Overview – Corporate Stock Redemptions
Distributions in Redemption of Stock and Partial Liquidations: Synopsis
A dividend results in ordinary income to the extent of earnings and profits, whereas a sale or
exchange can result in the more preferential capital gain treatment. A sale or exchange typically
occurs when a shareholders sells stock to a third party. A transfer of the shares back to the
corporation also qualifies as a sale or exchange and is known as a "redemption." Consequently,
many corporations, especially closely held corporations, will seek to engineer a redemption that is
the functional equivalent of a dividend (payout of earnings and profits) with no practical loss in
voting power or control. Code Sec. 302 addresses this planning opportunity by specifying the
circumstances that will result in dividend income and those that, with proper planning, can result
in capital gain or exchange treatment.
Capital gain vs. ordinary income
A shareholder's transfer of shares to another person for full value is usually considered a sale. A
transfer of the same shares for the same price back to the issuing corporation, however, is not
necessarily a sale, but could be a redemption ( Code Sec. 304) or a liquidating distribution ( Code
Sec. 346). Historically, the underlying concern of Congress has been to limit the capital gain
benefits associated with a sale to a distribution which is "not essentially equivalent to a dividend."
For example, the sole shareholder of a closely-held corporation could easily forego annual
dividends and "sell" a portion of his holdings back to the corporation for an amount equivalent to
the accumulated earnings and profits. In substance, this is nothing more than the functional
equivalent of a dividend: earnings have been distributed with no change in ownership, control or
voting power.
Noncorporate shareholders may prefer capital gain treatment to dividend treatment if the
corporation has earnings and profits. If the redemption payments are treated as a dividend, the
entire amount paid will be taxable to the noncorporate shareholder if it does not exceed the
earnings and profits of the corporation. However, if the redemption is treated as an exchange of
stock, the amount received will generate capital gain (regardless of the corporation's earnings
and profits) only to the extent that it exceeds the shareholder's basis in the stock. Capital gain
treatment may also be advantageous in that capital gain can be fully offset by capital loss.
Ordinary income is limited to the extent that it can be offset by capital loss. Noncorporate
taxpayers may offset capital losses dollar-for-dollar against up to $3,000 of ordinary income
(¶30,392.01).
Corporate shareholders may prefer dividend treatment to sale or exchange treatment because of
the 80-percent dividends-received deduction (100 percent for dividends received from a small
business investment company or for qualifying dividends described in Code Sec. 243(b)(1) and
70 percent for corporations that own less than 20 percent of the distributing corporation) available
to corporations (see ¶13,057.01). All corporate capital gains, whether long-term or short-term, are
taxed at the corporation's regular tax rate, which can be as high as 35 percent.
Redemption defined
A stock redemption occurs when a corporation reacquires its stock in exchange for property,
whether or not the stock is canceled, retired, or held as treasury stock. The term "property"
means any property, including money, securities, and indebtedness to the corporation except
stock or rights to acquire stock in the corporation making the distribution.
The redemption of stock by a corporation can be treated as an exchange, rather than a dividend,
if one of four tests is met (see ¶15,330.023). These tests are described more fully below.
Redemption treated as exchange
A redemption of stock by a corporation can be treated as a distribution in part or full payment in
exchange for the stock ( i.e., a sale or exchange) and gains or losses to stockholders from such
redemptions will be capital gains or losses, rather than distributions under Code Sec. 301 (which
are usually dividends taxable as ordinary income), if any one of the following applies:
(1) the redemption is not essentially equivalent to a dividend ( Code Sec. 302(b)(1)) (
¶15,330.024);
(2) the redemption is substantially disproportionate with respect to the shareholder's actual
or constructive holdings ( Code Sec. 302(b)(2)) ( ¶15,330.025);
(3) the redemption terminates the shareholder's entire interest in the corporation Code Sec.
302(b)(3) ( ¶15,330.026); or
(4) the redemption is of stock held by a noncorporate shareholder and is made in partial
liquidation of the redeeming corporation Code Sec. 302(b)(4) ( ¶15,330.027).
Redemption treated as a dividend -- Adjustment to basis of remaining stock
In any case in which an amount received in redemption of stock is treated as a dividend rather
than a sale, the shareholder must adjust the tax basis of the remaining stock ( Reg. §1.302-2(c)).
The problem arises because the shareholder has surrendered shares in the redemption
transaction even though the redemption was not recognized for tax purposes. For example, if a
sole stockholder holds 1,000 shares of stock which cost him $100 a share, or $100,000, and half
the stock is redeemed for $150,000, which constitutes a dividend (there being at least $150,000
in available earnings and profits), the basis of the remaining 500 shares is still $100,000, or $200
a share. The same result would apply if a husband and wife together own all the stock, the wife's
having been acquired by gift from her husband. If all the husband's shares are redeemed in a
transaction amounting to a dividend in the amount of the entire proceeds of the redemption, the
basis of the wife's shares after the redemption is the entire basis of both husband's and wife's
shares before the redemption ( Reg. §1.302-2(c), Example 2
Qualified Redemptions --Code Sec. 302
Redemptions Not Essentially Equivalent to a Dividend – Code Sec. 302(b)(1)
To be "not essentially equivalent to a dividend" the redemption, after application of the
constructive ownership rules, must result in a meaningful reduction of the shareholder's
proportionate interest in the corporation ( M.P. Davis, SCt, 70-1 USTC ¶9289, at ¶15,330.1315).
This vague standard makes the determination dependent upon the facts and circumstances, and
does not easily lend itself to clear guidelines. For example, a minority shareholder in a large
publicly-held corporation received a dividend distribution where his proportionate interest in the
corporation prior to a tender offer by the corporation for its own stock was exactly the same as
after such offer was accepted and the stock redeemed, even though only about 10 percent of
shareholders tendered a portion of their stock to the corporation ( Rev. Rul. 81-289, at
¶15,330.1315). The redemption of a portion of a sole shareholder's stock will always result in the
transaction being classified as a distribution that is subject to the dividend rules of Code Sec. 301.
The same is generally true when the redemption is pro rata, particularly if there is only one class
of stock.
Factors to be considered in determining whether a reduction in a shareholder's proportionate
interest in a corporation results in a meaningful reduction include the shareholder's ability to
control the corporation, any retained right to a share of the corporation's earnings, and retained
rights upon liquidation of the corporation ( Rev. Rul. 75-502, at ¶15,330.1391 and M.G. Roebling,
Dec. 38,039, at ¶15,330.1535).
According to the IRS, a reduction from 90 percent to 60 percent was not a meaningful reduction
because the redeeming shareholder still had control of the corporation ( Rev. Rul. 78-401, at
¶15,330.1391). However, the U.S. Supreme Court has held that where a taxpayer's interest in the
surviving corporation of a reorganization was reduced 29 percent by a cash distribution and the
taxpayer held less than 50 percent of the voting stock after the reorganization, there was a
meaningful reduction in the taxpayer's proportionate interest in the corporation ( D.E. Clark, 89-1
USTC ¶9230, at ¶15,330.1633).
A meaningful reduction in ownership often results from a redemption that fails to qualify either as
a complete termination of a shareholder's interest or as a substantially disproportionate
redemption. See, ¶15,330.025 and ¶15,330.026. Some examples are:
(1) A redemption resulted in a reduction in the taxpayer's stock ownership from 27 percent
to 22 percent, leaving him with slightly more than 80 percent of the stock he formerly held
before the redemption but preventing him from exercising control over the corporation
even if he acted in concert with any one of the other three shareholders (all of whom
were unrelated to the taxpayer).
(2) A redemption resulted in a reduction in the taxpayer's stock ownership from 57 percent
to 50 percent, but left control of the corporation's stock equally divided between the
taxpayer and an unrelated individual ( Rev. Rul. 75-502, at ¶15,330.1391 and M.G.
Roebling, Dec. 38,039, at ¶15,330.1535).
(3) A redemption left a minor shareholder owning 96.7 percent of the stock he previously
held (due to the operation of the attribution rules) but represented only a fraction of the
corporation's total stock (several hundred out of 28 million) ( Rev. Rul. 76-385, at
¶15,330.1394).
Moreover, partial redemptions of nonvoting stock may qualify as redemptions that are not
essentially equivalent to a dividend ( Roebling, ¶15,330.1535). For example, redemption of
nonvoting, nonconvertible, nonparticipating preferred stock that is not "section 306 stock" and that
is owned by a person who does not own any common stock is not equivalent to a dividend ( Rev.
Rul. 77-426, as clarified by Rev. Rul. 81-41, at ¶15,330.1535).
In addition, redemptions of fractional shares may qualify as redemptions entitled to be treated as
a sale or exchange. For example, redemptions that result in the payment of cash for fractional
shares are not treated as potential dividend distributions where the cash is not a separately
bargained-for consideration but is paid by the corporation to avoid having fractional shares ( Rev.
Rul. 74-36, at ¶15,330.1305).
The stock attribution rules of Code Sec. 318 apply in determining whether a redemption is
essentially equivalent to a dividend (M.P. Davis, SCt, 70-1 USTC ¶9289, at ¶15,330.1315).
Consequently, for many closely held family corporations, the attribution rules will often prevent a
redemption from qualifying as not essentially equivalent to a dividend ( Rev. Rul. 55-515, at
¶15,330.1398). However, a dispute exists as to whether the stock attribution rules can be
mitigated by proof of antagonism between related parties (see ¶15,330.0248).
Code Sec. 302(b)(1): Attribution rules in family disputes
In its 1970 decision in M.P. Davis ( 70-1 USTC ¶9289, at ¶15,330.1315), the U.S. Supreme Court
held: (1) that the attribution rules of Code Sec. 318 apply in testing whether a stock redemption is
"essentially equivalent to a dividend" under Code Sec. 302(b)(1), and (2) that, in determining
dividend equivalence, the "business purpose" for the redemption is irrelevant. The test is simply
whether there has been a "meaningful reduction in the shareholder's proportionate interest", with
the reduction being considered after applying the attribution rules.
The Davis case by no means answered all of the difficult questions that arise under Code Sec.
302, and some commentators have argued that the decision might leave room for ignoring the
attribution rules in situations of family disharmony. The basic thought underlying the Sec. 318
attribution rules is that the parties among whom the ownership of stock is attributed will act in
concert and for the benefit of each other. This assumption, however, is arguably inappropriate in
cases where the parties are at sword's point.
In its pre- Davis decision in A.H. Squier Estate ( Dec. 24,715, at ¶15,330.1399), the Tax Court
refused to find dividend equivalence where 30% of the stock of an estate was redeemed, but
where --by virtue of the attribution rules --the proportionate interest of the estate was reduced
only from 63.30% to 56.81% (leaving the estate with control and with a post-distribution
proportionate interest that was 89.74% of its pre-distribution proportionate interest). A major
reason for the decision was the existence of a serious disagreement between the executor of the
estate and the stockholders whose stock was deemed to be owned by the estate under the
attribution rules. See also annotations at ¶15,330.132; H.C. Parker, Dec. 24,715, at
¶15,330.1399.
Although the Tax Court ( Robin Haft Trust, 75-1 USTC ¶9209, at ¶15,330.1399) has taken the
position that the family dispute rationale of Squier is inconsistent with Davis, the Court of Appeals
for the First Circuit, on appeal, ruled that family hostility can mitigate the constructive ownership
rules in determining whether a stock redemption is essentially equivalent to a dividend, since
hostility can in fact result in a meaningful reduction of a shareholder's interest in a corporation.
The case was remanded for determination of the effect of family discord on redemption of the
stock of four trusts that benefited a principal shareholder's children. See ¶15,330.1399.
(In reviewing Davis, the Tax Court, in Robin Haft Trust, read that decision as attempting to bring a
measure of certainty to a highly confused area. It then noted that much of this certainty would be
lost if the courts were to undertake the task of inquiring into the existence of intra-family hostility,
whether it was serious, and whether it would actually or probably impair the ability of one member
of the family to influence the conduct of other members.)
The IRS views the attribution rules under Code Sec. 318 as requiring mechanical application and,
except for certain taxpayers who may have relied on its subsequently withdrawn acquiescence in
Squier, will not follow the First Circuit's decision in Haft ( Rev. Rul. 80-26, at ¶15,330.1399).
The Tax Court reiterated its position regarding the application of attribution-of-stock-ownership
rules to redemptions caused by family hostility in David Metzger Trust ( 82-2 USTC ¶9718, at
¶15,330.1399) which aligns the Tax Court squarely with the IRS's position that family hostility
does not prevent the application of the stock attribution rules. As a practical matter, family hostility
will be a factor in determining dividend equivalency only where a shareholder unrelated to the
redeeming shareholder is involved. Because the unrelated shareholder's stock will not be
attributed to the redeeming shareholder, a reduction of the redeeming shareholder's
proportionate interest may be possible. In both the Tax Court's and the IRS's views, only at this
point may family hostility become a factor, and then only in determining whether the reduction
was meaningful (caused a loss of control over the corporation). See Rev. Rul. 75-502, at
¶15,330.1391.
Code Sec. 302(b)(2): Substantially disproportionate distributions
A distribution of earnings and profits (dividend) is typically made pro-rata among the shareholders
and, thus, conforms to their relative ownership interests. If the distribution is substantially
disproportionate, the redemption is treated as a sale or exchange, with any gain treated as capital
gain, and with no danger of any portion of the gain being taxed as ordinary dividend income to the
shareholder whose stock is redeemed. As to whether other shareholders may be deemed to have
received a constructive dividend, see ¶15,330.163, ¶15,330.50 and ¶15,330.53.
Substantially disproportionate defined
A non-pro-rata distribution may qualify as an exchange, provided the following mechanical tests
are met immediately after the redemption:
(1) the stockholder owns less than 50 percent of the total combined voting power of all
classes of stock immediately after the redemption,
(2) the ratio of his holdings of voting stock immediately after the redemption to all the voting
stock in the corporation at that time is less than 80 percent of the ratio which the voting
stock he owned immediately before the redemption bore to the entire voting stock in the
corporation at that time, and
(3) the stockholder's ownership of common stock (whether voting or nonvoting) after and
before redemption also meets the 80 percent test. These tests will be applied to each
stockholder individually, regardless of the effect of the distribution on the other
stockholders.
Further, the redemption must not be pursuant to a plan the purpose of which is a series of
redemptions which result in the aggregate in a distribution which is not substantially
disproportionate. Where events are clearly part of an overall, integrated plan to reduce a
shareholder's interest in a corporation, the sequence of events will be disregarded --effect being
given only to the overall result --in determining whether a distribution is substantially
disproportionate in a plan calling for a stock redemption accompanied either by an issuance of
new stock or by a shareholder's sale of stock ( Rev. Rul. 75-447, ¶15,330.67).
Very often, competing shareholders may redeem their shares for independent reasons in
separate transactions. Nonetheless, the two redemptions can be considered in the aggregate
(pursuant to Code Sec. 302 (b)(2)(D)) where one shareholder's redemption is undertaken with
knowledge of the impending redemption of the second shareholder, even though there is no
agreement between the two. See annotations at ¶15,330.67.
The constructive ownership rules (see Code Sec. 318) apply when making a determination as to
whether a redemption is substantially disproportionate.
Example 1: X corporation has one class of stock, voting common, 100 shares of which are
outstanding immediately before a redemption. Smith owns 70 shares, Jones owns 25
shares and Taylor owns 5 shares. The shareholders are not related. X redeems 50 shares
of Smith's stock, 6 shares of Jones' stock and 4 shares of Taylor's stock for a total of 60
shares redeemed.
In order to determine whether the redemption is substantially disproportionate with respect
to any of the aforementioned shareholders, the following chart may be used:
Before Redemption
Shares
Shareholders
Owned
Total
%
Smith .............
70
100
70
Jones ............
25
100
25
Taylor ...........
5
100
5
After Redemption
Shares
Owned
Total
%
20
40
50.0
19
40
47.5
1
40
2.5
With respect to Smith, the redemption is not substantially disproportionate because,
although his current holdings ratio (50%) is less than 80% of his previous holdings (70% 
80% = 56%), his stock ownership after redemption is exactly 50% of all of the outstanding
voting stock, but the law requires his stock ownership to be less than 50% in order for the
redemption to qualify as substantially disproportionate with respect to him (such a
redemption may, however, qualify as a distribution not essentially equivalent to a dividend).
With respect to Jones, the redemption is not substantially disproportionate either. Although
he owns only 47.5% of all outstanding voting stock after redemption, his holdings ratio after
the redemption is greater than his holdings ratio before the redemption (47.5% v. 25%).
With respect to Taylor, the redemption would qualify as substantially disproportionate. Her
percentage of ownership in the corporation is well below 50% after the redemption (2.5%)
and her holdings ratio after the redemption (2.5%) is less than 80% of her holdings ratio
before the redemption (5%  80% = 4%).
Example 2: Assuming the same facts as in the immediately preceding example, with the
exception that Smith is related to Taylor, the redemption of four shares of Taylor's stock
does not qualify as substantially disproportionate. Taylor is treated as owning the shares
owned by Smith both before and after redemption. Consequently, although Taylor's
holdings ratio immediately after the redemption ( 21/40or 52.5%) is less than 80% of her
holdings ratio before the redemption ( 75/100 80% = 60%), she is treated as owning 52.5%
of all of the voting stock after the redemption.
Code Sec. 302(b)(3): Redemptions in complete termination of a shareholder’s interest
As a result of the operation of the attribution rules of Code Sec. 318, a shareholder in a familyowned, closely-held corporation may find it difficult to successfully effect a substantially
disproportionate distribution. Thus, Code Sec. 302(b)(3) provides that a redemption in complete
redemption of the shareholder's stock in the corporation will be treated as an exchange. If in
complete redemption, then no part of the distribution is taxable as a dividend. If not, further tests
must be met in order to determine whether a dividend may be involved.
Application of the constructive ownership rules in Code Sec. 318 can disqualify a sale of all
shares actually owned by the shareholder.
Termination of Stockholder's Interest --Code Sec. 302(b)(3): Waiver of family attribution
rules
As mentioned above, shareholders in a family-owned business may find it difficult to effect a
substantially disproportionate distribution and thereby avail themselves of sale or exchange
treatment. Relief from this result is available, however, through waiver of the family attribution
rules by the distributee under certain conditions. Waiver is permitted if, immediately after the
redemption, the distributee has no interest in the corporation (e.g., as an officer, director, or
employee) other than as a creditor, acquires no such interest for 10 years after the redemption,
and files an agreement with the IRS that the distributee will notify it of any interest acquired during
the 10-year period.
The IRS has clarified the requirements for filing the agreement with respect to tax years
beginning on or after May 30, 2006. The agreement must be in the form of a statement that has
this title: "STATEMENT PURSUANT TO SECTION 302(c)(2)(A)(iii) BY [INSERT NAME AND
TAXPAYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER OR RELATED PERSON, AS
THE CASE MAY BE], A DISTRIBUTEE (OR RELATED PERSON) OF [INSERT NAME AND
EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF DISTRIBUTING CORPORATION]".
The statement must be included on or with the distributee's first tax return for the tax year in
which the distribution occurs. If the distributee is a controlled foreign corporation ( Code Sec.
957), each United States shareholder ( Code Sec. 951(b)) must include the statement on or with
its tax return ( Reg. §1.302-4(a)).
The statement must include a representation that:
(1) The distributee (or related person) has not acquired , other than by bequest or
inheritance, any interest in the corporation (as described in section 302(c)(2)(A)(i)) since
the distribution; and
(2) The distributee (or related person) will notify the Internal Revenue Service of any
acquisition, other than by bequest or inheritance, of such an interest in the corporation
within 30 days after the acquisition, if the acquisition occurs within 10 years from the date
of the distribution.
The requirements for the form of agreement as described above are effective for tax years
beginning on or after May 30, 2006. Taxpayers may also follow this procedure with respect to an
original income tax return, and any amended return that is filed on or before the due date
(including extensions) of the original return, where a timely filing occurs on or after May 30, 2006 (
Reg. §1.302-4(h)).
If, during the 10-year period, the shareholder and unrelated persons organize a new corporation
that acquires a division of the redeeming corporation, this would not be sufficient reason to
require the shareholder to notify the IRS ( Rev. Rul. 76-496, at ¶15,330.1333).
An "interest in a corporation" for determining whether a waiver of attribution agreement is
ineffective ( Code Sec. 302(c)(2)(A)), thereby preventing termination of a stockholder's entire
interest under Code Sec. 302(b)(3), is different from the interest that must be terminated in order
for the stock redemption rules to apply (and the stock dividend rules not to apply).
A Code Sec. 302(b)(3) "interest" is outright and/or constructive stock ownership and includes a
beneficial interest. See ¶15,330.70 and ¶15,330.706. Thus, a former shareholder is treated as
having retained an "interest in the corporation" by being (1) a voting trustee of a trust that holds
the remaining corporate stock for the benefit of the shareholder's children ( Rev. Rul. 71-426 at
¶15,330.1341) and (2) the custodian of stock held under the Uniform Gift to Minors Act ( Rev.
Rul. 81-233 at ¶15,330.1341). On the other hand, a former shareholder can be a lessor of a
building that is rented by the corporation without possessing an "interest" ( Rev. Rul. 77-467, at
¶15,330.1426).
The IRS maintains that performance of services under a long-term contract to perform consultant
and advisory services for a corporation is an "interest in the corporation" for waiver purposes (
Rev. Rul. 70-104 at ¶15,330.1329). However, the Tax Court has held that an employment
relationship did not constitute an "interest" where:
(1) The former shareholder was employed as an independent contractor, performing
services of the same nature, extent and quality as would be provided to any other
employer;
(2) Operating policy was set by the corporation, i.e., the former shareholder was
implementing, not making, policy decisions;
(3) The former shareholder's employment was terminable at will by the corporation; and
(4) The remuneration of the former shareholder was not keyed to profits, but was
reasonable compensation for the services actually performed ( M. Lennard Est. Dec.
32,434, at ¶15,330.1329).
Conversely, the Tax Court has found that a former shareholder retained an interest in the
redeeming corporation from a management contract with another corporation through which he
was able to exercise sufficient control over the redeeming corporation ( J. Chertkof, 81-1 USTC
¶9462, at ¶15,330.1328).
The Tax Court ( L.V. Seda, Dec. 41,067, at ¶15,330.1333) has held that a family member who
continues to work for a closely held family corporation after it has redeemed all of his stock has
an interest in that corporation that undermines the waiver of constructive ownership provisions as
applied to the redemption. A "prohibited interest" had previously been defined by the Tax Court
as a financial stake in or managerial control of a corporation (as in Chertkof). Seda adopts a more
literal, stricter interpretation of this term. Thus, a family corporation shareholder may now run a
greater risk that a complete redemption of his shares will not be classified as an exchange and
that the redemption proceeds will not qualify for capital gain treatment where, after the
redemption, he continues in an advisory capacity in order to aid family members in running the
corporation.
Termination of Stockholder's Interest --Code Sec. 302(b)(3): Constructive ownership
Not only must the shareholder be divested of all interest in the corporation, but no stock in the
corporation may be held by such related interests as a partnership related to a partner (and vice
versa), an estate related to a beneficiary and vice versa, a trust related to its beneficiaries (not
including a remote contingent interest), a beneficiary related to a trust, a trust related to its grantor
as substantial owner of the trust corpus, or a corporation related to its controlling (50-percent or
more ownership) stockholder. Nor may the stockholder have an option to acquire stock in the
corporation.
Thus, in Rev. Rul. 56-103, at ¶15,330.1328, an estate's interest was not regarded as terminated,
even though all its stock was redeemed, where a beneficiary continued to hold shares in the
corporation. For a detailed discussion of the constructive stock ownership rules, see ¶15,906.01
et seq.
Termination of Stockholder's Interest --Code Sec. 302(b)(3): Waiver by entities
Under the stock attribution rules of Code Sec. 318, stock attributed to an individual because it is
owned by a member of his family may be reattributed to an estate or trust of which the individual
is a beneficiary, to a partnership in which he is a member, or to a corporation in which he is a
stockholder.
Example 3: Jim Smith is the beneficiary of a trust that owns corporate stock, all of which is
being redeemed. Although Smith owns no stock in the corporation, his son John does own
stock in the corporation that is not being redeemed. Consequently, since Smith is
considered to own the stock of John, the trust, in turn, is deemed to own the stock actually
owned by John.
An entity to which stock is reattributed (either a trust, an estate, a partnership, or a corporation)
may waive the family attribution rule, provided that it is also waived by the person through whom
the stock is attributed to the entity (e.g., Jim Smith in the above example). Both an entity and an
individual must meet the waiver requirements (see ¶15,330.1331) and agree to be jointly and
severally liable for additional tax if stock in the redeeming corporation is acquired by either within
the 10-year period ( Code Sec. 302(c)(2)(C)(ii)).
An entity may not waive any attribution rules other than the family attribution rules. Where the
beneficiary of a trust is considered to be its owner under Code Sec. 671 through Code Sec. 678,
a redemption of the trust's stock is considered to be a redemption of the beneficiary's stock ( Rev.
Rul. 72-471, at ¶15,330.1326). Under such circumstances, waiver of family attribution by the trust
would presumably not be required; waiver by the beneficiary would seem to be sufficient, since a
reacquisition by the trust would be considered a reacquisition by the beneficiary. In cases where
an individual dies after having his stock redeemed but before he makes an effective waiver of
family attribution, the executor of his estate is permitted to execute the waiver.
Partially Liquidating Distributions --Code Sec. 302(b)(4): Distributions in partial liquidation
to noncorporate shareholders
A distribution by a corporation to a noncorporate shareholder in redemption of that shareholder's
stock will qualify the redemption for sale or exchange treatment if it is made in partial liquidation
of the corporation.
A distribution is made in partial liquidation if it is not essentially equivalent to a dividend
(determined at the corporate rather than the shareholder level), is pursuant to a plan, and occurs
within the tax year in which the plan is adopted or within the succeeding tax year ( Code Sec.
302(e)). If a distribution qualifies as being in partial liquidation, it need not satisfy any of the
requirements relating to disproportionate distributions, distributions in complete termination of the
shareholder's interest or lack of shareholder-level dividend equivalency.
A distribution will be considered not to be the equivalent of a dividend, as determined at the
corporate level, if the following conditions are met:
(1) The distribution must be attributable to the cessation by the distributing corporation of
the conduct of a trade or business that was actively carried on, for a period of five years
preceding the date of redemption, by the corporation or by a predecessor from whom the
business was acquired in a transaction in which no gain or loss was recognized.
However, the distribution may take the form of the proceeds from the sale of the
discontinued assets of the business, of the current assets of that business, or a
combination of assets and sale proceeds.
(2) Immediately after the distribution, the distributing corporation must be actively engaged
in conducting another trade or business that also had been carried on for at least five
years before the date of redemption by the corporation or by a predecessor from whom it
was acquired in a nonrecognition transaction.
The distribution of a reserve that is not needed for expansion of a business is not a partial
liquidation ( Reg. §1.346-1). Similarly, where a corporation has accumulated a substantial amount
of earnings, but, because of a decline in the demand for its products, distributes cash realized
from the sale of portfolio bonds and excess inventories in redemption of a part of its stock, the
distribution is not a partial liquidation ( Rev. Rul. 60-322, at ¶15,704.426). Also, in case of a
condemnation that does not reduce business, if the corporation continues to operate for a
considerable time at the same pace as maintained before the condemnation, the proceeds
distributed in redemption of the corporation's stock are not considered to have been distributed in
a partial liquidation ( Rev. Rul. 67-16, at ¶16,361.1933).
On the other hand, a partial liquidation will not be upset merely because the right to receive
payments on a note (rather than the note itself) given by the purchaser of part of the corporation's
business was distributed to the shareholders ( Rev. Rul. 77-166, at ¶16,361.2325).
In determining whether a distributee is a noncorporate shareholder, stock owned by a
partnership, estate or trust will be treated as if held proportionately by its partners or beneficiaries.
Thus, for example, if a distribution in partial liquidation is made to a partnership in which a
corporation and an individual each has a 50-percent interest in the capital and profits of the
partnership, only 50 percent of the distribution will qualify as received in exchange for stock.
Shareholder Reporting Requirements
Reporting requirements for tax years beginning on or after May 30, 2006 have been clarified. A
significant holder that transfers stock to the issuing corporation in exchange for property from the
corporation must furnish a statement to the IRS if the transaction is an exchange that is not
taxable as a dividend. The statement must be included on or with the tax return for the tax year in
which the exchange occurs. A significant holder is a person who, immediately before the
exchange, owned at least the threshold amount of stock as measured by vote or value. For
publicly traded stock, the threshold amount is 5 percent of the total outstanding stock of the
issuing corporation. For stock that is not publicly traded, the threshold amount is 1 percent of the
total outstanding stock of the issuing corporation. If the significant holder is a controlled foreign
corporation ( Code Sec. 957), each United States shareholder ( Code Sec. 951(b)) is required to
file a statement.
Stock is "publicly traded" if it is listed on a national securities exchange that is registered under
section 6 of the Securities Exchange Act of 1934. Stock is also "publicly traded" if it is listed on an
interdealer quotation system sponsored by a national securities association that is registered
under section 15A of the Securities Exchange Act of 1934. The "issuing corporation" means the
corporation that issued the shares of stock that are transferred in the exchange.
The statement must have this title: "STATEMENT PURSUANT TO § 1.302-2(b)(2) BY [INSERT
NAME AND TAXPAYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A
SIGNIFICANT HOLDER OF THE STOCK OF [INSERT NAME AND EMPLOYER
IDENTIFICATION NUMBER (IF ANY) OF ISSUING CORPORATION]."
The following information must be included in the statement:
 The fair market value and basis of the stock transferred by the significant holder to the
issuing corporation; and
 A description of the property received by the significant holder from the issuing
corporation.
For the purposes of this statement, the taxpayer's good faith estimate of fair market value will be
accepted. The taxpayer's estimate of basis will be accepted by the IRS if, (a) the basis is not
relevant to the determination of taxable income for that tax year, and (b) the taxpayer cannot
precisely determine basis ( T.D. 9264 (May 30, 2006)).
This reporting requirement applies to tax years beginning on or after May 30, 2006. However,
taxpayers may use this procedure with respect to an original Federal income tax return, and any
amended return that is filed on or before the due date (including extensions) of the original return,
where a timely filing occurs on or after May 30, 2006 ( Reg. §1.302-2(d)).
The statement described above is not used if the transaction is a corporate liquidation. The
reporting requirements for a corporate liquidation are given in Reg. §1.331-1.
For tax returns filed before May 30, 2006, the shareholder was required to report the "facts and
circumstances" of the exchange on the tax return (Reg. §1.302-2(b), prior to amendment by T.D.
9264 (May 30, 2006) and T.D. 9329 (June 14, 2007)). The new rule clarifies what must be
included in the report ( Reg. §1.302-2(b)(2)). --CCH.
Corporate Liquidations
Synopsis - effect of liquidations on shareholders
A complete liquidating distribution is treated as a payment in exchange for stock ( Code Sec.
331(a)). Generally, therefore, the redemption of stock by a dissolving corporation results in a
capital gain or loss to the shareholders. There need not be a formal surrender of stock by the
shareholders or cancellation of the stock by the corporation. If the distribution is in complete
liquidation, it is treated as received in exchange for the stock. This applies to the entire liquidating
distribution, even though part of it may consist of corporate earnings which, had they been
distributed in a transaction other than in liquidation, might be ordinary dividend income.
Therefore, stockholders may be subject to a lower tax liability if they allow corporate profits to
accumulate until liquidation, instead of distributing them currently. However, the possible
application to the corporation of the accumulated earnings tax ( ¶23,004.01) must be considered.
Generally, when Code Sec. 331 applies to a corporate liquidation, the rules of Code Sec. 301 do
not apply ( Code Sec. 331(b)). Code Sec. 301 usually must be considered when shareholders
receive corporate distributions (see ¶15,305.01 et seq.). However, a liquidation followed by a
transfer to another corporation of all or part of the assets of the liquidating corporation may be
treated as a dividend distribution or as a transaction in which no loss is recognized and gain is
recognized only to the extent of "other property" (see ¶16,004.025; Reg. §1.331-1(c)). In addition,
Code Sec. 1246 and Code Sec. 1248 provide that the gain recognized by shareholders, resulting
from Code Sec. 331 liquidating distributions on stock of a controlled foreign corporation or a
foreign investment company, may be treated as ordinary income rather than capital gain (see
¶30,921.01 et seq. and ¶30,968.01 et seq.).
No gain or loss is recognized upon the receipt by a parent corporation of property distributed in
complete liquidation of its 80-percent owned subsidiary corporation (see ¶16,052.01 et seq.).
However, special rules apply if the subsidiary liquidation involves a foreign subsidiary or parent
(see ¶16,667.01 et seq.).
Shareholder's gain or loss
A stockholder's gain or loss is the difference between the cost or other basis of the stock and the
fair market value (FMV) of the property, or interest in property, received in liquidation of such
stock. It makes no difference whether cash or property or both are distributed. If property is
received, its fair market value is also used as the basis for determining gain or loss upon the
subsequent sale of such property ( Code Sec. 334; ¶16,152.01 et seq.). Gain is recognized when
the combined value of the money and the fair market value of assets received by the shareholder
in the distribution exceeds the shareholder's basis in the stock. If a corporation distributes its
assets in complete liquidation in installments, and it is not known what the total proceeds will be,
the stockholder should not report any part of the installments as income until the amounts
received exceed the basis in the stock. However, when contracts or claims to receive indefinite
amounts are acquired as a distribution, the IRS generally requires valuation of such contracts or
claims except in rare and extraordinary cases. See Rev. Rul. 58-402, at ¶29,225.153.
A distribution that is made as a single step in a series of distributions in complete liquidation
should be applied against the total basis of all the shareholder's stock, even though only some of
the shares are surrendered ( F.M. Quinn, Dec. 9571 (Acq.), at ¶16,004.163).
Calculating gain on installment obligations. Shareholders who receive an installment obligation in
a corporate liquidation use the installment method to calculate any gain on the liquidation unless
the shareholder elects out of the installment method pursuant to Code Sec. 453(d). Qualifying
shareholders would treat the receipt of payments under the obligation, not the receipt of the
obligation itself, as payment for their stock. Thus, gain with respect to such payments would be
reported on the installment method as payments are received ( Code Sec. 453(h); Reg. §1.45311(a)(1); ¶21,471.041; ¶21,471.044).
Generally, in order for the installment method to be used for an installment obligation received in
a corporate liquidation three requirements must be met: (1) Code Sec. 331 must be applicable to
the liquidation, (2) the installment obligation must result from a sale or exchange by the
corporation within the 12-month period after the date the plan of complete liquidation was
adopted, and (3) the liquidation must be completed within the 12-month period after the date the
plan of complete liquidation was adopted ( Code Sec. 453(h)). For more discussion of a
shareholder's treatment of installment obligations distributed to him in liquidation, see
¶21,471.041 et seq.
Where there is a sale of all corporate assets, followed by investment of the sale proceeds for a
period of time preceding a distribution to shareholders in complete liquidation, the corporation
may inadvertently become a personal holding company. If it does, the portion of the distribution
that represents the personal holding company income may be taxed as ordinary income ( A.S.
Weiss, DC Ohio, 75-2 USTC ¶9538, at ¶16,004.177).
Disproportionate liquidation distributions. Where shareholders receive a distribution in complete
liquidation that is disproportionate to their share holdings (a non-pro rata distribution), the
shareholders will still be considered for tax purposes as having received a pro rata distribution.
Where shareholders receive less than their share, the excess of their pro rata share over the
amount actually received is treated as if it had been used in a separate transaction to make gifts,
pay compensation, satisfy obligations of any kind, or accomplish other goals, depending on the
particular facts and circumstances. Where shareholders receive more than their share, the
excess is treated as a payment attributable to those shareholders who received less ( Rev. Rul.
79-10; ¶16,004.147).
Effect of Liquidations on Shareholders: Partial liquidations
A distribution that is one of a series of distributions in complete liquidation pursuant to a plan of
liquidation is classified as one made in complete liquidation. The distribution is treated as
received in exchange for stock, and any resulting gain qualifies for capital gain treatment ( Reg.
§1.331(a); Code Sec. 346).
A distribution made as a part of the contraction of the business of a corporation is not treated as a
liquidating distribution in exchange for stock if it is made to a corporate shareholder of the
liquidating corporation. Thus, a distribution of assets in redemption of stock by a corporation that
is not in the process of complete liquidation is treated as a taxable exchange by the corporation
and as a nonliquidating distribution (generally taxable as a dividend) by the corporate
shareholders. Furthermore, any amount treated as a dividend by the recipient corporation will
usually result in a reduction of the corporate shareholder's basis in the stock of the partially
liquidating corporation ( ¶30,021.01 et seq.). Distributions to noncorporate shareholders made in
connection with a contraction of the business are classified as redemptions qualifying for sale or
exchange treatment under Code Sec. 302 (see ¶15,330.01 et seq.).
Effect of Liquidations on Shareholders: Distribution subject to liabilities
If, as a condition to receiving a liquidation distribution, the shareholder agrees to pay a liability of
the liquidating corporation, the liability is taken into account in determining the amount of gain. If
the existence of the liability and its amount are known at the time of the distribution, the amount
received is reduced by the shareholder's portion of the amount of the liability which he agrees to
pay, even though it is paid in a year subsequent to the distribution. If an adjustment is not made
at the time that the distribution is received, the return which reflects the distribution should be
amended ( ¶16,004.209). Payment of the liability in a later tax year does not justify deduction of
the liability on the return for that year.
Complete Liquidation of Subsidiary: Synopsis - complete liquidation of subsidiary
Although stockholders generally must recognize gain or loss on liquidation of the corporation, this
is not the case when the stockholder is an 80% corporate parent of the liquidating corporation (
¶16,052.021). The nonrecognition of gain or loss on a subsidiary liquidation results in deferral of
gain or loss through the mechanism of carried over basis of the subsidiary's distributed assets (
¶16,052.025). For the nonrecognition rules to apply, the subsidiary liquidation must be completed
either within the tax year ( ¶16,052.03), or within three years under a plan of liquidation (
¶16,052.033). Distributions of earnings in outbound liquidations of U.S. holding companies may
trigger dividend income for the foreign parent company under certain circumstances (
¶16,052.027). Shareholders other than a qualifying 80% corporate parent recognize gain on the
liquidation ( ¶16,052.035). For recordkeeping and filing requirements, see ¶16,052.075.
Complete Liquidation of Subsidiary: Minority recognizes gain or loss
It is only the parent corporation which benefits from the nonrecognition of gain or loss provisions
on complete liquidation of a subsidiary ( Reg. §1.332-5). Due to the 80% stock ownership
requirement for the parent, as much as 20% of the stock might be owned by minority interests,
who also share in the liquidation. The minority shareholders are required to recognize gain or loss
on the liquidation distributions, under the rules described at ¶16,004.01.
Basis of Property Received in Liquidation: Synopsis - basis of property received in
liquidation
If property is received in a distribution in complete liquidation and gain or loss is recognized on
receipt of the property, the basis of the property in the hands of the person receiving it is the fair
market value of the property at the time of the distribution. Generally, if a liquidating corporation
distributes property to its noncorporate shareholders or to a corporation that owns less than 80
percent of the liquidating corporation's stock, the recipient will recognize gain or loss upon receipt
of the property ( ¶16,004.01). In this situation, the recipient's basis in the property will generally
be the property's fair market value.
If an 80-percent owner-parent corporation receives a distribution of property from a liquidating
subsidiary corporation, its basis in the property received will generally be the same as the
adjusted basis of the property in the hands of the liquidating subsidiary corporation. However, if
the distributing subsidiary corporation recognizes gain on the distribution of property to its 80percent owner-parent corporation in a liquidation described in Code Sec. 332 or Code Sec.
337(b)(1), the distributee's basis is the fair market value of the property. Although a liquidating
subsidiary will generally not recognize gain upon the distribution of property to its 80-percent
owner-parent corporation, the subsidiary will recognize gain upon certain distributions to a taxexempt corporation ( ¶16,227.01).
Basis of Property Received in Liquidation: Corporate parent's basis in subsidiary
liquidation property
When a parent liquidates a subsidiary, the parent corporation's basis in the property received is
the same as the liquidating subsidiary's basis in the property (i.e., the parent has a carryover
basis in the property) unless the subsidiary recognizes gain from the transfer. Special rules apply
where the subsidiary possesses built-in loss property which will subsequently be sold by the
parent. Those rules are beyond the scope of this course.