Family Attribution Rules for Stock Ownership: Section 318 Redemptions

The family attribution rules under Section 318 of the Internal Revenue Code treat you as constructively owning stock held by four specific relatives: your spouse, your children (biological or legally adopted), your grandchildren, and your parents.¹ Your actual shares plus those attributed shares are what the IRS uses whenever a tax rule references Section 318, and that combined figure often decides whether a stock redemption is taxed as a capital gain or as an ordinary dividend.

Which Relatives Count

The circle is deliberately narrow. Section 318 attributes to you the stock owned by:

Your spouse, unless the two of you are legally separated under a decree of divorce or separate maintenance.¹
Your children. A legally adopted child is treated the same as a child by blood for every purpose under this section.²
Your grandchildren. Attribution reaches one generation below your children.
Your parents.

Who Doesn’t Count

Just as important is who the statute leaves out. Siblings are excluded, so a brother’s or sister’s shares are not attributed to you under Section 318. Grandparents are excluded because upward attribution stops at your parents. Aunts, uncles, cousins, in-laws, and stepchildren who have not been legally adopted also fall outside the circle. The scope reflects a choice to focus on the nuclear family and leave more distant relatives’ holdings alone for corporate tax calculations that reference this section.

How the Shares Add Up

Constructive ownership is a legal fiction. The IRS deems you the owner of shares you have never bought, voted, or received a dividend on, purely because of the family tie. Your real shares plus your attributed shares equal your constructive ownership, and every threshold test that references Section 318 uses that combined number.¹

A short example makes the point. A daughter owns 40 percent of a corporation and her father owns 20 percent. Under Section 318, the daughter is treated as owning 60 percent because her father’s shares flow to her. The father is separately treated as owning 60 percent because her 40 percent flows to him. Neither may realize they’ve crossed the majority-ownership line until a redemption forces the math.

Attribution runs in every direction the statute allows, and it runs simultaneously. A parent’s shares flow down to children and grandchildren. A child’s shares flow up to parents. A spouse’s shares flow sideways. All of these flows happen at once for any test that invokes Section 318, so a single family can have several members who each constructively own a majority of the same corporation.

Where the Family Definition Changes

Section 318’s list is not the tax code’s only definition of family, and this matters if you are trying to plan across transactions. Section 267, which governs losses, expenses, and interest between related parties, defines family to include your siblings (full or half-blood), your spouse, all ancestors (grandparents and further back), and all lineal descendants (great-grandchildren and beyond).³ Section 544, used for personal holding company determinations, uses the same wider list.⁴

The practical result is that one transaction may ignore your brother’s shares entirely while another test aggregates them and produces a very different tax outcome. Confirm which section applies before assuming a Section 318 analysis covers the situation.

Why It Matters: Stock Redemptions

Family attribution does its most consequential work in stock redemptions. When a corporation buys back your shares, the tax treatment depends on whether the redemption meaningfully reduces your stake. If it does, you get capital gains treatment. If it doesn’t, the whole payment is taxed as a dividend, often at ordinary income rates. Long-term capital gains top out at 20 percent; ordinary income rates run as high as 37 percent.

Section 302(b) sets out the tests a redemption must pass to qualify for exchange treatment. The one that trips up family businesses is the substantially disproportionate test: after the redemption, your ownership of the corporation’s voting stock must drop below 80 percent of what it was before, and you must own less than 50 percent of total voting power.⁵ Constructive ownership through family members counts toward both measurements.

This is where families get burned. Suppose you own 30 percent of a corporation and your spouse owns 25 percent. You expect a partial redemption to reduce your stake enough to pass the 80-percent test. But the IRS treats you as owning 55 percent (your 30 plus your spouse’s 25), and your constructive percentage barely moves after the redemption because your spouse’s shares haven’t changed. The redemption fails the test and the entire distribution is recharacterized as a dividend under Section 302(d).⁶

Section 318 attribution also feeds into related-corporation redemptions under Section 304, preferred stock dispositions under Section 306, purchase definitions under Section 338, net operating loss limitations under Section 382, REIT rental income rules under Section 856, and controlled foreign corporation rules under Sections 958 and 6038.²

Turning Off Family Attribution After a Complete Redemption

There is one escape. When a corporation redeems all of your stock in a complete termination of your interest, Section 302(c)(2) lets you waive family attribution so that your relatives’ continuing ownership doesn’t poison your exchange treatment. The requirements are strict.

Two timing rules frame the waiver:

Ten-year look-back. You cannot have acquired any portion of the redeemed stock from a related party (whose ownership would be attributed to you) within the ten years before the redemption.⁷
Ten-year look-forward. For ten years after the redemption, you cannot acquire any interest in the corporation, including serving as an officer, director, or employee. Inheriting stock is the sole exception.⁷

You must also file a formal written agreement with your tax return for the year of the redemption. Treasury Regulation 1.302-4 specifies the format: a statement identifying you (or the related person) and the distributing corporation, representing that you have not acquired any prohibited interest since the distribution and that you will notify the IRS within 30 days of any such acquisition during the ten-year restricted period.⁸

The 30-day notification window is where compliance most often fails. People complete the redemption, file the agreement, and then accept a consulting role or board seat a few years later without remembering the reporting obligation. If the IRS finds the prohibited interest and no 30-day notice was filed, the entire redemption is retroactively recharacterized as a dividend, with back taxes and interest running from the original filing date. The waiver offers a clean exit from a family business, but it demands genuine separation, not paper separation, for a full decade.

When Options Override Family Attribution

Holding an option to buy stock counts the same as owning the stock for constructive-ownership purposes. If you hold the right to purchase 1,000 shares, the IRS treats you as already owning them, and an option to acquire an option is treated as an option on the underlying shares.²

When the same shares could be attributed to you through either an option or a family tie, the option rule takes priority. That priority matters because option attribution and family attribution follow different anti-chaining rules, so the classification changes what further attribution the IRS will permit.²

How Far Family Attribution Travels

Section 318 blocks endless re-attribution with a family-to-family limit: stock attributed to you through a family member cannot be re-attributed from you to another family member. If your son’s shares flow to you under the family rule, they cannot then jump from you to your spouse. Attribution gets one hop within the family tree and stops.¹

That limit is narrower than it sounds. Family attribution can still chain through an entity. If your father’s shares end up in a partnership he belongs to, the partnership’s shares can be attributed onward to you as a separate partner. The block only stops the same type of attribution from being applied twice in a row; two different types used in sequence remain permitted, which is where careful family planning either works or quietly breaks down.

1
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
2
Office of the Law Revision Counsel. 26 U.S. Code 318 – Constructive Ownership of Stock
3
Office of the Law Revision Counsel. 26 U.S. Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
4
Office of the Law Revision Counsel. 26 USC 544 – Rules for Determining Stock Ownership
5
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
6
Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock
7
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
8
GovInfo. 26 CFR 1.302-4 – Constructive Ownership of Stock