IRC Section 302: Sale vs. Dividend Treatment and the Four Tests

Under IRC Section 302, a corporate stock redemption is taxed as a sale or exchange if it passes any one of four tests; if it fails all four, the payment is treated as a distribution under Section 301, which usually means dividend income.¹ Sale treatment lets you subtract your basis and pay tax only on the gain. Dividend treatment can make the entire payout taxable with no basis offset. The four tests are: substantially disproportionate redemption, complete termination of interest, not essentially equivalent to a dividend, and partial liquidation.

What Sale vs. Dividend Treatment Actually Costs You

Sale treatment applies the ordinary gain-or-loss formula: amount received minus adjusted basis equals taxable gain.² A shareholder who paid $100,000 for stock redeemed at $150,000 recognizes $50,000 of capital gain. Long-term capital gains rates for 2026 top out at 20%.

When the redemption fails all four tests, Section 302(d) routes it through Section 301, and the math changes. Section 301(c) applies a three-step ordering: the portion covered by the corporation’s earnings and profits is taxed as a dividend; anything beyond E&P reduces stock basis; anything past that is capital gain.³ In a corporation with substantial accumulated earnings, most of the distribution lands in that first bucket.

The rate itself may not be the problem. For C corporation shareholders, qualified dividends are taxed at the same preferential rates as long-term capital gains. The real penalty is losing the basis offset. In the example above, sale treatment taxes $50,000; dividend treatment can make the full $150,000 taxable, even though the shareholder originally invested $100,000. That basis doesn’t disappear if the shareholder still holds other shares in the corporation, but it doesn’t reduce the dividend either.

Constructive Ownership Before You Run the Tests

Every Section 302 test measures the shareholder’s ownership before and after the redemption, and “ownership” includes shares the IRS attributes to you under Section 318.⁴ Without these rules, a family that controls a corporation could shuffle shares among relatives to manufacture a paper reduction that changes nothing about who runs the business.

Section 318 covers four categories:

Family attribution treats you as owning stock held by your spouse, children, grandchildren, and parents. Siblings are not on the list.
Entity-to-owner attribution pushes stock held by a partnership, estate, trust, or corporation out to the partners, beneficiaries, or shareholders, generally in proportion to their interest.
Owner-to-entity attribution runs the other direction: stock you personally hold can be attributed to entities you have an interest in.
Option attribution treats a holder of an option to buy stock as already owning it.

A shareholder who personally holds 20% but whose children hold another 40% is treated as owning 60% for testing purposes. Most planning succeeds or fails right here.

The Four Tests for Sale Treatment

A redemption needs to pass only one test. The mechanical tests are tried first because the numbers either work or they don’t; failing them doesn’t prevent qualifying under the facts-and-circumstances test.⁵

Substantially Disproportionate Redemption

Three numerical hurdles, all measured against actual plus constructively owned stock:¹

Immediately after the redemption, the shareholder must own less than 50% of the total combined voting power. This is a hard ceiling.
The shareholder’s post-redemption percentage of voting stock must drop below 80% of the pre-redemption percentage. If you owned 60% before, you need to be below 48% (60% × 80%) after.
The same 80% reduction must apply to the shareholder’s percentage of common stock, voting or nonvoting. With multiple classes of common, the comparison is by fair market value.

One trap: the IRS can disqualify a redemption that technically passes if it is part of a planned series of redemptions that, taken together, aren’t substantially disproportionate. A corporation redeeming shares from one shareholder in installments that each barely clear 80% but collectively leave the shareholder’s proportionate interest roughly unchanged risks having the whole series recharacterized.

Complete Termination of Interest

The shareholder must give up every share, direct and constructive. Family-owned businesses run into trouble here: a parent who sells all personal shares but whose children still own stock has not terminated under the attribution rules.

Section 302(c)(2) lets a departing shareholder waive family attribution, but only if all three conditions are met:⁶

Immediately after the redemption, the former shareholder holds no interest in the corporation, including as officer, director, or employee. A creditor interest is allowed, so a buyout note is fine.
The former shareholder acquires no ownership interest or prohibited role in the corporation for 10 years. Stock received by inheritance is the sole exception.⁷
The shareholder files a written agreement committing to notify the IRS within 30 days of acquiring any prohibited interest during the 10-year window and to keep records the IRS can use to verify compliance.⁷

The waiver reaches only family attribution under Section 318(a)(1). It does not override entity-to-owner or option attribution. A shareholder who personally terminates all stock but holds a partnership interest in a partnership that still owns corporation shares cannot waive that attributed ownership away.

Not Essentially Equivalent to a Dividend

The catch-all test, and the most subjective. There are no bright-line percentages. The redemption must produce a “meaningful reduction” in the shareholder’s proportionate interest. The Supreme Court set this standard in United States v. Davis, denying sale treatment to a shareholder who, after attribution, owned 100% of the corporation both before and after the redemption because nothing meaningful had changed about his control.⁸

The test looks at whether the redemption genuinely shifts voting power, the right to participate in earnings, or the right to share in corporate assets on liquidation. A reduction from 90% to 89% likely accomplishes nothing meaningful. A reduction from 57% to 48% might cross the threshold because the shareholder lost majority control. Context matters: in a two-shareholder corporation, even a small shift can be meaningful if it changes who can block corporate action.

Section 318 attribution still applies here (Davis confirmed it cannot be ignored), but the regulation makes clear that failing the mechanical tests doesn’t count against you.⁵ A redemption that narrowly misses the 80% threshold can still qualify if the facts show a genuine shift in control.

Partial Liquidation

This test focuses on what happened at the corporate level, not the shareholder level, and it applies only to shareholders who are not corporations. A corporate shareholder receiving a partial liquidation distribution has to look elsewhere.

To qualify, the distribution must not be essentially equivalent to a dividend judged at the corporate level, and it must happen under a plan adopted in the same taxable year or the following one. The statute provides a safe harbor: the distribution qualifies if the corporation is shutting down a separate line of business it actively conducted for at least five years and continues actively conducting at least one other qualified trade or business afterward.⁹ The five-year rule prevents a corporation from acquiring a business and immediately liquidating it for a tax-favored distribution.

What makes this test unusual is that it can bless a pro-rata distribution where every shareholder is bought out proportionally. That result would fail every other test because nobody’s proportionate interest actually changes. Here, the genuine contraction of the business is what matters.

When All Four Tests Fail

The entire payment is treated as a Section 301 distribution and runs through the three-tier waterfall:

The portion covered by current and accumulated earnings and profits is taxed as a dividend. C corporation shareholders meeting the holding period get qualified dividend rates rather than ordinary income rates.
Any amount beyond E&P reduces adjusted basis, tax-free.
Anything left after basis reaches zero is capital gain from a deemed sale.

A corporation with years of accumulated earnings usually has enough E&P to swallow the whole distribution into the first tier. Basis in the redeemed shares does not simply vanish. If the shareholder still owns other shares in the corporation, which is almost always the case when sale treatment failed, the basis of the redeemed shares is added to the basis of the remaining shares.⁵ That preserved basis helps when those remaining shares are eventually sold in a transaction that does qualify as a sale. It doesn’t help with the current tax bill.

Reporting and the Mismatch Problem

Sale-treated redemptions go on Form 8949, with the totals carried to Schedule D.¹⁰ The corporation or its transfer agent typically issues a Form 1099-B for the proceeds. Dividend-treated redemptions are reported by the corporation on Form 1099-DIV, and the shareholder reports the income on the dividend line of the return.¹¹

The classification mismatch is where problems start. The shareholder may report a sale on Schedule D while the IRS receives a 1099-DIV from the corporation, or vice versa. Mismatched forms tend to produce an audit notice. If the IRS reclassifies a redemption you reported as a sale into a dividend, the resulting deficiency can trigger a 20% accuracy-related penalty on the underpayment.¹² For individuals, a substantial understatement exists when the shortfall exceeds the greater of 10% of the correct tax liability or $5,000. Redemption amounts tend to be large enough that most misclassifications clear that threshold.

1
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
2
Office of the Law Revision Counsel. 26 USC 1001 – Determination of Amount of and Recognition of Gain or Loss
3
Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
4
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
5
eCFR. 26 CFR 1.302-2 – Redemptions Not Taxable as Dividends
6
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
7
Internal Revenue Service. Private Letter Ruling 202219011
8
Justia U.S. Supreme Court. United States v. Davis, 397 U.S. 301 (1970)
9
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (e)
10
Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
11
Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions
12
Internal Revenue Service. Accuracy-Related Penalty