A corporation can buy back its own stock from a shareholder – a “redemption.” If the redemption is treated as a sale or exchange, the shareholder recognizes capital gain or loss. If it’s treated as a dividend, the shareholder recognizes ordinary income (up to E&P). § 302.
Section 302 provides several tests for sale treatment. The most important are:
- Section 302(b)(1): The redemption is “not essentially equivalent to a dividend.” This requires a meaningful reduction in the shareholder’s proportionate interest in the corporation. United States v. Davis, 397 U.S. 301 (1970).
- Section 302(b)(2): The redemption is “substantially disproportionate.” The shareholder’s post‑redemption voting interest must be less than 80% of his pre‑redemption interest, and he must own less than 50% of the voting stock after the redemption.
- Section 302(b)(3): There is a complete termination of the shareholder’s interest. The shareholder must give up all his stock, directly and constructively.
The attribution rules of § 318 apply. That means the shareholder is deemed to own stock owned by family members and certain entities, which can make it harder to qualify.
In Davis, the taxpayer was the sole shareholder (by attribution) both before and after the redemption, so the redemption was essentially equivalent to a dividend. The Court held that “meaningful reduction” is required, and a reduction from 100% to 100% is not meaningful.
So if you want sale treatment, you need to genuinely reduce your stake – not just shuffle shares among family members.
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.
Was this helpful?
0 / 0