## Facts

- Merrill Lynch & Co., Inc. was the common parent of an affiliated group filing consolidated federal income tax returns.
- The group included Merrill Lynch Capital Resources (Resources), a subsidiary that owned interests in lower-tier subsidiaries holding valuable assets.
- In 1987, Merrill decided to dispose of Resources by selling its stock to an unrelated third party.
- Before selling Resources, Resources transferred (sold) stock of certain lower-tier subsidiaries to other Merrill subsidiaries for cash, allowing Merrill to retain selected assets within the consolidated group.
- After the internal transfers, Merrill completed the sale of Resources to the unrelated purchaser, terminating Resources’ ownership interests in the transferred lower-tier subsidiaries.
- On the consolidated returns, Merrill treated the cash received in the internal stock transactions as dividend income under rules applicable to certain related-party stock sales.
- The IRS determined deficiencies for 1987 and 1988, asserting the cash should be treated as redemption proceeds governed by I.R.C. § 302, producing sale-or-exchange treatment rather than dividend treatment.
- On remand from the Second Circuit, the Tax Court addressed whether the parent (Merrill) or the subsidiary whose interest was eliminated (Resources) was the relevant “shareholder” for § 302(b)(3) analysis.

## Issues

1. For I.R.C. § 302(b)(3) (complete termination of interest), whether the relevant “shareholder” is the common parent of a consolidated group or the subsidiary whose ownership interest in the issuing corporation was eliminated.
2. Whether the cash received in the intercompany stock transactions is treated as a dividend under I.R.C. §§ 301/304 or as redemption proceeds treated as a sale or exchange under § 302(b)(3).
3. Whether the step-transaction doctrine, using a “firm and fixed plan” standard, permits integrating the intercompany transfers with the planned sale of Resources to determine § 302(b)(3) treatment.

## Decision

- The Tax Court decided for the Commissioner on the remanded shareholder-identification issue and sustained the disputed characterization.
- The court held that the relevant shareholder for § 302(b)(3) purposes was the subsidiary whose interest in the lower-tier corporations was terminated (Resources), not the consolidated parent.
- Applying the step-transaction doctrine, the court treated the intercompany stock transfers and the later third-party sale of Resources as integrated steps under a firm and fixed plan.
- Because the integrated transaction resulted in a complete termination of Resources’ interest in the relevant lower-tier corporations, § 302(b)(3) applied.
- The resulting statutory treatment was sale-or-exchange characterization of the amounts received, not dividend treatment.

## Legal Principles

- In applying I.R.C. §§ 302 and 304 within a consolidated group, member corporations generally remain separate entities for identifying the shareholder whose interest is tested, absent a specific statutory rule to the contrary.
- Courts may apply the step-transaction doctrine to § 302(b)(3) to determine whether formally separate steps collectively effect a complete termination of a shareholder’s interest.
- Under a “firm and fixed plan” standard, transactions may be integrated when, at the time of earlier steps, there is a settled plan that will culminate in termination of the shareholder’s interest.
- If § 302(b)(3) is satisfied, a redemption is treated as a sale or exchange; if not satisfied, the distribution is generally treated as a dividend under § 301 (as relevant through § 304 in certain related-party stock transactions).

## Conclusion

The Tax Court held that the subsidiary whose ownership interest was eliminated, not the consolidated parent, was the relevant shareholder for § 302(b)(3), and that the intercompany cash payments were redemption proceeds treated as sale-or-exchange amounts because the steps were part of a firm and fixed plan culminating in complete termination of that subsidiary’s interest.


Merrill Lynch & Co. v. Commissioner, 131 T.C. 293 (2008)