Coastal Drillers Tax Memorandum Essay

Recently, Jeremiah Cranston contacted our office in regards to him possibly providing services under a consulting agreement for Coastal Drillers, Inc. He is concerned about the stock redemption that was completed six years ago and what effect, if any, working as an independent contractor might have on him regarding the redemption.

Facts: Coastal Drillers, Inc. is owned 100% by the Cranston family. Six years ago Jeremiah Cranston redeemed all of his directly owned stock in Coastal Drillers.

This redemption resulted in a qualified complete termination redemption of stock allowing Jeremiah to recognize a long-term capital gain on the redemption proceeds. Jeremiah satisfied all the requirements to waive the family attribution rule to qualify for sale or exchange treatment on the redemption. Coastal Drillers has now offered Jeremiah a one year consulting engagement, as an independent contractor, with the ability to renew the contract for up to a total of 5 years, averaging $30,000 per year in compensation. Issue: Does Jeremiah hold prohibited interest §302(c)(2)(A)(i) in Coastal Drillers, Inc. by being an independent contractor during the ten year period following his complete termination redemption?Authority/Law: §302(c)(2)(A) provides that constructive ownership of stock owned by family members as defined by §318(a)(1) does not apply to a complete termination redemption of stock, if immediately after a distribution the distributee does not hold interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor [§302(c)(2)(A) (i)] and the distributee does not acquire any such interest 10 years from the date of such distribution [§302(c)(2)(A)(ii)].

Under §318(a)(1)(A) an individual shall be considered as owning the stock owned, directly or indirectly, by or for their spouse [§318(a)(1)(A)(i)], children, grandchildren, and parents [§318(a)(1)(A)(ii)].The position taken from the standpoint of the IRS as stated in Rev. Rul. 70-104, 1970-1 C.B.

66 (1970), is that services from the consulting agreement by the father show a prohibited interest within §302(c)(2)(A)(i). The attribution to him would be terminated due to stock attribution rules of §318, which states that stock owned by family members individually may be reattributed to him through estate, trust, partnership or corporation of which he is a stockholder. Therefore the redemption does not qualify as a termination of his shareholder’s interest within the meaning of §302(b)(3) of the Code.

In a Tax Court case from 1974, Estate of Lennard v. Comm., 61 T.C. 554 (1974), the judgment of Congress was not to include independent contractors which possessed no financial stake in the corporation as retaining an interest in the corporation for attribution waiver rules. The Ninth Circuit Court of Appeals rejected this test by the Tax Court in Lynch v. Comm., 86-2 USTC ¶9731.

The Court held that taxpayers providing post redemption services either as an independent contractor or employee, held an interest prohibited by §302 (c)(2)(A)(i). Mr. Cranston would fall under the jurisdiction of the Ninth Circuit Court because he is a resident of California, and the higher court prevails. Since the Ninth Circuit Court is a higher court than the Tax Court, the Lynch v. Comm case law prevails over the case law of the Estate of Lennard v. Comm.Reasoning: Coastal Drillers, Inc.

offer for Jeremiah to serve as an independent contractor six years after the redemption places Jeremiah’s services within 10 years from the date of redemption. If as an independent contractor results in Jeremiah holding prohibited interest in the corporation then he would no longer meet the requirements to waive the family attribution rule and would still own the stock directly or indirectly owned by his spouse, children, grandchildren and parents. Jeremiah’s immediate family members own 100% of the stock in Coastal Drillers. Therefore, even though Jeremiah redeemed all his stock in Coastal Drillers he would still be considered owning 100% of the stock that his spouse, children, grandchildren and parents own. Conclusion: The position taken by the Internal Revenue Service along with case history that has been cited, would indicate that if Jeremiah performs services as an independent contractor for Coastal Drillers, Inc., he would hold a prohibited interest in the corporation within 10 years of his stock redemption, which violates §302(c)(2)(A)(i) and §302(c)(2)(A)(ii).

Therefore, Jeremiah no longer meets the requirements to waive the family attribution rule under §318. Jeremiah’s stock redemption from Coastal Drillers, Inc., would fail to qualify for a complete redemption under §302(b)(3). The money Jeremiah received from the corporation in redemption of his shares would be classified as a dividend distribution, taxable as ordinary income.

Research StepsThe first step in our tax research was to ensure that we understood the issue being questioned which in this particular case was whether or not Jeremiah would hold a prohibited interest in Coastal Drillers, Inc. by being an independent contractor during the ten year period following his complete termination redemption. Secondly, we made a list of key words that we researched using Commerce Clearing House (CCH).

Below is a list of the key words that we searched:Stock redemptionProhibited interest§302§318Rev. Rul. 70-104Lynch v. Comm.Estate of Lennard v. CommWe started our research on CCH, with a search for stock redemption which immediately brought §302 to our attention. In reading the current IRC code, 302(c)(2), we moved on to IRC code §318 which talked about what would constitute constructive ownership. To get a better understanding of both the sections above, we used CCH Explanations, which explained the codes in layman’s terminology.

We were given the Rev. Rul. 70-104 and Lynch v. Comm., and those were researched on CCH, too. Under the Rev.

Rul. 70-104, it stated the information regarding Estate of Lennard v. Comm., so we researched that case to understand the Tax Court’s position.

In Lynch v. Comm., we learned that the Tax Court’s ruling was rejected by the Ninth Circuit Court.

From our understanding of the hierarchy of the court system, the Ninth Circuit Court is a higher court than the Tax Court. Since the taxpayer involved lived in California, he was in the jurisdiction of the Ninth Circuit Court.We then search the Lynch v.

Comm case using Citator on CCH to make sure we had the most update information regarding the case. We select Citator in CCH then selected Citator- Federal Taxes and click on cases. We were then prompted with a numerous ways to search for cases.

We started with the first search option by inputting the numbers and paragraph associated with the case (86.2 USTC ¶9731) which leads us to the main Citator table for the Lynch v. Comm case. This table provided us with the information as to if this case was the most current information available. The table provided us a short list of cases. The top of the list was an annotation about distributions in redemption of stock and partial Liquidations: Termination of Stockholder’s Interest: Termination determined in which the Lynch v. Comm case was mentioned.

The next case was the Lynch v. Comm case which was heard by Tax Court and eventually appealed in the US Court of Appeals California Ninth Circuit Court. Since no other cases, appeals, or rulings were made after the Lynch v. Comm in the main Citator table, this informs us that the Lynch v. Comm case is the most current ruling.After careful review of all our findings, we came to our conclusion by IRC Codes, case law and the position of the IRS with the Revenue Ruling.