Distributions not Essentially Equivalent to a
Dividend: Stock Redemptions and Partial
Liquidations
Overview--Redemptions vs. Dividends
Stock Redemption Defined
A stock redemption is a purchase by a corporation of its own stock from an existing
shareholder. Like a dividend distribution, a stock redemption may involve the distribution of
cash, property or both to a shareholder. But a legitimate redemption differs from a dividend
both in motivation and effect.
Unlike a dividend, which is a distribution of corporate earnings to a shareholder, a stock
redemption represents the liquidation of all or a portion of the shareholder's actual
investment in the corporation. Thus, a stock redemption represents a return of the
shareholder's capital investment in the corporation, rather than a return on that
investment.
The two transactions result from differing incentives: a dividend is a form of compensation
to the shareholder for continuing her/his investment in the corporation whereas a stock
redemption represents an actual reduction in the shareholder's investment in the
corporation. As a result, their effects on the shareholder also differ. Although some portion
of a redemption payment may consist of the shareholder's interest in accumulated earnings,
the redemption typically reduces her interest in the corporation, and thus her interest in
future earnings. A dividend distribution, in contrast, does not affect the shareholder's
continuing interest in the corporation and thus does not alter her interest in future earnings.
Example 1: Corporation X is owned by three shareholders, A, B, and C.
Assume that last year, X had undistributed earnings and profits (E&P) of
$120,000, and distributed $25,000 to each shareholder as a dividend. The
distribution reduces X's E&P to $45,000 ($120,000 - $75,000 dividend), but
does not reduce any of the shareholders' interests in the corporation. A, B
and C each continue to own one-third of Corporation X's stock.
This year, the company had current earnings and profits of $60,000,
increasing its total E&P to $105,000. In October, A decided to retire from
Corporation X. In order to liquidate A's interest in Corporation X, the company
purchased all of A's shares for $135,000. This price reflected the $100,000
value of A's initial investment in the company, plus her $35,000 share of the
company's undistributed E&P (one-third of $105,000). Although a portion of
the distribution is comprised of A's share of corporate earnings, the
distribution is treated as a redemption because it reduces A's continuing
interest in the corporation from 33 percent to zero.
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General Consequences to Shareholders
A legitimate, or qualified, stock redemption is treated as a sale by the shareholder of her
stock back to the corporation. Under current law, structuring a transaction as a stock
redemption rather than a dividend may reduce the tax liability associated with the
transaction for individual shareholders. Because the transaction is treated as a sale of part
or all of the shareholder’s shares, the amount received will be offset by the basis of the
shares received. In contrast, a dividend distribution is generally fully taxable, depending on
the level of corporate earnings and profits. As a result, stock redemptions often trigger a
smaller amount of taxable income than do dividend distributions.
Example 2: Gene owns 250 shares of stock in X-Ray Incorporated. His tax
basis in the X-Ray stock is $250,000. He is in the 35 percent tax bracket. This
year, Gene sold 125 of his X-Ray shares back to X-Ray in a qualified stock
redemption transaction. The purchase price for the shares was $400,000.
Gene must recognize a $275,000 gain on the redemption transaction
($400,000 received - $125,000 basis in the shares surrendered). Although
Gene is in the 35 percent tax bracket, his tax on the gain from this
transaction will be only $42,250 ($275,000 capital gain x 15 percent capital
gains tax rate). Note that had the $400,000 distribution received from X-Ray
been treated as a dividend, Gene's tax liability would have been $60,000
($400,000 x 15 percent dividend tax rate). Thus, by treating the payment as
a sale of Gene's stock back to X-Ray, he saves $17,750 in taxes.
Note that the maximum tax rate on dividends has been equivalent to that on
capital gains only since 2003. Beginning in 2011, the maximum tax rate on
dividends is scheduled to revert to 39.6%, while that on capital gains would
revert to 20%. If the preferential tax rates on dividends and capital gains are
not extended, the tax advantages associated with structuring distributions as
a stock redemption rather than as a dividend will be increased significantly.
Unlike individual shareholders, corporate shareholders often prefer dividend treatment over
treatment as a qualified stock redemption. There are two reasons for this preference. First,
the 15 percent maximum tax rate on capital gains does not apply to corporate taxpayers,
only to individuals. Thus, there is no tax preference for capital gains. In contrast, however,
corporations receive special treatment for dividend income. Under §243, corporations are
entitled to claim a dividends received deduction, substantially reducing the tax burden on
dividend income.
Example 3: Assume the same facts as in Example 2, except that Y
Corporation, rather than Gene, exchanges X-Ray stock for $400,000 cash.
Further assume that Y Corporation is in the 35 percent tax bracket, and owns
60 percent of the outstanding shares of X-Ray Incorporated. Its basis in the
X-Ray stock exchanged is $125,000 as in Example 2. If the transaction is a
qualified redemption, treated as a sale of Y's X-Ray stock for $400,000, Y will
recognize a $275,000 taxable gain on the redemption, increasing its tax
liability by $96,250 ($275,000 x 35 percent). If, on the other hand, the
$400,000 payment is treated as a dividend distribution, Y's tax liability on the
distribution will be substantially less. After deducting the 80 percent dividends
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received deduction, Y's taxable dividend income will be only $80,000. At 35
percent, Y's tax liability on the distribution will be only $28,000. Thus,
treatment as a dividend rather than a qualified stock redemption reduces Y's
tax liability by $68,250.
It is clear from these examples that individual and corporate shareholders have different
incentives for structuring distributions as dividends versus qualified stock redemptions. For
that reason, most stock redemption transactions take place between individual shareholders
and relatively small or closely-held corporations. In these settings, it is often difficult to
distinguish between dividend distributions and true stock redemptions, particularly given the
incentives for individual shareholders to structure corporate distributions as stock
redemptions. The primary focus of the tax law in this area is on preventing closely-held
corporations from "disguising" dividend distributions as stock redemptions.
Example 4: Brad owns 5,000 shares in Hoosier Corporation. His tax basis in
the Hoosier stock is $50 per share, or $250,000. Hoosier's E&P is $1,500,000.
This year, Brad, who is in the 39.6 percent tax bracket, received a $300,000
distribution from Hoosier.
If the distribution is treated as a dividend, Brad's associated tax liability will
be $45,000 ($300,000 X 15 percent). If the transaction is treated as a stock
redemption of half his shares, however, Brad will recognize a $175,000
capital gain ($300,000 less the $125,000 tax basis of half his shares) rather
than a $300,000 dividend. His tax on the gain will be $26,250 ($175,000 X 15
percent). The tax savings associated with treatment as a stock redemption
will be $18,750.
Qualified Stock Redemptions: Requirements for Treatment
As A Sale of Stock
Redemption Must Reduce Shareholder's Interest in the Corporation
In order to be accorded sale treatment for tax purposes, the shareholder must be able to
show that the payment received from the corporation was not "essentially equivalent to a
dividend." Conceptually, the primary difference between a dividend (a return on capital) and
a stock redemption (a return of capital) is that the latter reduces the shareholder's capital
investment in the company, and thereby reduces her interest in the company's future
operations. Thus, dividend equivalency, or the lack thereof, for tax purposes is based on the
effect the distribution has on the shareholder's continuing interest in the company. In order
to be treated as a qualified stock redemption, the distribution must result in a "meaningful
reduction of the shareholder's proportionate interest in the corporation.” If the distribution
does not reduce the shareholder's continuing proportionate interest in the corporation, for
tax purposes it will be treated as a dividend.
Example 5: Shelly Parker owns 1,000 shares of stock in Parker Companies.
There are no other shareholders. Shelly's basis in her Parker shares is
$100,000. Parker Companies has E&P of $250,000. This year, Shelly sold 100
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shares of Parker stock back to the company for $75,000. Although the
transaction was structured as a sale of stock, it did not affect Shelly's
continuing interest in Parker Companies. Prior to the sale, Shelly owned 1,000
shares of Parker stock, representing 100 percent of the shares outstanding.
After the "sale," she owned 900 shares, still representing 100 percent of the
company's outstanding stock. Thus, for tax purposes, the form of the
transaction will be disregarded and the $75,000 payment to Shelly will be
treated as a dividend distribution under Section 301.
Section 318: Determining the Shareholder's Interest in the
Corporation
In determining the shareholder's interest in the corporation before and after a stock
redemption, §302(c) requires that the attribution rules of §318 be applied. Under §318, a
shareholder is considered to own shares held by certain other, related shareholders. That is,
under §318, the shareholder is considered the "constructive" owner of shares held by
related shareholders in addition to those shares the shareholder holds directly. The
shareholder is also considered to own any shares which may be purchased in the future if
the shareholder currently holds an option on those shares.
Example 6: Becky owns 200 of the 1,000 outstanding shares of Western
Corp. In addition to her 200 shares, Becky owns an option entitling her to
purchase an additional 800 shares of Western stock over the next 5 years. No
other shareholders have a similar option. Under Section 318, Becky's interest
in Western is determined as if the options were exercised. If the options were
exercised, Becky would own 1,000 shares of Western, and Western's
outstanding shares would be increased by 800, to 1,800 shares. Becky is thus
deemed to own 55.5 percent of Western's stock (1,000 shares ÷ 1,800 shares
outstanding).
Family Attribution
In addition to acceleration of a shareholder's option rights, Section 318 attributes ownership
between related individuals, between individuals and certain related entities, and from
individuals to certain related entities. Under §318(a)(1), individual shareholders are deemed
to constructively own all the shares owned, directly or indirectly, by their spouses, children,
grandchildren, or parents. No ownership is attributed from any other relative (e.g.,
brothers, sisters, grandparents, etc.).
Example 7: A owns 100 shares of stock in X Corporation. Of the remaining
900 shares of X Corporation stock outstanding, 300 are owned by A's mother,
300 by A's maternal grandmother, and 100 by each of A's three brothers and
sisters. Under Section 318, A is deemed the constructive owner of the 300
shares held by her mother, in addition to the 100 shares A owns directly,
giving her a 40 percent actual and constructive interest in the corporation
(400 shares actual and constructive ownership ) 1,000 shares outstanding).
A's mother, in contrast, is deemed the actual and constructive owner of 100
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percent of X Corporation's stock. In addition to the 300 shares owned directly
by the mother, she is the constructive owner of the shares held by A (100
shares), A's three brothers and sisters (300 shares), and A's maternal
grandmother (300 shares). Note that the same is true for A's maternal
grandmother, who is deemed the constructive owner of the shares held by A's
mother (300 shares) and the shares held by A and her three brothers and
sisters (400 shares total). Thus, both A's mother and her grandmother are
deemed to own, directly and indirectly, 100 percent of the outstanding stock
of X Corporation.
Attribution from Entities
Under §318(a)(2), a taxpayer is also deemed the constructive owner of a proportionate
share of stock owned, directly or indirectly, by a partnership in which (s)he is a partner, a
trust or estate in which (s)he is a beneficiary, and stock owned by a corporation in which
(s)he owns 50 percent or more of the outstanding stock. Note that attribution from a
partnership, trust, or estate is required regardless of the taxpayer's proportionate interest in
the entity, whereas attribution from a corporation is required only if (s)he owns at least 50
percent of such corporation's stock. Also note that attribution from these entities is
proportionate: the shareholder is deemed to own only that portion of stock held by the
entity which corresponds to his/her percentage of ownership or other interest in the entity.
Example 8: The outstanding stock of J Corporation is owned by the following
shareholders:
Shareholder
Shares Owned
Ernie
Ricky
Zelna
RQ, Inc.
QLR Partnership
QLR,Inc.
350
250
150
200
300
250
Total shares outstanding
1,500
Ernie, Ricky and Zelna are unrelated individuals. Ricky owns 50 percent of the
outstanding stock of RQ, Inc., a one-third interest in QLR Partnership, and
one-third of the outstanding stock of QLR, Inc. Neither Ernie nor Zelna own
any interest in these entities. Under Section 318(a)(2), Ricky is deemed to
own 100 (50 percent) of the J Corporation shares held by RQ, Inc., and 100
(one-third) of the shares in J held by QLR Partnership, in addition to the 250
shares Ricky owns directly. Although Ricky is also a shareholder in QLR, Inc.,
no attribution of ownership in J from this corporation is required because
Ricky owns only one-third of its stock. Thus, for purposes of Section 302,
Ricky is deemed to own 450 of the 1,500 outstanding shares of J Corporation.
Attribution to Entities
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The rules for attribution to entities are similar to those for attribution from entities, except
that attribution is full rather than proportionate. A partnership, trust or estate is deemed the
constructive owner of all the shares of stock held by a partner, or beneficiary, regardless of
the partner's or beneficiary's interest in the partnership, trust, or estate. A corporation is
deemed to own all the shares of stock in another corporation held by any shareholder
holding at least a 50 percent interest in such corporation. Note that the attribution rules
also apply in determining whether an individual is a 50 percent shareholder in the
corporation.
Example 9: The outstanding stock of R Corporation is owned by the following
shareholders:
Albert Jones
Rhonda Jones
Eleanor Polk
Polk-Jones, Inc.
500
500
500
500
Total shares outstanding
shares
shares
shares
shares
2,000 shares
Albert and Rhonda are married. Both are unrelated to Eleanor Polk.
Additionally, Albert, Rhonda and Eleanor each own one-third of the stock of
Polk-Jones, Inc. Because Albert and Rhonda are married, they are each
deemed to own two-thirds of Polk-Jones, Inc. (their own one-third interests,
plus the one-third interest of their spouse). Thus, under Section 318, each is
deemed to own two-thirds of the R Corporation stock owned by Polk-Jones,
giving each a total direct and indirect interest in R Corporation of 1,333
shares. Likewise, Polk-Jones is deemed the constructive owner of all 1,000
shares of R Corporation stock owned by Albert and Rhonda, giving it a total
direct and indirect interest in R Corporation of 1,500 shares. No attribution is
required between Eleanor and Polk-Jones, Inc. because Eleanor owns less
than 50 percent of the stock in Polk-Jones.
Multiple Attribution
As noted above, Section 318 generally attributes ownership of stock held directly or
indirectly by a shareholder to all persons or entities deemed related to that shareholder.
There are, however, limits on the extent to which the statute requires stock which is
deemed to be constructively owned by a shareholder to be "reattributed" to another, related
party. Section 318(a)(5) establishes certain operating rules under which two types of
multiple attribution are specifically prohibited. The first provides that stock which is
attributed to an individual from a member or members of her family cannot then be
reattributed, through her, to another member of the family.
EXAMPLE 10: Martin Corporation is a family-owned company, owned by the
following shareholders:
Janice Johnson
Ralph Johnson
April Martin
200 shares
100 shares
500 shares
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Denise Martin
Total shares outstanding
200 shares
1,000 shares
Janice and Ralph are married. April is Janice's mother and Denise is Janice's
sister. Under Section 318 Janice is deemed to constructively own all the stock
owned by her spouse (Ralph), her parents (April) and her children (not
applicable here). She is not deemed to own the stock owned by her sister
(Denise). Similarly, April is deemed to own the stock owned by her children
(Janice and Denise), but not by her son-in-law (Ralph) because he is not her
child. Under Section 318, April is not deemed the owner of the stock held by
Ralph even though that stock is attributed to Janice. Section 318(a)(5)
prohibits the reattribution of Ralph's stock from Janice to April. Similarly,
Janice is not deemed to own the stock held by Denise, even though such
stock is deemed constructively owned by April. Section 318(a)(5) prohibits
the reattribution of Denise's stock through April to Janice.
Section 318(a)(5) also prohibits multiple attribution through entities. Specifically, stock the
ownership of which is attributed to an entity from one of its owners cannot be reattributed
from the entity to another of its owners.
Example 11: Jane and Bob are each 50 percent beneficiaries of the JB family
trust, established by their grandfather several years ago. Jane also owns 100
shares of the family corporation. Under Section 318(a)(3), the estate is
deemed the constructive owner of Jane's 100 shares. Although Bob is
considered the constructive owner of half of the stock owned by the trust,
constructive ownership of Jane's shares cannot be reattributed to Bob through
the trust under Section 318(a)(2).
Note, however, that there is no prohibition against multiple attribution of stock from one
entity through an owner or beneficiary of such entity to another entity in which such owner
also owns an interest.
Example 12: A owns 100 percent of the outstanding stock of Corporations X
and Y. Corporation X owns 100 percent of the stock of Corporation Z. Under
§318(a)(2), A is deemed the constructive owner of 100 percent of
Corporation X's stock in Corporation Z (because A owns 100 percent of
Corporation X). Under §318(a)(3), A's indirect ownership of Z stock is also
reattributed to Corporation Y. Thus, Corporation Y is also deemed to own 100
percent of the stock of Corporation Z.
Example 13: The outstanding stock of Johnson Corporation is owned by the
following shareholders:
Jill Smith
Smith-Jones, Inc.
Coggins, Smith, Becker Partnership
Ernie Jones
Total shares outstanding
7
100
500
600
300
1,500
shares
shares
shares
shares
shares
Jill owns half the stock of Smith-Jones, Inc. In addition, she is a one-third
partner in the Coggins, Smith, Becker Partnership. Ernie Jones, who is no
relation to Jill, owns the other fifty percent of stock in Smith-Jones, Inc. He
has no interest in the partnership.
As a one-third partner in the Coggins, Smith, Becker partnership, Jill is
deemed the constructive owner of 200 of its 600 shares in Johnson
Corporation. As a fifty-percent shareholder in Smith-Jones, Inc., she is
deemed the constructive owner of 250 of the 500 shares in Johnson
Corporation which Smith-Jones owns directly. Although Smith-Jones is also
the constructive owner of Ernie Jones' 300 Johnson shares, these shares
cannot be reattributed to Jill. Thus, Jill is deemed the actual and constructive
owner of 550 shares of Johnson stock (100 shares owned directly, plus 200
shares attributed from Coggins, Smith, Becker, plus 250 shares attributed
from Smith-Jones, Inc.).
Statutory Safe Harbors of Section 302
Section 302(b)(2)--Substantially Disproportionate Redemptions
Section 302 provides three "safe harbors" which, if satisfied by the taxpayer, will assure
that a redemption qualifies for treatment as a sale of stock. Note that if the taxpayer does
not satisfy one of these safe harbor provisions, the transaction may still qualify for sale
treatment, but it will be much more difficult. Outside the safe harbor provisions, the
taxpayer must show that the transaction satisfies the more vague "not essentially
equivalent to a dividend" standard discussed later in this chapter.
Under the first safe harbor provided by Section 302, a distribution will be treated as a
redemption (rather than a dividend) if it is "substantially disproportionate." A distribution
will be considered substantially disproportionate only if all of the following are true:

the shareholder must own less than 50 percent of the total combined
voting power of all corporate stock immediately after the distribution;

the redemption must reduce the shareholder's interest in the
corporation's voting stock by more than 20 percent; and

the redemption must reduce the shareholder's interest in the
corporation's common stock (voting and nonvoting) by more than 20
percent.
The first requirement assures that the taxpayer does not have control of the corporation
after the redemption. No matter how many shares are redeemed, if the shareholder retains
control of the corporation after the redemption, the transaction will not be considered
substantially different from a dividend.
Example 14: John owns 800 of the 1,000 outstanding shares of voting stock
in Lite Corporation. In July, Lite Corporation redeemed 200 of John's shares
for $150,000. No shares of any other shareholder were redeemed. Lite
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Corporation's E&P at the date of the redemption was $500,000. Even though
John surrendered 200 of his shares in Lite Corporation, the redemption did
not dilute John's control of the company: he still retains 75 percent (600 of
the remaining 800 outstanding shares) of the voting stock of Lite. Thus, the
distribution will not qualify as a substantially disproportionate redemption and
John must treat the $150,000 payment as a dividend.
Note that in determining the effect of the distribution on the shareholder's interest in the
corporation, the taxpayer must take into account the reduction in total shares outstanding.
Thus, to satisfy the requirements that the distribution reduce the taxpayer's interest in the
corporation's voting and other common stock by more than 20 percent, the corporation
must redeem much more than 20 percent of the taxpayer's pre-redemption holdings.
Example 15: Arlene owns 1,000 of the 2,500 outstanding shares of common
stock in Zero, Inc. There are no other classes of stock outstanding. In
December, Zero redeemed 250 of Arlene's shares for $250,000. Immediately
after the redemption, Arlene owns 750 of the remaining 2,250 shares of Zero
stock outstanding. Since this is less than 50 percent, the distribution satisfies
the first requirement of §302(b)(1): she does not have control of Zero. Taking
into account the reduction in Zero's outstanding shares, however, the
distribution does not satisfy the requirement that Arlene's interest be reduced
by more than 20 percent. Her interest in Zero prior to the redemption was 40
percent (1,000 shares ÷ 2,500 shares outstanding). To satisfy the second and
third requirements for treatment as a substantially disproportionate
redemption, however, her interest must after the redemption must be less
than 32 percent (40% x 80%). Her interest after the redemption is 33
percent (750 remaining shares ÷ 2,250 shares outstanding). Thus, the
redemption will not qualify for treatment as a substantially disproportionate
redemption.
Finally, note that the attribution rules of §318 must be applied in determining whether the
requirements of §302(b)(1) are satisfied.
Example 16: The outstanding stock of Caster Oil, Inc. is owned in the
following ratios by the following shareholders:
Shares Owned
Paul Caster
Sara Caster
Bobbi Martin
Judy Louise
Total shares outstanding
500
500
250
250
1,500
shares
shares
shares
shares
shares
Paul and Sara are husband and wife. Bobbi is Paul's sister. Judy is unrelated
to Paul. In August, Caster Oil, Inc. redeemed 300 of Paul's shares for
$900,000. Applying Section 318, prior to the redemption Paul is deemed the
constructive owner of Sara's stock, giving him a total direct and indirect
interest in the corporation of 66.67 percent (1,000 shares owned ÷ 1,500
shares outstanding). After the redemption, he is deemed the owner of his
remaining 200 shares, plus the 500 shares owned by his wife, Sara, giving
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him a total direct and indirect interest in the corporation of 58.33 percent
(700 shares owned ÷ 1,200 shares outstanding). Thus, the distribution will
not qualify as a substantially disproportionate redemption. It will likely be
treated as a dividend.
Section 302(b)(3)--Complete Termination of a Shareholder's
Interest
General Framework. The second safe harbor applies when the redemption completely
terminates the shareholder's interest in the corporation. For this purpose, the family
attribution rules (but not the entity attribution rules) are waived. In order to qualify, the
following requirements must be satisfied:

after the redemption, the shareholder must retain no interest in the
corporation (including an interest as an officer, director or employee)
other than as a creditor; and

the shareholder must agree not to acquire any prohibited interest
(other than by bequest or inheritance) in the corporation for ten years
following the redemption.
The shareholder's agreement not to acquire a prohibited interest for ten years after the
redemption must be filed with her tax return for the year of the redemption. The agreement
must state that the shareholder will notify the IRS if a prohibited interest is acquired within
the ten-year period. Moreover, filing the agreement extends the statute of limitations for
assessment of tax for such return, so that if a prohibited interest is acquired before
expiration of the ten-year period, the shareholder must file an amended return for the year
of the redemption recharacterizing the distribution as a dividend.
Example 16: The stock of Carpenter Brothers, Inc. is owned by the following
shareholders:
Karl
Karen
Lisa
John
Total shares outstanding
400
400
200
1,000
2,000
shares
shares
shares
shares
shares
Karen is Karl's wife. Lisa is his granddaughter, and John is his father.
Accordingly, under Section 318, Karl is deemed the actual and constructive
owner of 100 percent of the stock in Carpenter Brothers, Inc. In May, the
company redeemed all 400 shares of stock owned directly by Karl. Assuming
Karl does not maintain a prohibited relationship with the corporation, the
family attribution rules will be waived, and the redemption will be treated as a
sale of his stock back to the corporation.
Waiver of Family Attribution Rules. Note that the family attribution rules are waived only
if the shareholder does not retain or acquire a prohibited interest in the company after the
redemption. In the above example, for instance, if Karl remained a director of the company,
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or even an employee, the family attribution rules would not be waived, and the distribution
would not qualify for redemption (sale) treatment. Karl could, however, retain a relationship
with the corporation as a bondholder or other creditor without affecting the tax treatment of
the stock redemption.
As indicated above, only the family attribution rules, and not the entity attribution rules, are
waived. Moreover, the family attribution rules are waived only for purposes of determining
whether the redemption constitutes a complete termination of the shareholder's interest in
the corporation. If the transaction does not satisfy the requirements for treatment as a
complete termination, the family attribution rules will be applied to determine whether the
redemption is substantially disproportionate.
Example 17: Nordane, Inc. is owned by the following shareholders:
Jill Price
Eddie Price
Susan Price
Price family trust
Total shares outstanding
1,500
250
250
1,000
3,000
shares
shares
shares
shares
shares
Jill Price inherited her 1,500 shares from her parents several years ago. At
that time, the elderly Prices also established the Price family trust. Jill and her
two children, Eddie and Susan, are equal beneficiaries of the trust. In April
this year, Jill decided to retire and turn control of the corporation over to
Eddie and Susan. Pursuant to this plan, Nordane redeemed all 1,500 of Jill's
shares for a price of $1.5 million. Jill retained her interest in the family trust.
As a result, although the family attribution rules are waived, the redemption
does not qualify as a complete termination of Jill's interest in Nordane. Under
Section 318, she is still deemed to own one-third of the shares held by the
trust in which she is a one-third beneficiary. The transaction also fails to
qualify for treatment as a substantially disproportionate redemption. For this
purpose, the family attribution rules are not waived and Jill is deemed the
constructive owner of 100 percent of Nordane's stock, even after the
redemption [333 shares attributed from the family trust, plus 583 shares
each from Eddie and Susan (250 shares owned directly plus 333 shares
attributed from the trust)].
Exceptions for Certain Tax-motivated Transactions
The family attribution rules are not waived in certain circumstances involving a transfer of
stock between the distributee-shareholder and a related party within the ten-year period
preceding the redemption. For this purpose, the waiver is nullified if:

any portion of the stock being redeemed was acquired from a related
party (as defined in Section 318) within the ten-year period ending on
the date of the redemption; or
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
the distributee-shareholder transferred stock in the redeeming
corporation to a related party within ten years of the date on which the
corporation redeemed the shareholder's remaining stock.
These provisions are intended to prevent shareholders from using pre-redemption stock
transfers to convert a transaction which is in substance a dividend distribution into a
qualified stock redemption. Accordingly, the limitations only apply if a principal purpose of
the pre-redemption transfer was to avoid federal income tax.
Example 18: In 2000, Harriet inherited all 1,000 shares of stock in her
family's corporation. In January this year, she gave 900 shares to her
husband, Roy. Three months later, the corporation redeemed Harriet's
remaining 100 shares for $1 million. The obvious purpose for the preredemption transfer of 900 shares to Roy was to allow Harriet to structure the
subsequent distribution as a complete termination of her remaining interest.
By transferring the 900 shares to her husband, Harriet ensured that she
would retain an interest in the company after redemption. Accordingly, the
waiver of the family attribution rules in this case is nullified, and the
redemption does not qualify as a complete termination of her interest in the
corporation. Moreover, since 100 percent ownership of the company is
attributed to Harriet from Roy after the redemption, the transaction also will
not qualify as a substantially disproportionate redemption. The $1 million
distribution to Harriet will be taxed as a dividend to the extent of the
corporation's E&P.
Example 19: Rogers Feed, Inc. is owned by the following shareholders:
Bill Rogers
Larry Rogers
Terri Rogers
Rogers Family Trust
Total shares outstanding
750
150
150
450
1,500
shares
shares
shares
shares
shares
Larry and Terri are brother and sister. Bill is their father. In addition to the
stock each owns directly, Larry and Terri are each 50 percent beneficiaries of
the Rogers Family Trust. Larry would like to have the corporation redeem his
shares. Due to his interest in the trust, however, the redemption would not
completely terminate his interest. Such a stock redemption also would not
qualify as a substantially disproportionate distribution since for that purpose
he will be attributed ownership of stock from both his father and the trust.
Accordingly, a redemption of Larry's interest will not qualify for sale
treatment. To avoid the attribution rules, Larry transferred ownership of his
150 shares in the corporation to his wife, Cindy. Since she is not a beneficiary
of the Rogers Family Trust, ownership of its stock can only be attributed to
her through Larry. Since the family attribution rules are waived in a complete
termination of the shareholder's interest, redemption by the corporation of all
150 shares transferred to Cindy would ordinarily qualify for treatment as a
sale. However, in this case, the family attribution rules are not waived,
because the principal purpose for Larry's transfer of the shares to Cindy was
to obtain preferential tax treatment for the subsequent redemption.
12
Section 302(b)(4)—Partial Liquidations
The third statutory safe harbor applies to individual shareholders receiving a redemption in
partial liquidation of the redeeming corporation. To qualify as a partial liquidation, the
distribution must result from a "genuine contraction" of the corporation's business activities,
must be made under a written plan providing for partial liquidation of the corporation, and
must be made in the year such plan is adopted or within the succeeding year.
It is not always clear what constitutes a genuine contraction of a corporation's business
activities. For example, the regulations under Section 346 state that a distribution of
insurance proceeds from a fire which destroyed part of a corporation's business might
qualify as a partial liquidation, whereas distribution of funds accumulated in a reserve for an
expansion program which has been abandoned will not qualify1.
To alleviate this uncertainty, §302(e)(2) provides a safe harbor under which certain
redemption distributions will be guaranteed treatment as partial liquidations (and thus
qualify for sale treatment). Under the safe harbor, a distribution will qualify as a partial
liquidation if the following requirements are satisfied:

the distribution is attributable to the cessation of, or consists of the
assets of, a qualified trade or business; and

immediately after the redemption, the corporation continues to be
actively engaged in the conduct of another qualified trade or business.
For this purpose, a qualified trade or business is defined as one which:

has been actively conducted (though not necessarily by the redeeming
corporation) for a period of at least 5 years prior to the redemption;
and

was not acquired in a taxable or partially taxable transaction by the
redeeming corporation within the preceding five years.
These requirements ensure that a taxpayer cannot cause a controlled corporation to invest
its E&P in a targeted business before distributing it to her in order to avoid treatment of the
distribution as a dividend.
Example 20: Sharon owns 100 percent of the stock of Reynolds Corporation.
Reynolds has earnings and profits of $1,000,000. This year, Sharon decided
to buy an apartment complex near the local university. In order to buy the
1 Reg. Sec. 1.346-1. Note that the requirements for treatment as a partial liquidation are found in the regulations
under Section 346, which defines corporate liquidations, while the regulations dealing with the requirements for
treatment as a substantially disproportionate distribution or a complete termination of the shareholder's interest
are provided under Section 302.
13
complex, which is listed for sale at $485,000, Sharon plans to use corporate
funds. She does not, however, want title to the apartment complex to be held
in the corporation's name. She also does not want to withdraw corporate
funds to purchase the complex because any distribution to her will be taxable
as a dividend. Instead, she decides to have the corporation purchase the
apartment complex and subsequently distribute it to her in partial liquidation
of the corporation's business activities. Under Section 302(e), this scheme will
not work. Operation of the apartment complex does not constitute the active
conduct of a trade or business. Moreover, even if operation of the complex did
constitute an active trade or business, the complex was purchased by the
corporation in a fully taxable transaction within five years of its distribution to
Sharon.
Example 21: Wilson Manufacturing Co. is wholly-owned by Fred Wilson. Prior
to this year, the company was involved in two lines of business. In its plant in
Des Moines, Idaho, Wilson manufactured tractor parts. In a separate plant in
Texas, the company manufactured feed supplements for the cattle industry.
This year, Fred decided that the company should concentrate its efforts on
the manufacture of tractor parts. To this end, Wilson Manufacturing sold its
feed supplement operations to a competitor. About half of the proceeds from
the sale were invested in an expansion project at the tractor parts plant. The
remainder of the proceeds was distributed to Fred in redemption of 10
percent of his Wilson stock. Both the tractor and the feed operations have
been conducted by Wilson for more than five years prior to the sale of the
feed supplement business. The distribution to Fred will be treated as a partial
liquidation eligible for treatment as a sale.
Note that a distribution in partial liquidation is treated as a qualified redemption only by
individual shareholders. A distribution to a corporate shareholder in partial liquidation of the
distributing corporation will be treated as a dividend distribution2.
Example 22: S, Inc. is owned 60 percent by Jill Gray and 40 percent by Blue
Corporation. This year, S sold one of its 2 lines of business and distributed the
proceeds to Jill Gray and Blue Corporation in redemption of a portion of their
shares in S. Assuming that both of S's lines of business were qualified
businesses, the distribution to Jill will be treated by her as received from the
sale of part of her S stock back to S. The distribution to Blue Corporation, on
the other hand, will be treated by Blue as a dividend distribution even though
Blue is surrendering a portion of its stock in exchange for the distribution.
Blue will be able to shelter 80 percent of this distribution from taxation by
using the dividends received deduction.
Redemptions Outside the Safe Harbors--The Dividend Equivalency
Standard
2 Sec. 302(b)(4)(A).
14
A stock redemption does not necessarily have to satisfy the requirements of any of the
above safe harbor provisions to qualify for sale treatment. Under Section 302(b)(1), a
redemption will be treated as a sale of stock so long as it is "not essentially equivalent to a
dividend." The safe harbors described in the preceding sections identify three types of
redemptions which will be deemed to satisfy this requirement. Where a stock redemption
does not satisfy the provisions of any of the safe harbors, treatment as a sale vs. dividend
will depend on the facts and circumstances particular to the redemption transaction.
The standard to be applied in determining whether the redemption qualifies for sale
treatment is whether it results in a "meaningful reduction" in the shareholder's interest in
the corporation after application of the constructive ownership rules of Section 3183.
The underlying premise of the Section 318 attribution rules is that related parties will act in
accordance with common objectives so that it does not matter which of the related
shareholders actually owns the stock. In cases involving family disharmony, where
members of a family are hostile to one another, this premise may be unfounded.
Nevertheless, the Fifth Circuit has ruled that the Section 318 attribution rules are applied
mechanically, regardless of the hostility between family members. In David Metzger Trust et
al. vs. Commissioner, CA-5, 82-2 USTC ¶9718, 693 F2d 459, affirming 76 TC 42, Dec.
37,614, the court noted the difficulty faced by courts and the IRS in determining the
"pattern, intensity and predicted duration of a family fight," and refused to waive the family
attribution rules even in the face of family discord. Given the difficulty of analyzing the
relationships among family members, the court praised the "fixity" of the family attribution
rules as a strength rather than a weakness. This decision, though inconsistent with an
earlier ruling of the First Circuit,4 has subsequently been adopted by the Tax Court5 and the
IRS.6
The Internal Revenue Service has indicated that the following factors should be considered
in determining whether a redemption results in a meaningful reduction in the shareholder's
interest:

whether the redemption affects the shareholder's "ability to control"
the corporation;

whether the redemption affects the shareholder's future interest in the
corporation's earnings; and

whether the distribution affects the shareholder's rights upon
liquidation of the corporation.7
The first factor is consistent with the requirements for qualification as a substantially
disproportionate redemption, suggesting that no redemption which leaves the recipient
shareholder in control of the redeeming corporation will be deemed to substantially reduce
3 U.S. vs. Maclin P. Davis 20 AFTR 2d 5515, 09/15/1967
4 Robin Haft Trust v. Commissioner, CA-1, 75-1 USTC &9209, 510 F2d 43, vacating and remanding 61 TC 398,
Dec. 32,400.
5 See M.N. Cerone v. Commissioner, 87 TC 1, Dec. 43,144.
6 See Revenue Ruling 80-26, 1980-1 CB 66.
7 Revenue Ruling 75-502, 1975-2 CB 111.
15
the shareholder's interest in the corporation. Thus, for example, where a corporation
redeems shares held by its sole shareholder, the redemption will always be treated as a
dividend (unless the redemption results from a qualified partial liquidation).
It is possible, however, for a redemption to qualify for sale treatment where it prevents the
recipient-shareholder from acting in concert with another shareholder to control the
corporation. Moreover, the redemption may qualify for sale treatment even if it would not
satisfy the provisions of the substantially disproportionate redemptions safe harbor
(because it does not result in more than a 20 percent decrease in the shareholder's interest
in the corporation).
Example 23: J Corp is owned by 4 shareholders as indicated below:
A
B
C
D
Total shares outstanding
280
240
240
240
1,000
shares
shares
shares
shares
shares
None of the four shareholders, all individuals, are related. Although none
individually possesses enough shares to control the corporation, A can act in
concert with any other shareholder to exert control (A's 270 shares, when
combined with any other shareholder's 240 shares, results in 52 percent
control). Thus, A can control the corporation merely by convincing one other
shareholder to side with her.
Early this year, A needed money. J Corp redeemed 50 of her 280 shares for
$250,000 cash. The redemption will not qualify as a substantially
disproportionate redemption because A's interest in J Corp is not reduced by
more than 20 percent. (A's interest would have to be reduced to less than
22.4 percent--80% x 28%--to qualify). However, the redemption eliminates
A's ability to act in concert with any other single shareholder to control the
corporation. After the redemption, A will have to convince at least two of the
remaining three shareholders to side with her in order to exert control over J
Corp. Thus, the redemption significantly reduces A's "ability to control" J
Corp, and should be treated as a sale of her stock back to J, rather than as a
dividend.
Note that in order to avoid dividend equivalence, the redemption itself must cause a
diminution in the shareholder's ability to control the corporation. In the above example, if A
had owned only 240 shares of J stock before the redemption, any group of two shareholders
(A and B, A and C, or A and D) would have had insufficient voting power to control the
corporation. The votes of at least three shareholders would be necessary to exceed 50
percent control. Accordingly, any redemption of A's stock likely would have to satisfy one of
the safe harbors to be treated as a stock sale.
The other two factors indicated by the Service (relating to the redemption's impact on the
shareholder's future interest in corporate profits or corporate assets) are most likely to arise
in cases involving the redemption of preferred stock. Since preferred shares generally do
not entitle their holder to vote on corporate management issues, redemption of preferred
16
shares generally will not affect the shareholder's ability to control the corporation.
Nonetheless, if the redemption of preferred shares significantly affects the shareholder's
future interest in corporate profits and/or assets, the redemption will qualify for sale
treatment.
Example 24: J and D each own 50 percent of R Corporation's outstanding
common stock. In addition, J owns 200 shares of R Corporation preferred
stock, giving her a preferential interest in R Corporation's income and assets
upon liquidation. J and D are not related. D has no preferred shares. This
year, R Corporation redeemed all of J's preferred shares for $200,000.
Although the redemption does not affect J's interest in the voting stock of R
Corporation, it may still qualify for sale treatment if it substantially alters her
interest in R's income and assets. This determination, in turn, would depend
on the relative magnitude of the preferred stock rights when compared to the
rights to income and assets accorded common shareholders.
A factor which is not considered in determining whether a stock redemption is essentially
different from a dividend is the business motive for the redemption. Thus, if a redemption
does not qualify for sale treatment under one of the safe harbors (substantially
disproportionate redemption, complete termination of shareholder's interest, or partial
liquidation), and does not affect her control of the corporation, nor her interest in corporate
income or assets, it will be treated as a dividend distribution even if motivated by a sound
business purpose.
The Supreme Court has ruled that the existence of a valid business purpose for a stock
redemption has no bearing on the tax treatment accorded the transaction.
In Maclin P. Davis v. Commissioner (ibid), the taxpayer was the largest shareholder in a
family-owned corporation. All the other shares in the corporation were owned by the
taxpayer's spouse and his children. In order to satisfy certain working capital requirements
necessary to receive a loan, Mr. Davis purchased 1,000 shares of preferred stock. It was
understood that the preferred stock would be redeemed by the corporation as soon as the
loan was repaid. Upon repayment of the loan, the preferred stock was redeemed. Applying
the constructive ownership rules, Mr. Davis was deemed the constructive owner of all the
company's stock both before and after the redemption. Accordingly, the Supreme Court
ruled that the redemption was properly taxable as a dividend, even though it was motivated
by a legitimate business purpose rather than for reasons of tax avoidance.
Example 25: The outstanding stock of Tico, Inc. is owned by the following
shareholders:
Marty
Sherry
Terry
MST, Inc.
Shares Owned
1,000 shares
750 shares
750 shares
500 shares
Tax Basis
$150,000
$115,000
$115,000
$ 75,000
Marty and Sherry are married. Terry is Marty's brother. In addition to their
shares in Tico, Marty, Sherry and Terry each own one-third of the shares of
MST, Inc. This year, Tico redeemed all of Sherry's Tico stock for $200,000.
Tico's E&P at the date of the redemption was $750,000.
17
Prior to the redemption, Sherry is deemed the constructive owner of Marty's
stock, both in Tico Corporation and MST, Inc. As a result, she is deemed a
controlling shareholder (two-thirds stock ownership) of MST, Inc. and is
attributed two-thirds or 367 shares, of MST's stock in Tico. Accordingly, the
redemption does not qualify as a complete termination of Sherry's interest in
Tico, even though the family attribution rules are waived for purposes of this
determination. The redemption also fails to qualify as a substantially
disproportionate redemption. Prior to the redemption, Sherry is deemed the
constructive owner of all 1,000 shares of stock owned by Marty, and 367
shares owned by MST, Inc., in addition to her own 750 shares, giving her a
total interest of 2,119 shares, or 70.57 percent (2,117 ÷ 3,000). After the
redemption, she will be deemed the constructive owner of 1,367 shares
(1,000 from Marty, plus 367 from MST). However, there are now only 2,250
shares outstanding, so that Sherry's interest leaves her in control of Tico
(1,367 shares ÷ 2,250 shares outstanding = 60.75 percent). Accordingly, the
redemption fails to satisfy the requirements for treatment as a substantially
disproportionate redemption. The redemption also fails to reduce Sherry's
ability to control the corporation. Thus, it is essentially equivalent to a
dividend.
Section 303: Redemptions to Pay Death Taxes
Stock Must Constitute Significant Portion of Estate
Certain redemptions to pay death taxes are treated as sales of stock regardless of their
effect on the shareholders' relative interests in the corporation. Under Section 303, if stock
in a closely held corporation comprises a significant portion of a decedent's estate, a
redemption by the corporation of stock held by the estate or its beneficiaries may be treated
as a sale. In enacting Section 303, Congress acknowledged that corporate funds may be
necessary in these cases to pay the estate tax. Section 303 applies when the value of stock
included in the decedent's gross estate exceeds 35 percent of the net value of the estate
after allowances for funeral and administrative expenses, certain losses, and other claims
against the estate.
Where the decedent owned stock in two or more corporations, all blocks constituting at
least a 20 percent interest in a particular corporation are aggregated for purposes of
determining compliance with the 35 percent threshold.
Example 26: A died this year, leaving behind an estate with a net value of
$2.5 million. Included in A's estate were shares of stock in the following
corporations:
Shares
Value of
Corporation
Shares Owned
Outstanding
A's Interest
X Corp
Y Corp
Z Corp
10,000
50,000
1,000
30,000
100,000
20,000
18
$250,000
$500,000
$200,000
Total Value
$950,000
For purposes of determining whether Section 303 applies, the estate can
aggregate A's shares in Corporations X and Y, in which A owned 33 percent
and 50 percent respectively. Corporation Z, in which A owned only a 5
percent block, is disregarded. Since the X and Y stock together constitute only
30 percent of the net value of A's estate ($750,000 ) $2,500,000), Section
303 will not apply. The tax treatment of any redemptions of X or Y stock will
therefore depend on whether the redemption satisfies one of the safe harbors
of Section 302, or is otherwise not essentially equivalent to a dividend.
Qualified Redemption Limited to Taxes and Funeral Expenses
Where Section 303 does apply, sale treatment extends only to that portion of the
redemption the proceeds of which do not exceed the aggregate of all federal and state
estate and inheritance taxes, plus funeral and administrative expenses incurred by the
estate. Moreover, because the purpose of Section 303 is to allow the estate (or
beneficiaries) to use corporate funds to pay the estate tax liability, the redemption must
occur within 90 days after the expiration of the period for assessing the federal estate tax in
order for Section 303 to apply.8
Example 27: W died this year, leaving a net estate valued at $5 million.
Included in this amount was a block of stock in a family-owned corporation
with a gross value of $4 million. Estate and inheritance taxes (federal and
state) totaled $2,450,000. Funeral and administrative expenses totaled
$150,000. Shortly after W's death, the family corporation redeemed 75
percent of the stock held by the estate for $3 million. Under Section 303, $2.6
million of the redemption proceeds are treated as proceeds from a sale of the
stock to pay death taxes (the total of the estate and inheritance taxes,
funeral and administrative expenses). The remaining $400,000 of the
redemption proceeds will be treated as dividend income unless the
redemption can be shown to have meaningfully reduced the estate's interest
in the corporation. (Remember that any stock owned by the beneficiaries will
be attributed to the estate for purposes of this determination).
Consequences to the Shareholder
Although the purpose of Section 303 is to allow the estate, or the beneficiaries, to use
corporate funds to help pay the taxes and/or funeral and administrative expenses incurred
as a result of the decedent's death, the statute does not require that any of the redemption
proceeds actually be used for that purpose. Even where the estate has sufficient liquidity to
pay all necessary expenses, it is often beneficial to redeem stock under Section 303. The
benefit derives from the step-up in the basis of the estate assets allowed under Section
1014. Since estate assets are stepped up to their fair market value as of the decedent's
date of death (or an alternate valuation date six months later if applicable), a stock
redemption under Section 303 is generally a nontaxable transaction to the shareholder (the
8 Sec. 303(b)(1). Note that this period can be extended if the estate petitions the Tax Court for resolution of a
disagreement with the IRS, or elects to pay the estate tax liability in installments.
19
estate or beneficiary). Accordingly, in many cases, it is beneficial to redeem as much stock
as allowable under Section 303 even if the proceeds are not needed to pay taxes or other
estate expenses.
Example 28: H died this year, leaving a $2 million net estate. Included in the
net estate are 1,000 shares of a family-owned corporation valued at $1
million. The balance of the estate consists of $750,000 in life insurance
proceeds and $250,000 in other assets. Under §1014, the estate will take a
basis in the family stock equal to its $1 million value. Assume estate taxes
and funeral and administrative expenses total $800,000. A redemption of 80
percent of the family corporation stock will be treated as a sale of such stock
back to the corporation under Section 303, even though the redemption
proceeds are not necessary to pay the taxes and other expenses. Moreover,
since the basis of the stock to the estate will be equal to its $800,000 value
(only 80 percent of the stock is being redeemed), no gain or loss will be
recognized for income tax purposes as a result of the redemption.
Example 29: Estelle owned 100 percent of the stock of E Inc. when she died.
The value of Estelle's E stock was $2.2 million. Her net estate (after funeral
and administrative expenses) was valued at $4 million. The estate tax liability
on her estate was $1,900,000. Funeral and administrative expenses totaled
$250,000. During the administration of the estate, E Inc. redeemed half the
shares held by the estate for $1,100,000. Of this amount, $700,000 was used
to pay the estate tax liability. The remainder was invested in U.S. Treasury
bonds. E, Inc. had E&P at the date of the redemption of $1,200,000.
Under Section 303, the redemption of stock held by the estate, or
beneficiaries thereof, will be a qualified redemption regardless of its effect on
the shareholder's interest in the corporation. To qualify, the decedent's stock
in the redeeming corporation must constitute at least 35 percent of the net
value of the estate after payment of funeral and administrative expenses, and
the redemption must occur within 6 months of the due date for payment of
the estate tax liability. Although Section 303 applies only to the extent the
redemption proceeds do not exceed the sum of the estate tax liability, funeral
and administrative expenses, it does not require that the redemption
proceeds be used to pay these expenses. Here, the value of the E stock
constitutes 55 percent of the value of the net estate ($2.2 million ÷ $4
million). The redemption proceeds do not exceed the estate tax liability. Thus,
the redemption qualifies for sale treatment under Section 303. Since the tax
basis of the estate's E shares equals their value at the date of Estelle's death
($1.1 million), no gain is recognized on the redemption.
20
Tax Consequences of Corporate Redemptions
Individual Shareholders
As noted previously, a qualified redemption is treated by individual shareholders as a sale of
their stock back to the corporation. Accordingly, they recognize capital gain or loss equal to
the excess of the redemption proceeds over their basis in the redeemed shares. Their basis
in remaining stock is reduced by the basis allocable to the redeemed shares.
Example 29: Ralph owned 1,200 shares in RM, Incorporated. His basis in his
RM stock was $125,000. This year, RM redeemed 40 percent of Ralph's stock
for $150,000 in a qualified redemption under §302(b)(2) (substantially
disproportionate redemption). Ralph's basis in the redeemed shares was
$50,000. He must recognize a capital gain of $100,000 ($150,000 redemption
proceeds less $50,000 basis in redeemed shares). Note that the maximum
tax rate on this gain is 15 percent. Ralph's basis in his remaining RM shares
will be $75,000 ($125,000 less $50,000 basis in redeemed shares).
If the stock redemption does not qualify for treatment as a sale, the shareholder must
recognize dividend income to the extent of her share of corporate E&P. The shareholder's
basis in remaining shares in this case is increased by the basis allocated to the surrendered
shares. The result in most cases is that the shareholder's total stock basis remains
unchanged. However, if the distribution exceeds corporate E&P, so that a portion is treated
as a return of capital, the shareholder's total stock basis will be reduced by the return of
capital. In either case, the shareholder's per share basis in the remaining shares will
generally increase.
Example 30: V owns all 1,000 shares of the stock of Vero Corp. V's basis in
her Vero shares is $150,000. Vero's E&P is $105,000. This year, Vero
redeemed 500 of V's shares for $125,000. The redemption was not the result
of a partial liquidation. Moreover, since V is the sole shareholder of Vero, the
redemption did not affect her interest in the company. She must recognize
$105,000 of dividend income (limited to corporate E&P). The remaining
$20,000 of the distribution is a nontaxable return of capital, reducing her
basis in her stock to $130,000 ($150,000 original basis less $20,000 return of
capital). This basis is allocated among her remaining shares, leaving her with
a basis, per share of stock, of $260 ($130,000 total stock basis ÷ 500
remaining shares).9
Corporate Shareholders
The consequences to corporate shareholders of a qualified redemption are generally the
same as those for individual shareholders, except that there is no cap on the tax rate
applied to corporate capital gains. Recall, however, that a redemption in partial liquidation
9 Note that when a shareholder surrenders all her stock in a nonqualified redemption, her stock basis is allocated
to the basis of stock held by others whose shares are attributable to the distributee-shareholder under Section 318.
See Reg. Sec. 1.302-2(c).
21
of the redeeming corporation is not treated as a sale of stock by corporate shareholders.10
Instead, corporate shareholders treat redemptions in partial liquidation as dividend
distributions eligible for the dividends received deduction.
Under §1059(e), these dividends must be treated by corporate shareholders as
extraordinary dividends. Accordingly, corporate shareholders must reduce their bases in
remaining shares by the dividends-received deduction taken with respect to the redemption.
Example 31: X Corporation owns 50 percent of the stock (10,000 shares) of
GX, Incorporated. GX has E&P of $600,000. X's basis in its GX stock is
$400,000. This year, GX redeemed 2,000 of the shares held by X for
$200,000 in a qualified partial liquidation under Section 302(b)(3). Although
the redemption qualifies as a partial liquidation, as a corporate taxpayer, X
treats the $200,000 distribution as a dividend. As a 50 percent shareholder in
GX, X is entitled to a dividends received deduction equal to 80 percent of the
amount received, or $160,000. Under Section 1059(e), X must reduce its
basis in the GX stock by a like amount. Accordingly, X's basis in its remaining
GX shares is $240,000 ($400,000 less $160,000 dividends received
deduction).
Consequences to the Redeeming Corporation
Distributions in redemption of corporate stock are not subject to special treatment for the
redeeming corporation. Under §311, if the corporation distributes property in redemption of
its stock, the redeeming corporation must recognize gain, but not loss, as if the property
had been sold at fair market value. Gain must be recognized whether the distribution is
treated as a qualified redemption or as a dividend. Corporate E&P must be adjusted to
reflect the gain.
Corporate E&P is also adjusted to reflect the distribution. If the distribution is not treated as
a sale or exchange (i.e., is not a qualified redemption), corporate E&P must be reduced by
the portion of the distribution treated as a dividend. If the distribution qualifies for sale
treatment, the distributing corporation's E&P is reduced by the lesser of:

the fair market value of the distributed property (including cash); or

the portion of the corporation's E&P attributable to the redeemed
shares (the ratio of the fair market value of the redeemed shares
divided by the total fair market value of the corporation's outstanding
stock).11
Example 32: Jones Corporation has 100,000 shares of stock outstanding. Its
E&P is $750,000. This year, it distributed property worth $125,000 (basis
$70,000) and $75,000 cash to its shareholders in redemption of 20 percent of
their stock. The redemption qualified as a partial liquidation. Jones has no
corporate shareholders. The distribution affects Jones in two ways. First, it
10 Sec. 302(b)(3).
11 Sec. 312(n)(7).
22
must recognize a $55,000 gain on distribution of the property ($125,000
value less $70,000 basis). The gain increases Jones' E&P to $805,000. Next,
it must reduce E&P by the lesser of the fair market value of the distributed
property, including cash ($200,000 total value) or the portion of the E&P
attributable to the redeemed shares (20 percent). In this case, the portion of
E&P attributable to the redeemed shares, $161,000, is less than the fair
market value of the distributed property, so Jones' E&P is reduced to
$644,000 ($805,000 - $161,000) after the redemption.
Example 33: Jacob and Helen Finch, brother and sister, each own 50 percent
(1,000 shares) of the stock of Finchmasters Corp. This year, Finchmasters
redeemed 400 of Jacob's shares, in a qualified redemption, in exchange for
land valued at $300,000 (basis $175,000). The corporation's E&P prior to the
redemption was $350,000.
Finchmasters must recognize a $125,000 gain on distribution of the property
as if it had been sold for $300,000. This gain increases the corporation's E&P
to $475,000. This balance must then be reduced to reflect the redemption.
Finchmasters' E&P is reduced by the lesser of the amount of the distribution
($300,000), or the amount attributable to the redeemed shares. The
redemption involved 20 percent of the company's stock (400 shares ÷ 2,000
shares outstanding). Twenty percent of Finchmasters' $475,000 E&P balance
is $95,000. Thus, Finchmasters' post-redemption E&P is $380,000.
Anti-Abuse Provisions
Section 306--Preferred Stock Bailouts
Section 306 was implemented to discourage the use of certain preferred stock transactions
designed to allow shareholders to withdraw corporate E&P without reducing their interests in
the corporation. The specific transaction targeted by Section 306 involves the issuance by a
corporation of preferred stock as a tax-free stock dividend, followed by a sale or redemption
by the shareholder of the preferred stock received.
Example 34: J is the sole shareholder of Jenkins Corporation. Jenkins has
E&P of $500,000. J's basis in Jenkins stock is $130,000. The fair market value
of the Jenkins stock is $1,000,000. On August 1 this year, Jenkins distributed
nonvoting preferred stock worth $250,000 to J as a nontaxable stock
dividend. J recognizes no gain on the distribution and allocates one-fifth of his
common stock basis, or $26,000, to the preferred shares ($250,000 ÷
($1,000,000 + $250,000)). J subsequently sold the preferred stock to his
sister, K, for its $250,000 value. Shortly thereafter, Jenkins Corporation
redeemed the preferred shares held by K for $250,000. Since K's basis in the
preferred shares was $250,000, she recognizes no gain on the redemption.
Combining the three transactions, the net effect is a transfer by Jenkins
Corporation of $250,000 to J (through K). Both before and after the
distribution, J owned 100 percent of Jenkins' voting stock. Section 306
requires that the consequences of this transaction, and others like it, be
23
determined by reference to the combined net effect of the three transfers,
rather than viewing each transfer as a separate transaction.
Sale of Section 306 Stock
Section 306 generally applies when a shareholder sells preferred stock received as a
nontaxable stock dividend, or when the corporation issuing such preferred stock
subsequently redeems it.12 When the shareholder sells these "tainted" shares of preferred
stock (hereafter referred to as Section 306 stock), the proceeds from the sale will be
taxable as ordinary income, but only to the extent of the dividend income which would have
been recognized by the shareholder had the corporation distributed cash to the sellershareholder rather than Section 306 stock.13 Thus, the seller will recognize ordinary income
equal to the lesser of the amount realized from the sale of the Section 306 stock, or the
issuing corporation's E&P at the date on which the Section 306 stock was distributed to the
shareholder.
Example 33: Consider the facts in Example 32 above. J's sale of the
preferred stock to K for $250,000 will trigger $250,000 of ordinary income to
J. His basis in the preferred stock will be reassigned to his common shares,
leaving him with a basis in the common shares of $130,000, the same as
before the distribution of the preferred stock dividend. Note that had J sold
the preferred shares to K for $600,000, his ordinary income under Section
306 would have been limited to $500,000, Jenkins Corporation's E&P at the
date of the preferred stock dividend to J.
Although the selling shareholder recognizes ordinary income in the same amount as if a
cash distribution had been received in lieu of the preferred stock dividend, the sale by such
shareholder of the preferred shares is not treated as a dividend by the corporation. The
corporation's E&P balance is not affected. If, however, the corporation subsequently
redeems the preferred stock from the buyer, E&P is reduced at that time by the portion
attributable to the redeemed shares. Recall from part E.3, however, that the reduction in
E&P cannot exceed the fair market value of the property, including cash, distributed in
redemption of the preferred shares.
Example 34: Again consider the facts from Example 28. Shortly after K
purchased the preferred stock from J for $250,000, the corporation redeemed
K's newly acquired preferred shares for the same price. Recall that the value
of the preferred stock was $250,000, and that the total value of all the
Jenkins stock outstanding was $1,250,000 ($1,000,000 common stock, plus
the $250,000 in preferred). The redemption of K's preferred stock (which
completely terminates K's interest in the corporation) is a redemption of onefifth of Jenkins' stock (by value). Its E&P must therefore be reduced by the
lesser of 20 percent (one-fifth) or $250,000 (the redemption price). Assuming
that Jenkins E&P immediately prior to the redemption of K's preferred stock
remained $500,000, the redemption will reduce Jenkins' E&P to $400,000.
12 Section 306 also applies to the sale or redemption of stock received in exchange for "tainted" shares of
preferred stock. See Sec. 306(c) for a list of specific types of stock to which the statute applies.
13 Sec. 306(a)(1).
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Redemption of Section 306 Stock
An alternative to selling the Section 306 stock to a third party is for the issuing corporation
to subsequently redeem the preferred shares from the distributee-shareholder (J in the
above Example). In this case, Section 306 treats the redemption of the tainted stock as a
distribution that is essentially equivalent to a dividend (i.e., a nonqualified redemption).14 As
a dividend, the redemption of Section 306 stock, unlike the sale of such stock to a third
party, will cause a reduction in the redeeming corporation's E&P.
Example 35: The stock of McAlex Incorporated is owned equally by unrelated
individuals A and B. This year, when the company's E&P was $375,000,
McAlex distributed 500 shares of nonvoting preferred stock to each
shareholder as a nontaxable stock dividend. A took a basis in her preferred
stock of $50,000. The preferred stock was valued at $175,000. On December
31, McAlex redeemed all of A's preferred shares for $175,000 cash. None of
B's preferred shares were redeemed at that time. Nonetheless, regardless of
the effect of the redemption on A's interest in the corporation's future profits,
or in its assets, the payment to A will be treated as a dividend distribution
under Section 306. A will recognize $175,000 dividend income and McAlex will
reduce its E&P by $175,000. A's basis in the preferred shares redeemed by
McAlex will be added to her basis in her remaining common stock.
Exceptions--Transactions to which Section 306 will not apply
Under §306(b), the provisions of §306 do not apply to the sale or redemption of Section
306 stock in the following situations:

the sale or redemption completely terminates the shareholder's
interest in the corporation;

the redemption of Section 306 stock is the result of a qualified partial
liquidation as described in Section 302(b)(4);

the shareholder exchanges Section 306 stock for other stock in a
nontaxable transaction (typically associated with tax-free corporate
reorganizations); or

the sale or redemption of Section 306 stock was not motivated by tax
avoidance purposes.
Note that a sale (as opposed to a redemption) which completely terminates a shareholder's
interest in the corporation is exempted from Section 306 only if the buyer is not a related
party to the seller as defined in Section 318. Note also that where the shareholder
exchanges Section 306 stock for other stock in a nontaxable exchange, although Section
306 is not triggered, the replacement stock becomes Section 306 stock.
14 Sec. 306(a)(2).
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Example 36: Kerry owns 25 percent of the outstanding stock of KC, Inc. The
remaining 75 percent of KC shares are owned by Kerry's parents and
grandparents. Last year, KC distributed 100 shares of preferred stock to Kerry
as a nontaxable stock dividend. At the date of the distribution, KC's E&P
totaled $650,000. Kerry took a basis in the preferred stock of $15,000. This
year, KC redeemed all of Kerry's preferred stock (received in the prior as a
stock dividend) for $75,000. If none of Kerry's common stock in the
corporation is redeemed, the transaction will be treated as a $75,000
dividend. On the other hand, if KC also redeemed all of Kerry's common
stock, in addition to her preferred shares, Section 306 will not apply and the
transaction will be treated as a qualified redemption (i.e., a sale of Kerry's
stock back to KC) in its entirety.
Example 37: Assume in Example 36 above that rather than having KC
redeem all her stock, Kerry sold her entire interest (including her common
shares) to her father for $250,000. Of this amount, $75,000 was received for
her preferred shares and $175,000 for her common shares. As noted in
Example 32, Kerry's basis in the preferred stock was $15,000. Assume her
basis in the common stock was $35,000. Although the sale completely
terminates Kerry's interest in KC, the buyer is a related party under Section
318. Accordingly, Section 306 is not waived, and Kerry must recognize
$75,000 ordinary income on the sale (the sales price of the preferred stock).
Her basis in the preferred is added back to her basis in the common shares,
increasing that basis to $50,000. Thus, the sale of the common stock triggers
a $125,000 capital gain. KC's E&P balance is not affected by the sale.
Section 304--Redemptions Using Related Corporations
Similar rules apply when a taxpayer sells stock in a controlled corporation to a related
corporation. Under Section 304, the structure of the transaction is disregarded, and the tax
consequences are determined by reference to the underlying economic substance. There are
two types of related corporation transfers governed by Section 304: Brother-Sister
redemptions, and Parent-Subsidiary redemptions.
Brother-Sister Redemptions
In a brother-sister redemption, the taxpayer sells stock in one controlled corporation to
another corporation also controlled by the taxpayer. Although neither entity owns stock in
the other, they are related by virtue of being controlled by the same shareholder or group of
shareholders.
Example 38: Jim owns 100 percent of the stock of both B Corporation and S
Corporation. Jim's basis in his B stock (500 shares) is $100,000. His basis in
his S stock (100 shares) is $150,000. B has E&P of $250,000. S has E&P of
$300,000. On June 1, Jim sold 40 percent of his B shares (200 shares) to S
for $225,000. His basis in the B shares sold was $40,000. Although the
transaction is structured as a sale of stock, Jim's interest in B Corporation is
not affected by the stock transfer. As the sole shareholder of S Corporation,
26
Jim still controls the B shares held by S. Thus, just as before the transfer, Jim
owns 100 percent of the stock of B. As a result, Section 304 disregards the
structure of the transaction and prohibits Jim from treating the transfer as a
sale.
Under Section 304, the sale of stock in one controlled corporation to another controlled
corporation (a brother-sister redemption) is treated as a two-step transaction:

First, the purchasing corporation is deemed to have issued new shares
of its own stock to the shareholder in exchange for stock in the related
corporation;

Second, the purchasing corporation is treated as if it immediately
redeemed the newly issued shares for a cash payment equal to the
purchase price.
Example 39: Reconsider Example 38. Jim's transfer of 200 shares of B stock
to S Corporation will be treated as occurring in a two-step transaction. First,
Jim will be deemed to have contributed the B stock to S in exchange for
additional S shares. Since Jim's basis in the B stock was $40,000, the
contribution increases his basis in his S stock by $40,000. S takes a $40,000
basis in the B stock received (rather than $225,000, the amount "paid" for
such stock). S is then treated as if it immediately redeemed the newly issued
shares for $225,000. Since Jim owns 100 percent of S's outstanding stock
both before and after the redemption, the $225,000 payment to Jim will be
treated as a dividend, paid from S's E&P.15 S's E&P is reduced to $75,000
($300,000 beginning balance less $225,000 dividend). Jim's basis in his S
stock remains at $190,000 ($150,000 original basis plus $40,000 basis
acquired on deemed contribution to S). His basis in his B stock is $60,000
($100,000 original basis less $40,000 transferred to S).
Parent-Subsidiary Redemptions
The second type of related corporation transfer covered by Section 304 is the ParentSubsidiary redemption. In a parent-subsidiary redemption, the taxpayer sells stock in a
controlled corporation (the Parent) to a subsidiary of the same corporation. Since the
taxpayer controls the parent, and the parent controls the subsidiary, the sale generally has
no meaningful effect on the taxpayer's interest in the Parent.
Example 40: Paula owns 100 percent of the stock of P Corporation (1,000
shares). P owns 100 percent of the stock of S Corporation (500 shares).
Paula's basis in her P stock is $100,000. P's basis in its S stock is $150,000. P
has E&P of $325,000 and S has E&P of $175,000. On June 1, Paula sold 20
percent of her P stock (200 shares) to Corporation S for $200,000. Although
this transaction is structured as a sale of stock, Paula's interest in Corporation
P is not affected by the stock transfer. Indeed, since P owns 100 percent of
15 Note that under Section 304(b)(2), if the payment to Jim exceeded S's E&P, it would then be deemed to come
from B's E&P. The net result is that Jim recognizes dividend income to the extent the payment from S does not
exceed the combined E&P of S and B Corporations.
27
the stock of Corporation S, the transaction is not economically distinguishable
from a sale of Paula's P stock back to P (i.e., a redemption by P of its own
stock). Accordingly, under Section 304, Paula must apply the rules of Section
302 (stock redemptions) to determine the tax consequences of this
transaction.
Consistent with the economic substance of such transactions, Section 304 treats the sale of
stock in a Parent Corporation to a subsidiary of the Parent as a redemption by the Parent of
its own stock from the seller-shareholder.
Example 41: Consider the facts of Example 40. Paula's sale of P stock to S is
treated as a redemption by P of its own stock. Since Paula owns 100 percent
of the stock of P both before and after the transaction, the redemption is not
essentially different from a dividend. Accordingly, Paula must recognize
$200,000 of dividend income. Corporation P must reduce its E&P to $125,000
($325,000 beginning balance less $200,000 dividend). Since the so-called
"sale" of P Corporation stock is disregarded, Paula's basis in the 200 shares of
Corporation P stock transferred is re-allocated to her remaining P shares.
Paula's basis in her remaining 800 P shares is $100,000 (increasing her pershare basis in the remaining P stock to $12.50 per share).
Example 42: Arthur Johnson owns all 10,000 shares of the outstanding stock
of Z Corporation. His basis in his Z stock is $125,000. Last year, Z distributed
1,000 shares of preferred stock to Arthur as a nontaxable stock dividend. Z's
E&P at the date of the stock dividend was $95,000. Arthur took a basis in the
preferred shares of $50,000 (reducing his basis in his common shares to
$75,000). In January, Arthur sold the preferred shares to a business associate
for $115,000. In April, Z redeemed the shares from the buyer for $120,000.
Z's E&P at the date of the redemption was $145,000.
Section 306(a)(1), which applies to the sale of Section 306 stock to a third
party, provides that the proceeds of the sale will be taxed to the seller as
ordinary income to the extent the seller would have recognized dividend
income had a cash distribution been received at the date of the preferred
stock dividend. Here, Z Corporation's E&P at the date of the dividend was
$95,000. Thus, Arthur must recognize $95,000 dividend income. Note that
the remaining $20,000 of the sales proceeds will be treated as a nontaxable
return of capital. Arthur's basis in his common shares after the sale will be
$105,000 ($75,000 + $50,000 allocable to the preferred stock, less $20,000
return of capital).
Assume that the preferred stock constitutes 40 percent of the total value of Z
Corporation's outstanding stock. The sale of the preferred stock by Arthur,
although generating a large amount of ordinary income to him, will not affect
Z's E&P. Upon redemption of the preferred stock held by the buyer, however,
Z must reduce its E&P by the lesser of the amount of the distribution
($120,000) or the portion of E&P attributable to the redeemed shares (40
percent). Here, 40 percent of the E&P balance is only $58,000 ($145,000 X
40 percent). Thus, Z must reduce its E&P to $87,000 ($145,000 - $58,000).
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