Introduction to Redemptions of Stock Under Section 302(b)

A stock redemption is when a “corporation acquires its stock from a shareholder in exchange for property.” To the shareholder, a lot of times this can either look like a sale, or look like an ordinary dividend. The tax rules on this issue are trying to divide the line between these two situations.

The retirement of stock through redemption can happen in a number of different situations; it can be a liquidation, a recapitalization, or other type of reorganization of the corporation. The corporation could also be trading its own stock on the market, or there could be a death or retirement that prompts a shareholder to withdraw from ownership.

Redemptions in complete liquidation are governed by Section 331 or 332, and redemptions brought about by reorganizations are subject Section 356. The main point of the rules we’ll discuss here were drafted to try and prevent individuals essentially receiving dividends but having them taxed as capital gains. At this point in time these rules are more important to corporate shareholders than they are to individual shareholders.

The Redemption of Stock in a Continuing Corporation

There are two general code sections that control the shareholder’s tax as it relates to a redemption:

Section 303: This covers redemptions to cover or pay for death taxes

Section 302: This covers all other redemptions

“…stock shall be treated as redeemed by a corporation if the corporation acquires its stock froma ¬†shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.” – Section 317(b)

There has to be an acquisition of the stock, and there has to be a transfer of property from the corporation to the shareholder.

Example of a Stock Redemption With No Meaningful Reduction in Ownership

Let’s say Tim owns 100% of ABC INC, and Ron comes to him and says, “I’ll buy 20% of your stock for $500,000.” If Tim has a basis of $300,000 in that 20% interest, then he would recognize a gain of $200,000.

How will Tim’s gain be taxed?

If the stock had been held for more than a year, it would be given long-term capital gain treatment and taxed at a maximum rate of 15%.

Now let’s say that instead of selling the 20% to Ron, Tim just sells the 20% of stock back to the corporation, for which he receives the same $500,000. Tim has given up 20% of his ownership, and received $500,000 in exchange.

Isn’t this the exact same scenario as Tim selling it to Ron?

The answer is no, it wouldn’t be the same. What happens here is that Tim’s still owns 100% of the stock, even though he sold 20% of the stock he was holding back to the corporation. So Tim still owns all the shares of ABC INC, but he’s been enriched by $500,000. This is essentially a dividend, and will be treated as such…

So what difference does it make if this redemption is treated as a sale or as a dividend? Won’t he be taxed at a rate of 15% either way?

Yes, but if it’s treated as a sale and he had a basis of $300,000, he’ll only be taxed on the gain of $200,000. If it’s treated as a dividend, he has to pay 15% on the entire $500,000.

At the end of the day…

In order for a shareholder to receive “sale or exchange” treatment instead of dividend treatment on a redemption subject to Section 302, the shareholder must have a meaningful reduction in ownership.

Redemption of Stock Under Section 302(a)

Section 302(a) provides that a redemption will be treated as a sale or exchange of stock if one of the four tests in Section 302(b) applies:

  1. Not equivalent to a dividend
  2. Substantially disproportionate
  3. Termination of a shareholders’ interest, or
  4. A partial liquidation(this only applies to non-corporate shareholders): This is completely different than the above three tests. This looks at the change within the corporation. This means there are really only 3 tests… kind of.

With the exception of redemptions under Section 303 which are redemptions to pay death taxes, all other redemptions are taxable as dividends under Section 301.

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