Q. Much attention has been paid to the DuPont-Seagram transaction including the proposed legislation that followed. What planning opportunities did this transaction raise for closely held businesses?

A. In the DuPont-Seagram transaction, Seagram raised a significant amount of capital by selling shares of DuPont but having the transaction characterized as a dividend, rather than as a capital gain. As a corporate shareholder, Seagram's so-called dividend was subject to the 80% dividends-received deduction under Internal Revenue Code section 243(c).

According to reports of the transaction, Seagram "sold" 156 million shares of DuPont in exchange for $8.3 billion in cash and notes and approximately 156 million warrants to purchase DuPont stock. The warrants were "out-of-the-money" (the exercise price was above the current market price) but could become valuable in the future if DuPont shares appreciate by 15% per year. Seagram retained 8.2 million shares (1.2% of DuPont). Thus, on a fully diluted basis, Seagram's percentage interest in DuPont did not change.

Tax treatment. IRC section 317 classifies the transaction as a redemption--a corporation's acquisition of its stock in exchange for property. IRC section 302 provides rules for whether a transaction modeled as a redemption will be taxed as such instead of as a dividend. The key to redemption treatment is falling within one of the categories of transactions set forth in section 302(b):

* A complete termination of interest (section 302(b)(3)).

* A substantially disproportionate redemption (section 302(b) (2)).

* A partial liquidation (section 302(b)(4)).

* Not essentially equivalent to a dividend (section 302(b)(1)).

While the requirements for each are beyond this article's scope, in most cases a shareholder's percentage interest in the corporation must be reduced, after taking into account certain attribution rules, to receive capital gain treatment. Those rules can make capital gain treatment difficult to achieve. They apply, for example, to stock held by relatives and related entities. Individuals generally prefer capital gain treatment and thus plan to avoid the attribution rules.

Seagram, however, wanted dividend treatment; the key was issuance of the warrants. Under IRC section 318(a)(4), someone who owns an option to acquire shares is deemed to own those shares. In revenue ruling 68-601, 1968-2 C.B. 124, the Internal Revenue Service said a warrant is treated as an option if (1) the holder has the right to obtain the stock at his or her election and (2) there are no contingencies with respect to the election. Seagram, by receiving warrants (which satisfied both tests) equal to the number of shares redeemed was deemed to still own 164.2 million shares. With no reduction in Seagram's proportionate interest, the company received dividend treatment.

How is Seagram-DuPont relevant to a closely held business? It should remind tax practitioners of the need to use caution in planning around section 302. In particular, they should be aware that the existence of an option could change what was considered a redemption into a dividend.

What constitutes an option? The definition should be narrowly construed, especially if the safe harbors in the section 382 regulations (regarding limitations on the use of net operating losses) are applied by analogy. Under these rules, a security arrangement, such as the right to reacquire stock in the event of a default, is not an option (Treasury regulations section 1.382-4(d)(7)(ii)). Similarly, the option to acquire stock under a shareholders' agreement on the occurrence of certain events (such as another shareholder's death) should not be construed as an option (Treasury regulations section 1.382-4(d)(7)(v)).

CPAs may find other opportunities to use DuPont-style Planning, such as a shareholder in a start-up C corporation that has generated only losses. The corporation has no current or accumulated earnings and profits, but has a strong revenue future. A shareholder looking to cash-out part of his or her investment might do better to redeem stock in a transaction structured as a dividend rather than to sell stock.

Example. Michele Young invested $1,000 in Axel Corporation, which has no current or accumulated earnings and profits; the stock is now worth $2,000. Jay Gordon is willing to become a 50% stockholder by investing $1,000. If Gordon bought 50% of Young's stock, she would have a $500 capital gain ($1,000-$500--the allocable basis). If Axel instead redeemed Young's stock in a transaction structured as a dividend, she would have a $1,000 return of basis due to the absence of current or accumulated earnings and profits.

BRYAN BLOOM, JD, LLM, is a tax attorney with WRH Partners, LLC, in Morristown, New Jersey. He is an author in the AICPA tax CEA series.