Why redemption treatment matters
When a corporation buys back a shareholder's stock, the shareholder wants sale or exchange treatment — recovering basis and reporting capital gain — rather than dividend treatment, where the entire distribution is ordinary dividend income to the extent of E&P with no basis recovery.
Tests for sale treatment (§302)
- Complete termination of the shareholder's interest — the cleanest route; family attribution can be waived if strict conditions are met (no interest other than as a creditor, and no reacquisition for 10 years)
- Substantially disproportionate — after the redemption the shareholder owns less than 80% of their prior percentage and less than 50% of total voting power
- Not essentially equivalent to a dividend — a facts-and-circumstances test requiring a meaningful reduction in the shareholder's proportionate interest
- Partial liquidation — at the corporate level, a genuine contraction of the business
IMPORTANT — attribution rules (§318): A shareholder is treated as owning stock held by spouse, children, grandchildren, and parents, plus stock held through entities. In a closely held family corporation this frequently defeats the disproportionate-redemption tests, converting what looks like a sale into a dividend.
Complete liquidation
| Level | Consequence |
|---|---|
| Corporation | Recognizes gain and generally loss as if it sold all assets at fair market value |
| Shareholder | Capital gain or loss equal to FMV received minus stock basis |
| Subsidiary liquidating into an 80% parent (§332) | Tax-free; the parent takes a carryover basis in the assets |
EXAMPLE: A shareholder owns 60% of a corporation. After a redemption she owns 45%. Substantially disproportionate requires ownership below 80% of the prior percentage (below 48%) and below 50% of voting power. She satisfies both — 45% is under 48% and under 50% — so sale treatment applies, assuming no attribution problems.
EXAM TIP: A corporation distributing appreciated property in a non-liquidating distribution recognizes gain but never a loss. In a complete liquidation, losses generally are recognized (subject to related-party and anti-abuse limits). That asymmetry gets tested.