Stock Redemption Example: Section 302 Tests and Tax Treatment

When a corporation buys back your shares, the IRS either treats the payment as a sale of stock, letting you subtract your basis and pay tax only on the gain, or as a dividend, taxing the full distribution to the extent of the corporation’s earnings and profits with no basis offset. That is the whole stock redemption sale vs. dividend tax treatment question, and it turns on whether your redemption clears one of four tests under Section 302(b) after your ownership is run through the constructive ownership rules of Section 318.¹ Miss all four, and the entire check is a dividend.

Why the Difference Matters in Dollars

Sale treatment works the way any stock sale does. Proceeds minus adjusted basis equals the taxable gain, and if you held the shares more than a year, that gain is taxed at long-term capital gains rates, which top out at 20% for 2026.¹

Dividend treatment is a different calculation. The entire distribution is treated as a corporate distribution under Section 301, and the portion covered by the corporation’s earnings and profits is a dividend.² For shareholders of a domestic C corporation who meet the holding-period rules, that dividend generally qualifies for the same preferential rates as long-term capital gains, so the rate itself may look similar. The damage is in the base. Under dividend treatment, you cannot subtract basis. A shareholder who paid $200,000 for stock and receives $500,000 in a failed redemption is taxed on the full $500,000 to the extent of E&P, not on $300,000 of gain. On a six- or seven-figure buyback, the gap easily reaches tens of thousands of dollars in extra tax.

The Four Tests That Get You Sale Treatment

A redemption qualifies as a sale or exchange only if it satisfies one of four tests under Section 302(b). Each is built to confirm that the redemption actually changes your position in the company rather than functioning as a disguised dividend.¹

Not Essentially Equivalent to a Dividend

This is a facts-and-circumstances test with no numerical threshold. The Supreme Court held in United States v. Davis that the redemption must produce a “meaningful reduction of the shareholder’s proportionate interest in the corporation.”³ Courts look at voting power, rights to earnings, and rights to net assets on liquidation. A shareholder dropping from control to a minority position has a strong case. A sole shareholder whose constructive ownership remains at 100% has none. Because the outcome is subjective, advisors usually prefer the mechanical tests when the facts allow.

Substantially Disproportionate Redemption

This is the most commonly used mechanical test. All three of the following must be true immediately after the redemption:

You own less than 50% of the total combined voting power of all classes of stock entitled to vote.
Your percentage of the corporation’s voting stock after the redemption is less than 80% of the percentage you held before.
The same 80% reduction applies to your ownership of all common stock, voting or nonvoting.

Failing any one disqualifies the redemption under this test.¹ The 80% condition is where most taxpayers trip up.

Complete Termination of Interest

If the corporation redeems every share you own, the redemption automatically qualifies as a sale or exchange. The real value of this test is that it lets you waive the family attribution rules of Section 318. Without the waiver, a parent whose child still holds stock would be treated as still owning the child’s shares, and the “complete” termination would not be complete.¹

To waive family attribution, you have to meet three conditions. You cannot retain any interest in the corporation (including as officer, director, or employee) other than as a creditor. You cannot acquire any such interest for 10 years after the redemption, other than stock received by inheritance. And you must file a written agreement with the IRS promising to notify it of any prohibited acquisition during that window.¹ A 10-year clean break is the price of ignoring family ownership.

Partial Liquidation

Partial liquidation treatment is available only to non-corporate shareholders and focuses on activity at the corporate level rather than on your proportionate interest. The common fact pattern: the corporation has conducted at least two active businesses for five years or more and terminates one while continuing the other, under a plan adopted in the same taxable year or the following one.¹

Why Family Can Sink a Clean-Looking Sale

You cannot apply any of the four tests using only the shares in your own name. First you have to run your ownership through the constructive ownership rules of Section 318, which treat you as owning stock held by certain related people and entities. In closely held corporations, attribution is the usual reason a redemption that looks like a sale on paper ends up taxed as a dividend.⁴

Under family attribution, you are treated as owning stock held by your spouse, children, grandchildren, and parents. Siblings are not on the list. Stock you only constructively own because of family attribution cannot be re-attributed sideways from you to another family member. Attribution also runs through entities: stock held by a partnership or estate flows out proportionately to partners and beneficiaries, and stock held by a partner or beneficiary flows in full to the entity. For corporations, the shareholder must own 50% or more by value before stock is attributed in either direction. Options to acquire stock count as ownership of the underlying shares.⁴

A Worked Example

Alpha Corp is a closely held C corporation with 1,000 shares of common voting stock outstanding and significant accumulated E&P. Three shareholders own the stock:

Shareholder A: 300 shares (30%). A is the mother of Shareholder B.
Shareholder B: 200 shares (20%). B is A’s son.
Shareholder C: 500 shares (50%). C is unrelated to A and B.

Shareholder A wants to pull back and has Alpha Corp redeem 150 of her 300 shares for $450,000. Her adjusted basis in those 150 shares is $100,000. If she gets sale treatment, she pays tax on $350,000 of gain. If she doesn’t, the full $450,000 is a dividend to the extent of E&P.

Before the Redemption

A directly holds 300 of 1,000 shares, or 30%. Family attribution requires adding B’s 200 shares to A’s count because B is her child. A’s constructive ownership before the redemption is 500 of 1,000, or exactly 50.0%.⁴

After the Redemption

The 150 redeemed shares are retired, so total outstanding shares drop from 1,000 to 850. A directly holds 150 shares. B still holds 200, C still holds 500. After attribution, A constructively owns 350 of 850, or 41.18%.

Running the Tests

Start with the substantially disproportionate test:

50% voting power: A is at 41.18%, which is below 50%. Passes.
80% voting stock reduction: A’s pre-redemption percentage was 50.0%; 80% of that is 40.0%. A’s post-redemption 41.18% is not below 40.0%. Fails.

Because the 80% condition fails, the substantially disproportionate test is out.¹ Complete termination fails too, because A still holds 150 shares directly. She could try the “not essentially equivalent to a dividend” test, pointing to a drop from 50% to 41.18%, but that is a subjective argument with no guaranteed outcome.

Without a mechanical test, the $450,000 is a dividend to the extent of Alpha Corp’s E&P. A gets no offset for her $100,000 basis in the redeemed shares.²

How Shareholder A Could Have Structured This Differently

The math points to the fix. A needed to come in below 40.0% after the redemption. Had Alpha Corp redeemed 200 shares instead of 150, total outstanding would be 800. A would directly hold 100 shares; with B’s 200 attributed, her constructive ownership would be 300 of 800, or 37.5%. That clears the 40.0% threshold and sits below 50%, passing all three conditions of the substantially disproportionate test.

If A wanted to exit entirely, she could have all 300 shares redeemed and waive family attribution under the complete termination rules. She would need to sever every tie with Alpha Corp for 10 years, but the full proceeds would receive sale treatment.¹

What Happens to Your Basis if the Redemption Is a Dividend

Basis in the redeemed shares does not disappear under dividend treatment. It shifts to the basis of your remaining shares in the corporation.⁵ In the Alpha Corp example, A’s $100,000 basis in the 150 redeemed shares would move to her remaining 150 shares.

If every share you own is redeemed but you still get dividend treatment because of family attribution, the basis shifts to the related person whose shares were attributed to you. The basis isn’t lost. Whether you recover it depends on what that related party eventually does with their stock.

Costs That Hit Either Way

Sale or dividend, the proceeds may also carry the 3.8% Net Investment Income Tax. Both capital gains and dividend income count as net investment income. The NIIT applies to individuals whose modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately). For estates and trusts, the 2026 threshold is approximately $16,000.⁶ On a $450,000 redemption the surcharge can add over $13,000. It doesn’t change which characterization is preferable, but it raises the total bill.

On the corporate side, a cash redemption produces no gain or loss at the corporation, though the corporation reduces its E&P to reflect the distribution. Distributing appreciated property is a different story. Under Section 311(b), the corporation must recognize gain as if it sold the property to the shareholder at fair market value.⁷ A corporation handing over real estate with a $200,000 basis and $600,000 fair market value recognizes $400,000 of gain on the distribution even though nothing was sold. This trap catches closely held corporations trying to fund buyouts with appreciated assets.

A Special Rule for Estates

Section 303 gives estates a dedicated path when they need cash to pay death taxes and funeral or administration expenses. If the value of the decedent’s stock in a corporation exceeds 35% of the adjusted gross estate (gross estate minus deductions under Sections 2053 and 2054), the estate can redeem enough stock to cover those costs and receive automatic sale or exchange treatment.⁸ The sale treatment is capped at the amount of estate taxes, inheritance taxes, and allowable funeral and administration expenses. Any excess falls back to the Section 302 tests. For families whose wealth sits inside a closely held business, Section 303 can prevent having to sell the business itself to raise cash for the IRS.

Reporting the Redemption

The corporation reports a dividend-treated redemption on Form 1099-DIV, which covers dividends and other corporate distributions.⁹ A redemption qualifying as a sale or exchange is generally reported on Form 1099-B as a securities sale. On your return, capital gains go on Schedule D; dividend income goes on the appropriate line.

If you waive family attribution under the complete termination rules, the written agreement with the IRS has to be attached to your return for the year of the redemption. Failing to file that agreement, or reacquiring an interest in the corporation within the 10-year window, can retroactively convert the sale treatment to a dividend and bring penalties and interest on the resulting underpayment.

1
Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock
2
Office of the Law Revision Counsel. 26 U.S. Code 301 – Distributions of Property
3
Justia Law. United States v. Davis, 397 U.S. 301 (1970)
4
Office of the Law Revision Counsel. 26 U.S. Code 318 – Constructive Ownership of Stock
5
eCFR. 26 CFR 1.302-2 – Redemptions Not Taxable as Dividends
6
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
7
Office of the Law Revision Counsel. 26 USC 311 – Taxability of Corporation on Distribution
8
Office of the Law Revision Counsel. 26 USC 303 – Distributions in Redemption of Stock to Pay Death Taxes
9
Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions