39 T.C. 199">*199 OPINION.

In these consolidated proceedings, respondent determined deficiencies in income1962 U.S. Tax Ct. LEXIS 45">*50 tax of $ 3,001.92 and $ 4,017.47 for the calendar years 1957 and 1958, respectively.

The only issues for decision are:

(1) Whether the petitioners, the grantors of a trust created in 1957, are taxable on the income of said trust for the years 1957 and 1958.

(2) Whether the petitioner Ralph L. Humphrey received dividend income in 1957 in the amount of $ 2,000 as a result of the transfer of his stock in Humphrey Awnings, Inc., to Humphrey Products, Inc.

All of the facts have been stipulated and are found accordingly.

During the years 1957 and 1958 the petitioners resided in Wichita, Kansas, and filed their income tax returns with the district director of internal revenue at Wichita, Kansas.

On July 1, 1957, the petitioners entered into a trust agreement which provided as follows:

This Agreement, entered into by and between Ralph L. Humphrey and Eva May Humphrey, husband and wife, hereinafter known as Grantors, and Loren 39 T.C. 199">*200 R. Humphrey, Frank L. Humphrey and Ralph L. Humphrey, hereinafter known as Trustees;

Witnesseth:

Whereas, the Grantors herein are desirous of creating a trust and may from date hereof grant to the Trustees both real and personal property, or either, for the1962 U.S. Tax Ct. LEXIS 45">*51 use and benefit of the following: Charles Worth Humphrey and William Stephen Humphrey to be known as beneficiaries of the trust. It is understood and agreed that the property so conveyed herein shall be received by the Trustees and held by them for the use and benefit of the above named beneficiaries; that the Trustees shall receive all property herein granted and shall be privileged to receive the income therefrom, invest and reinvest such income and shall be privileged to make sale or sales of all of such property for the trust and make conveyances of the same on such terms and conditions as in their judgment shall be for the best interest of the beneficiaries.

Our Trustees, in addition to the powers herein given, shall be privileged to assign, transfer, mortgage or hypothecate any of the assets of the trust and to do all acts necessary in the management of such property without the intervention of any court, and on such terms and conditions as our Trustees shall deem best and they shall be privileged to repair, remodel or improve any or all of the assets of the trust estate and in so doing shall incure [sic] no liability to our beneficiaries under the terms of this trust on1962 U.S. Tax Ct. LEXIS 45">*52 the account of errors or mistakes in judgment.

From the earnings of the property of this trust our Trustees are specifically authorized and empowered to either reinvest such earnings or to expend from such earnings or principal of the trust, if necessary, such sums as in their judgment shall be necessary for the health, general welfare and education of any of our beneficiaries, in such amounts and at such periods as in their judgment shall be for the best interest of the beneficiaries of this trust.

This trust shall continue until July 1, 1972, and until such date no part of the corpus of the trust property, or any of the earnings realized therefrom shall at any time be a part of the assets of the Grantors and the Grantors shall at no time acquire any interest in earnings from the trust property or the proceeds therefrom, but after such date all trust property remaining in the hands of the Trustees may, at the option of the Grantors, revert to the Grantors.

It is understood, and as a condition of this trust, that no beneficiary herein named shall have any right, at any time during the existence of this trust, to assign, pledge or sell the beneficial interest of such beneficiary, and1962 U.S. Tax Ct. LEXIS 45">*53 that none of the principal or earnings therefrom shall at any time be subject to the debts or obligations of any beneficiary.

In the event of death, disability or removal from the state of Kansas of one or more Trustee the remaining trustees shall, in thirty (30) days after the occurence [sic] of such event, select a successor agreeable to the remaining two Trustees, or in the event of the disability, removal or death of all trustees, succeeding trustees shall be appointed by Division No. 1 of the District Court of Sedgwick County, Kansas.

The Trustees herein are further authorized to enter into partnerships at their choosing, to incorporate the assets of the trust, or to handle the same in any business form or style that suits their convenience and appears to be for the best interest of the trust estate.

Loren R. Humphrey was the brother of petitioner Ralph L. Humphrey (sometimes hereinafter referred to as Ralph), and Frank L. Humphrey was Ralph's father. The beneficiaries of the trust, Charles 39 T.C. 199">*201 Worth Humphrey and William Stephen Humphrey, were petitioners' children.

The corpus of the trust consisted of a one-third interest in a partnership known as the Humphrey Building1962 U.S. Tax Ct. LEXIS 45">*54 Company. The Humphrey Building Company owned improved real estate.

The amount of the Humphrey Building Company's taxable income for 1957 and 1958 which is attributable to the one-third partnership interest forming the corpus of the trust and the character of such income were as follows:

Ralph, Frank, and Loren each owned one-third of the outstanding stock of Humphrey Awnings, Inc. (hereinafter referred to as Awnings).

The outstanding stock of a corporation known as Humphrey Products, Inc. (hereinafter referred to as Products), was owned as follows:

Grace is the wife of Frank and the mother of Ralph and Loren. Erma, Lynn, and Beverly are children of Loren and grandchildren of Frank and 1962 U.S. Tax Ct. LEXIS 45">*55 Grace. Pauline is Loren's wife and the mother of Loren's children.

In July of 1957, Frank, Loren, and Ralph each transferred their 200 shares of Awnings to Products, and Products paid to each the sum of $ 2,000.

The transferred shares of Awnings cost Ralph $ 2,000.

As of the fiscal year ended July 31, 1957, both Products and Awnings had earnings and profits in excess of $ 6,000.

The first issue concerns the correctness of respondent's determination that (pursuant to the provisions of section 677(a)(2) of the Internal Revenue Code of 1954) ¹ the petitioners are to be treated as the owners of a trust created by them on July 1, 1957.

39 T.C. 199">*202 Section 677(a)(2) provides, in effect, that the grantor shall be treated as the owner of any portion of a trust whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be held or accumulated for future1962 U.S. Tax Ct. LEXIS 45">*56 distribution to the grantor.

In the case before us, the pertinent parts of the trust agreement provided that the trust was to last for 15 years; that it was for the benefit of petitioners' children; that the trustees were to be Ralph, Loren (Ralph's brother), and Frank (Ralph's father); that the trustees were authorized either to reinvest the income of the trust or to expend it for the benefit of petitioners' children; that during the term of the trust the petitioners were to have no interest in the corpus or the earnings of the trust; and that upon termination of the trust, all trust property ²1962 U.S. Tax Ct. LEXIS 45">*57 was to revert to the petitioners. The trust agreement contained no limitation on the extent to which the trustees could accumulate the trust's earnings, and the petitioners offered no evidence indicating that any of the trustees qualified for designation as an adverse party within the meaning of section 672(a). ³ Accordingly, pursuant to section 672(b)⁴ the trustees are subject to classification as nonadverse parties.

We believe respondent's determination with respect to this issue is correct. The record discloses that the trustees, who were nonadverse parties, could in their unfettered discretion accumulate the earnings of the trust during the entire term of the trust, and that upon termination of the trust the petitioners could receive the trust property consisting of corpus and accumulated income. Such circumstances as they relate to the accumulated income require the application of section 677(a)(2).

The petitioners contend, however, that section1962 U.S. Tax Ct. LEXIS 45">*58 677(a)(2) is rendered inapplicable in the instant case by reason of the exception contained 39 T.C. 199">*203 in the last sentence of section 677(a). This sentence reads as follows:

This subsection shall not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the expiration of a period such that the grantor would not be treated as the owner under section 673 if the power were a reversionary interest; but the grantor may be treated as the owner after the expiration of the period unless the power is relinquished.

Petitioners reason that, since the trust agreement provided that the grantors were to have no interest in the earnings of the trust during the initial period of 15 years, the exception stated in section 677(a) is operative in this case.

The petitioners' resort to the exception contained in section 677(a) is debarred by the regulations. It is therein provided that:

The exception set forth in the last sentence of section 677(a) does not apply merely because the grantor must await the expiration of a period of time before he can receive or exercise discretion over previously accumulated income of the trust, 1962 U.S. Tax Ct. LEXIS 45">*59 even though the period is such that the grantor would not be treated as an owner under section 673 if a reversionary interest were involved. Thus, if income (including capital gains) of a trust is to be accumulated for 10 years and then will be, or at the discretion of the grantor may be, distributed to the grantor, the grantor is treated as the owner of the trust from its inception. [Sec. 1.677(a)-1, Income Tax Regs.]

We believe the respondent's regulation is a reasonable and permissible construction of section 677(a). See also Rev. Rul. 57-363, 1957-2 C.B. 326.

The second issue in these proceedings is whether Ralph received dividend income in 1957 as the result of the transfer of his stock in Awnings to Products.

Prior to July of 1957, Ralph, his brother (Loren), and his father (Frank) each owned one-third of the stock of Awnings. In July of 1957, the three stockholders of Awnings transferred their stock to Products, and each received the sum of $ 2,000. The stock of Products was owned as follows:

1962 U.S. Tax Ct. LEXIS 45">*60 Respondent contends that the transfer of Awnings stock to Products by petitioners constituted a redemption under section 304(a)(1)⁵1962 U.S. Tax Ct. LEXIS 45">*61 and 39 T.C. 199">*204 consequently the entire amount received by petitioners was taxable as a dividend pursuant to the rules of sections 301 and 302. ⁶

1962 U.S. Tax Ct. LEXIS 45">*62 39 T.C. 199">*205 Applying the constructive ownership rules of section 318(a), ⁷ it is apparent that Ralph, his brother, and his father were in control of both Awnings and Products. Such being the case, the payment received by Ralph as a result of the sale of his Awnings stock is transformed by section 304(a) into a distribution in redemption of his Products stock.

1962 U.S. Tax Ct. LEXIS 45">*63 Although the distribution to Ralph is now classified by section 304 as one in redemption of stock, we must look to section 302(b) to ascertain the taxable status of such a distribution. A determination under section 302(b) is made by reference to the stock of the issuing corporation, which in this case is Awnings. See footnote 5, supra.

Under section 302(b) there are four alternative requirements for obtaining capital gain treatment with regard to a corporate redemption of stock. The parties concede that the specific requirement under 39 T.C. 199">*206 section 302(b)(4) involving stock issued by railroad corporations is not applicable to the instant case.

The first statutory requirement we will consider is set forth in section 302(b)(2) and involves a situation in which there is a substantially disproportionate redemption of stock. In order for this section to apply, the stockholder cannot own more than 50 percent of the voting stock of the corporation after the redemption, nor may the stockholder's percentage interest in the voting stock after redemption be equal to 80 percent or more of such percentage interest owned before the redemption.

In determining the ownership of stock for1962 U.S. Tax Ct. LEXIS 45">*64 purposes of section 302(b)(2) the constructive ownership rules of section 318(a)(1)(A), as well as the attribution rules of section 318(a)(2)(C) without regard to the 50 percent limitation contained therein (see section 304(b)(1)), are applicable.

Prior to the redemption Ralph owned through actual and constructive ownership 66 2/3 percent of the stock of Awnings, and after the redemption Ralph owned through actual and constructive ownership 55.4 percent of the stock of Awnings. Eighty percent of Ralph's ownership in Awnings prior to the redemption equaled 53.3 percent.

In view of these facts it is clear that the redemption was not substantially disproportionate as to Ralph. Following the redemption he not only owned more than 50 percent of Awnings stock, but his interest at such time was greater than 80 percent of this interest prior to the redemption.

We will consider next section 302(b)(3), wherein a stock redemption qualifies as an exchange if a shareholder's interest is completely terminated. Here again, applying the attribution rules of section 318(a)(2)(C) to the effect that stock owned by a corporation will be deemed owned by a shareholder, we find that Ralph constructively1962 U.S. Tax Ct. LEXIS 45">*65 owned shares in Awnings through his ownership of Products stock. Such being the case, the redemption did not terminate all of Ralph's interest in Awnings and section 302(b)(3) is rendered inapplicable.

The last alternative to be considered is section 302(b)(1) and, as previously noted, provides, in effect, that a redemption will be treated as a distribution in part or full payment in exchange for the stock if the redemption is not essentially equivalent to a dividend. It is recognized in the case law and in the regulations that the question whether a redemption is essentially equivalent to a dividend depends on the facts and circumstances of each case. Earle v. Woodlaw, 245 F.2d 119 (C.A. 9, 1957), certiorari denied 354 U.S. 942">354 U.S. 942 (1957); Standard Linen Service, Inc., 33 T.C. 1">33 T.C. 1 (1959); sec. 1.302-(b), Income Tax Regs. In the present case Ralph, who owned a one-third interest in Awnings prior to July 1957, transferred that interest to Products, a corporation 39 T.C. 199">*207 in which he owned a 44.6 percent interest ⁸ and received the sum of $ 2,000.

1962 U.S. Tax Ct. LEXIS 45">*66 We are obliged to consider the net effect of this transaction. Flanagan v. Helvering, 116 F.2d 937 (C.A.D.C. 1940), affirming a Memorandum Opinion of the Board of Tax Appeals; Ferro v. Commissioner, 242 F.2d 838 (C.A. 3, 1957), affirming a Memorandum Opinion of this Court; Thomas Kerr, 38 T.C. 723">38 T.C. 723 (1962); and John A. Decker, 32 T.C. 326">32 T.C. 326 (1959), affirmed per curiam 286 F.2d 427 (C.A. 6, 1960). In making determinations under section 302(b) it is appropriate to consider the attribution rules of section 318(a). Thomas G. Lewis, 35 T.C. 71">35 T.C. 71, 35 T.C. 71">77 (1960). Applying the constructive ownership rules of this section, more particularly section 318(a)(2)(C) without regard to the 50 percent limitation contained therein, it is evident that Ralph by reason of a 44.6 percent interest in Products is the constructive owner of a 44.6 percent interest in Awnings as well. Thus, as a result of the transaction, Ralph has received the sum of $ 2,000 without diminution of his interest in Awnings, ⁹ at a time when 1962 U.S. Tax Ct. LEXIS 45">*67 both Awnings and Products had earnings in excess of $ 6,000. In the absence of any other evidence regarding the tenor of this transaction, it is the opinion of this Court that the distribution of $ 2,000 to Ralph by Products was essentially equivalent to a dividend.

Decisions will be entered for the respondent.