A stock redemption receives sale or exchange treatment under Section 302 if it satisfies any one of four tests in Section 302(b). Pass one, and you subtract your basis from the proceeds and pay tax only on the gain. Fail all four, and Section 302(d) treats the entire payment as a distribution under Section 301, taxed as a dividend to the extent of the corporation’s earnings and profits with no basis offset against the current payment. The dollar difference between those outcomes is usually the whole reason the question matters.
Start With Constructive Ownership
Every one of the four tests measures your ownership before and after the redemption, and every one uses constructive ownership under Section 318 rather than the shares registered in your name.1Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock Get this step wrong and every calculation after it is wrong.
Family attribution treats you as owning every share held by your spouse, children, grandchildren, and parents. Personal holdings of 40 shares plus a spouse’s 30 shares means the IRS counts you as owning 70. Involvement in the business is irrelevant, and so is the state of the family relationship. Siblings and grandparents are not attributed.1Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
Entity attribution moves shares through partnerships, estates, trusts, and corporations to their owners or beneficiaries. Owning at least 50 percent of the value of a corporation’s stock picks up a proportionate share of whatever stock that corporation owns in other companies. Trust and estate beneficiaries are attributed stock in proportion to their interest, though a contingent interest worth 5 percent or less of trust property is treated as too remote to count.1Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
Option attribution treats any shares you have the right to acquire through options or warrants as if you already own them. Options on 1,000 shares add 1,000 shares to your constructive ownership before any test runs.1Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
Test 1: Not Essentially Equivalent to a Dividend
Section 302(b)(1) qualifies a redemption for sale treatment when the distribution is “not essentially equivalent to a dividend.”2Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock There is no numerical threshold. In United States v. Davis, the Supreme Court held that the redemption must produce a “meaningful reduction of the shareholder’s proportionate interest in the corporation.”3Justia. United States v. Davis, 397 U.S. 301 (1970)
Courts weigh three attributes when deciding whether that reduction happened: voting power, the right to share in earnings, and the right to share in assets on liquidation. A meaningful drop in any one of them can be enough. Level of control that stays essentially the same after the buyback will not be.
Minority shareholders in large corporations have the easiest path here. The IRS has treated a reduction from roughly 0.011 percent to 0.010 percent as meaningful for a small shareholder with no practical control before or after.4Internal Revenue Service. Notice CC-2004-038 A shareholder going from 60 percent to 55 percent has a much harder argument, because that shareholder still dominates corporate decisions.
Test 2: Substantially Disproportionate Redemption
Section 302(b)(2) offers a numerical safe harbor. Clear both bright lines and the redemption qualifies for sale treatment regardless of the facts-and-circumstances analysis.5Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (b)(2)
The 50-percent rule requires that, immediately after the redemption, you own less than 50 percent of the total combined voting power. Half or more of the votes and the safe harbor is gone, no matter what the other numbers show.
The 80-percent rule requires that your percentage of voting stock after the redemption drop below 80 percent of your percentage before the redemption. The same 80-percent threshold applies separately to your percentage of common stock, whether voting or nonvoting. Both the voting-stock and common-stock versions of the test must be satisfied.5Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (b)(2)
A Worked Example
Say you own 60 of a corporation’s 100 outstanding shares (60 percent). The corporation redeems 25 of your shares, leaving 35 out of 75 total (46.67 percent). The 50-percent test passes because 46.67 is below 50. Divide the post-redemption percentage (46.67) by the pre-redemption percentage (60) and you get about 77.8 percent, which falls below the 80-percent ceiling. Both tests pass. Sale treatment applies.
Change the facts. Only 10 shares are redeemed, leaving 50 out of 90 (55.56 percent). The 50-percent test fails immediately and the safe harbor is unavailable. Remember that these percentages use constructive ownership, not just registered shares. Attribution from a spouse or child can push you over the 50-percent line even when your personal holdings look safely below it.
The Series-of-Redemptions Trap
The safe harbor does not apply where the redemption is part of a planned series of buybacks that, taken together, leave the shareholder’s overall position essentially unchanged.6Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (b)(2)(D) The IRS looks at the aggregate result of the plan. If the end state is not substantially disproportionate, every step in that plan loses the safe harbor.
Test 3: Complete Termination of Interest
Section 302(b)(3) qualifies a redemption for sale treatment when the corporation redeems every share you own, with no percentage math required.7Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (b)(3) The problem is that “every share” includes constructive ownership. Shares still held by a spouse or child make you a continuing owner and the termination incomplete.
Waiving Family Attribution
Section 302(c)(2) lets you ask the IRS to disregard family-attributed shares if you meet several strict conditions.8Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (c)(2) Immediately after the redemption you cannot hold any interest in the corporation other than as a creditor. No role as officer, director, or employee.
The IRS reads “any interest” broadly. In Revenue Ruling 70-104, the Service held that a father who entered a long-term consulting agreement with the corporation after his shares were redeemed still had a prohibited interest, even as an independent contractor. The Tax Court has at times allowed the waiver where a consulting arrangement was informal and terminable at will, but the IRS has not accepted that position. Cutting all service relationships with the company, paid or unpaid, is the safe path.
The Ten-Year Rules and the Filing Step
The waiver is blocked if you acquired any of the redeemed stock from a family member within the ten years before the redemption, or if you transferred stock to a family member during that period, unless that person’s shares are redeemed in the same transaction. Inheriting stock is the one exception.8Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (c)(2)
Looking forward, you cannot acquire any prohibited interest in the corporation for ten years after the redemption. You also have to attach a written agreement to your tax return for the year of the redemption promising to notify the IRS if you reacquire such an interest. That agreement extends the statute of limitations for the government to recharacterize the transaction. Skip the filing and the entire waiver is disqualified.9Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (c)(2)(A)
Test 4: Partial Liquidation
Section 302(b)(4) works from the corporate side rather than the shareholder’s proportionate interest. The distribution qualifies if it amounts to a partial liquidation of the corporation and the shareholder receiving the payment is not itself a corporation.10Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (b)(4) Corporate shareholders cannot use this test.
A distribution counts as a partial liquidation if it is not essentially equivalent to a dividend judged at the corporate level (not the shareholder level) and it happens under a plan adopted within the same tax year or the following year. The statute provides a safe harbor for shutting down one of at least two active businesses, provided each business was operated for at least five years before the redemption and the corporation continues running the remaining business afterward.11Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (e)(2) The redemption can be pro rata among all shareholders and still qualify, which is impossible under the other three tests.
What Happens When All Four Tests Fail
Section 302(d) reclassifies a failed redemption as a property distribution under Section 301.12Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock – Section (d) Section 301 applies a three-layer ordering rule.
First, the portion coming out of the corporation’s current or accumulated earnings and profits is a dividend. Substantial earnings and profits can consume the entire payment at this layer. Second, any amount beyond the dividend layer reduces the basis of your remaining stock. Third, anything left after basis is exhausted is capital gain.13Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property – Section (c)(3)
The critical difference from sale treatment: the basis of the redeemed shares does not offset the payment. That basis shifts to your remaining shares or, where family attribution caused the failure, to the related person’s shares.14eCFR. 26 CFR 1.302-2 – Redemptions Not Taxable as Dividends The basis is not lost forever and will reduce gain when those shares are eventually sold, but the immediate tax hit is much larger because it cannot offset the current distribution.
One point worth flagging. Dividend treatment does not automatically mean ordinary income rates. Dividends from a domestic C corporation that meet the holding-period requirement are qualified dividends taxed at the same preferential rates as long-term capital gains. The damage from failing Section 302 is not usually a higher rate. It is paying tax on the entire distribution instead of just the profit above basis.
Reporting the Redemption
A qualifying redemption is reported on Schedule D and Form 8949. List the redemption proceeds, subtract your adjusted basis in the surrendered shares, and report the resulting gain or loss.15Internal Revenue Service. Instructions for Form 8949 This is the same process used for any stock sale and it lets you offset gains with capital losses from other transactions. Keep records of the original purchase price and any adjustments.
A failed redemption taxed as a dividend appears on Form 1099-DIV instead.16Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions The 1099-DIV reflects the full distribution as dividend income to the extent of earnings and profits. Your basis in the redeemed shares does not appear on this year’s return as an offset; it rides along on your remaining stock, or on a related party’s shares if attribution drove the outcome.
High-income shareholders also face the 3.8 percent net investment income tax on the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 ($250,000 for joint filers).17Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax Both capital gains from a qualifying redemption and dividend income from a failed one fall within net investment income, so this surtax applies either way.