## Facts

- William M. Lynch formed W.M. Lynch Co. in 1960 and initially owned all 2,350 outstanding shares.
- Lynch owned specialized pipe machines individually and leased them to the corporation, which subleased them to contractors.
- On December 17, 1975, Lynch transferred 50 shares to his son, Gilbert; Lynch and his wife resigned as corporate directors and officers the same day.
- On December 31, 1975, the corporation redeemed Lynch’s remaining 2,300 shares in exchange for property and a promissory note.
- Gilbert, as the sole remaining shareholder, pledged his 50 shares as security for the corporate note; if the corporation defaulted, Lynch could vote or sell Gilbert’s pledged shares.
- On the redemption date, Lynch entered a five-year consulting agreement providing monthly payments and expense reimbursements.
- After the redemption, Lynch continued regular on-site involvement (including frequent office visits), shared office space with Gilbert, and remained on the corporation’s group medical insurance.

## Issues

1. Whether the redemption qualified as a “complete termination” of Lynch’s interest under I.R.C. § 302(b)(3), permitting sale-or-exchange treatment under § 302(a).
2. Whether Lynch satisfied I.R.C. § 302(c)(2) to waive family attribution, including whether he retained a “prohibited interest” in the corporation other than as a creditor.

## Decision

- The Ninth Circuit reversed the Tax Court.
- The court held that Lynch retained a prohibited interest after the redemption, preventing waiver of family attribution under § 302(c)(2).
- Because the requirements for complete termination were not met, the redemption did not qualify for § 302(a) sale-or-exchange treatment.
- The proceeds were taxable as dividend distributions under § 301 (to the extent of earnings and profits), rather than as long-term capital gain.

## Legal Principles

- A redemption receives sale-or-exchange treatment under I.R.C. § 302(a) only if one of § 302(b)’s tests is satisfied, including complete termination under § 302(b)(3).
- Family attribution can be waived under I.R.C. § 302(c)(2) only if the redeemed shareholder does not retain a prohibited interest in the corporation other than as a creditor.
- Creditor status does not include contingent rights that effectively preserve control or influence, such as contractual power to vote or dispose of pledged shares upon default.
- Post-redemption relationships and agreements may be evaluated in combination to determine whether the shareholder’s interest was truly terminated for § 302 purposes.
- If a redemption fails § 302, amounts received are treated under § 301 as distributions potentially taxable as dividends.

## Conclusion

The Ninth Circuit recharacterized the redemption as a dividend because Lynch’s pledge-related voting/sale rights over his son’s shares, together with his continuing paid involvement, constituted a prohibited interest that defeated the § 302(c)(2) attribution waiver and prevented § 302(b)(3) complete-termination treatment.


Lynch v. Comm’r, 801 F.2d 1176 (9th Cir. 1986)