 304 theory as an evidentiary unsupported “new matter” raised only in post-trial briefing.
- The court held Mary Ann was a “2-percent shareholder” under § 1372 via § 318 attribution; therefore, HMI-paid health insurance premiums were includable in her income, subject to any allowable deduction under § 162(l).

## Legal Principles

- A redemption may receive exchange treatment under § 302(b)(3) only if the shareholder’s interest is completely terminated; retention of a post-transaction interest other than as a creditor can defeat exchange treatment.
- Security arrangements commonly associated with installment financing (including stock pledged as collateral, cross-collateralization, and cross-default provisions) can be consistent with creditor status and do not necessarily constitute a retained equity interest.
- A theory raised by the IRS that requires different facts and proof than those tried is a “new matter”; when raised only in post-trial briefing and unsupported by evidence, it may be rejected.
- For fringe-benefit purposes, an S corporation’s “2-percent shareholder” under § 1372 includes constructive ownership determined under § 318; employer-paid health insurance premiums for such a shareholder-employee are includable in gross income, with potential deductibility under § 162(l) if statutory requirements are met.

## Conclusion

The Tax Court treated the Hursts’ 1997 HMI redemption and related stock sale as a complete termination under § 302(b)(3) producing capital-gain exchange treatment, declined to apply § 304 because it was raised too late and lacked proof, and required inclusion of S-corporation-paid health insurance premiums in Mary Ann’s income because attribution made her a 2-percent shareholder.


Hurst v. Commissioner, 124 T.C. 16 (U.S. Tax Ct. 2005)