What happens if a shareholder sells stock of one corporation to another corporation that he also controls? The IRS could treat the sale as a redemption, subject to the dividend tests of § 302. Section 304 addresses this.
There are two situations:
- Brother‑sister (§ 304(a)(1)): The acquiring corporation is treated as making a distribution in redemption of its own stock. The analysis is made by reference to the issuing corporation (the one whose stock was sold).
- Parent‑subsidiary (§ 304(a)(2)): The subsidiary is treated as making a distribution in redemption of the parent’s stock.
“Control” for § 304 is ownership of at least 50% of the stock by vote or value. § 304(c)(1). The attribution rules of § 318 apply, with some modifications that broaden the reach of § 304.
If the redemption is treated as a dividend under the § 302 tests, the distribution comes first from the acquiring corporation’s E&P, then from the issuing corporation’s E&P. § 304(b)(2). The shareholder increases his basis in his remaining shares of the issuing corporation by his basis in the shares sold. Reg. § 1.304‑2(a).
Why does this matter? Because if you’re planning to sell stock of one controlled corporation to another, you might expect capital gain treatment. But § 304 can recharacterize the sale as a dividend – ordinary income. So plan carefully. In Hurst v. Commissioner, 124 T.C. 16 (2005), the IRS tried to apply § 304, but the court held it was “new matter” not properly raised. Still, it’s a risk you need to consider.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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