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Why this topic matters
How money comes out of an entity determines how it is taxed. Tax Compliance and Planning (TCP) Area III tests corporate distributions and earnings and profits (E&P), stock redemptions that qualify for sale treatment, complete liquidations, and parent-subsidiary liquidations — plus the contrast with pass-through entities.
Corporate distributions
- Dividend to the extent of current E&P (allocated pro rata to all distributions during the year), then accumulated E&P (in date order).
- Then a tax-free return of capital, reducing stock basis.
- Then capital gain.
- Property distributions: the corporation recognizes gain (not loss) as if it sold the property at fair market value (FMV). The shareholder's distribution = FMV − liabilities assumed; basis in the property = FMV.
- E&P is reduced by cash distributed, the adjusted basis of property (or FMV for appreciated property, after adding the gain to E&P), less liabilities assumed. Distributions can't create or increase an E&P deficit.
- Stock dividends are generally tax-free (basis is allocated across old and new shares), unless shareholders can choose cash or the distribution changes proportionate interests (Section 305).
- Constructive dividends: excessive compensation to shareholder-employees, below-market loans, personal use of corporate assets, and bargain sales to shareholders can be recharacterized as dividends.
Stock redemptions
When a corporation buys back its own stock, the shareholder wants sale or exchange treatment (capital gain, with basis recovery) rather than a dividend (the whole amount taxed to the extent of E&P). A redemption is an exchange if it meets one of the Section 302 tests:
| Test | Requirement |
|---|---|
| Substantially disproportionate | After the redemption, the shareholder owns less than 50% of the voting power, and their percentage is less than 80% of their percentage before (for both voting and common stock) |
| Complete termination | All of the shareholder's stock is redeemed. Family attribution can be waived if the shareholder has no interest (other than as a creditor) for 10 years and files an agreement |
| Not essentially equivalent to a dividend | A meaningful reduction in the shareholder's interest, based on facts and circumstances |
| Partial liquidation (noncorporate shareholders) | Distribution due to a genuine contraction of the corporation's business |
| Redemption to pay death taxes (Section 303) | Stock in the decedent's estate worth more than 35% of the adjusted gross estate; proceeds up to death taxes and funeral and administration expenses |
Constructive ownership (Section 318) applies: a shareholder is treated as owning shares held by a spouse, children, grandchildren, and parents (not siblings), and proportionately through partnerships, estates, trusts, and corporations (50%+ owned). Attribution often defeats the tests in family companies.
EXAMPLE: A corporation has 100 shares: A owns 60, unrelated B owns 40. The corporation redeems 30 of A's shares. Before: A owns 60%. After: A owns 30 of 70 shares = 42.9%. Is 42.9% < 50%? Yes. Is it < 80% × 60% = 48%? Yes. The redemption is substantially disproportionate — sale treatment.
For the corporation, distributing appreciated property in a redemption triggers gain; E&P is reduced by the redeemed shares' ratable share of E&P (not more than the amount distributed).
Complete liquidations
| Party | General rule (Sections 331 and 336) |
|---|---|
| Liquidating corporation | Recognizes gain and loss as if it sold all its assets at FMV — but losses are limited on distributions to related parties (more than 50% shareholders) of non-pro-rata or recently contributed property, and on built-in loss property contributed with a tax-avoidance purpose |
| Shareholders | Treat the distribution as full payment in exchange for their stock: capital gain or loss = FMV received − stock basis; basis in property received = FMV |
This is the "double tax" on exiting a C corporation.
Parent-subsidiary liquidation (Sections 332 and 337)
- If a parent owns at least 80% of the subsidiary's voting power and value and the subsidiary liquidates, no gain or loss is recognized by the subsidiary on distributions to the parent or by the parent.
- The parent takes a carryover basis in the assets and inherits tax attributes (net operating losses, E&P).
- Distributions to minority shareholders are taxable (gain recognized by the subsidiary; minority shareholders get exchange treatment).
Pass-through contrasts
- S corporations: distributions are generally tax-free to the extent of stock basis (and the accumulated adjustments account); property distributions trigger corporate-level gain that passes through; liquidations are taxed once, at the shareholder level, after the gain passes through.
- Partnerships: current and liquidating distributions are generally tax-free except cash in excess of outside basis; losses only in limited cases; ordinary income for disproportionate distributions of hot assets.
Planning points
- Structure redemptions to meet a Section 302 test — watch family attribution, and use the 10-year waiver for complete terminations.
- Use Section 303 redemptions to provide estate liquidity in family businesses.
- Avoid distributing appreciated property from C corporations when possible; distribute loss property only when the loss is allowed (usually better to sell it and distribute cash).
- Consider the timing of dividends against E&P — distributions in a year with no current E&P and an accumulated deficit can be tax-free returns of capital.
How it is tested
- Classify a distribution as dividend, return of capital, or gain.
- Apply Section 302 tests with attribution to a redemption.
- Compute corporate and shareholder results in a complete liquidation.
- Apply the parent-subsidiary liquidation rules.
EXAM TIP: Current E&P is checked first and can make a distribution a dividend even when accumulated E&P is negative. Only if both are zero or negative is the distribution a return of capital.