Redemptions

• Pages: 141-186
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

141

Chapter 5

REDEMPTIONS

5.01 Introduction

A “redemption” (more precisely, a “distribution in redemption of

stock”) is the purchase by a corporation of some of its own stock.

§ 317(b). How should a redemption be taxed to the corporation and to

the selling shareholder? On the one hand, a redemption might be

treated as any other distribution made with respect to a

shareholder’s stock, producing ordinary income, recovery of basis,

and capital gain to the distributee shareholder depending on the

corporation’s earnings and profits account and on the shareholder’s

stock basis. See § 301. Consistent with this approach, the

distributing corporation would recognize gain but not loss on the

distribution. See § 311(b). On the other hand, a redemption could be

treated like any other purchase and sale of a capital asset, giving the

selling shareholder exclusively recovery of basis and capital gain,

independent of the corporation’s earnings and profits account. Were

this characterization followed at the corporate level, gain or loss

could be recognized on the exchange.

Consider a corporation with a single shareholder that redeems

some of the shareholder’s stock. The redemption is just like any other

distribution. Before and after the redemption, the shareholder owns

all of the corporation’s stock, is entitled to all distributions on the

stock, and enjoys all voting rights on the stock. As you may suspect,

that redemption is treated like a § 301 distribution. In contrast, if a

small shareholder of a large corporation has all of her stock

redeemed, that redemption is treated as a sale (at least if she is

related to none of the other shareholders).

The shareholder-level taxation of redemptions is governed by

§ 302, and this section incorporates both approaches.

1

Under § 302,

redemptions resembling a sale of stock to a third party qualify for

exchange treatment, while those redemptions more closely

resembling dividend distributions follow the general distribution

rules of § 301. The rules of § 302 distinguish among types of

redemptions by generally considering the effect of the redemption on

the distributee shareholder’s interest in the corporation. If the

distributee shareholder enjoys exchange treatment, the shareholder

recognizes gain or loss, (generally capital gain or loss) equal to the

1

The corporate level taxation of redemptions is discussed at Section 5.04

infra.

142

REDEMPTIONS

Ch. 5

difference between the redemption proceeds and the basis of the

stock redeemed.

For example, suppose that individual B owns 100 outstanding

shares of X Corp., that B has a $70 adjusted basis in each share, and

that X redeems 10 of B’s shares for $1,000 (their fair market value).

If the redemption is accounted for under the distribution rules of

§ 301, B has dividend income of $1,000 (assuming sufficient earnings

and profits). In contrast, if the redemption is treated as an exchange,

B has $300 of capital gain ($1,000 amount realized minus $700

basis). Thus, dividend treatment results in ordinary dividend

income,

2

while exchange treatment results in basis recovery and

typically capital gain (or loss). With most dividends now taxable at

the same rate as long-term capital gain,

3

an individual shareholder

owning stock with a very low basis may be practically indifferent to

the distinction between exchange and distribution treatment.

Conversely, a shareholder with high share basis generally will prefer

exchange treatment. In fact, with a sufficiently high stock basis

exchange treatment can generate a taxable loss while distribution

treatment can at best be tax-free.

The possibility of exchange treatment becomes even more

significant in the case of inherited stock because of the fair market

value basis given to property at death by § 1014. Thus, if B in the

example above dies and devises his shares to children C and D, each

child will take a $100 basis in each share. If the corporation then

redeems all of C ’s stock, distribution treatment produces income up

to $100 per share while exchange treatment results in no gain or loss.

2

To the extent the distribution exceeds available earnings and profits, the

shareholder reduces basis and then recognizes gain, typically, capital gain. § 301(c)(2)

and (3).

Note that it is not cle ar how the basis reduction should occur, and there are at

least three alternatives. First, the amount deemed distributed in redemption could be

allocated only to the shares redeemed, with the basis reduction limited to those shares,

an approac h used in 2002 proposed regulations that were withdrawn in 2006. See

Announcement 2006–30, 2006–19 I.R.B. 879. Second, the amount deemed distributed

could be allocated among all shares held by the redeemed shareholder in the redeemed

class, with the basis reduction applied pro rata to those shares. Any remainin g basis

in the redeemed shares would b e allocated to the shareholder’s non-redeemed shares

in the redeemed class. This approach was employed in 2009 proposed regulations that

were withdrawn in 2019. See 84 Fe d. Reg. 11686 (March 28, 2019). Finally, the basis

of the redeemed shares could first be allocated proportionately among, and blended

with, the basis of the nonredeemed shares of t he same class held by the redeemed

shareholder. Then, the amount deemed distributed could be allocated among the non-

redeemed shares. with the basis reduction applied pro rata to those shares. See

NYSBA Tax Se ction, Report on Basis Recovery in Dividend Equ ivalent Redemptions

(Report No. 1112, June 13, 2006) (describing these three approaches, among others).

Cf Regs. § 1.1367–1(c)(3) (providing for an “aggregate” approach, allowing the recovery

of the entire basis of stock held by an S corporation shareholder).

3

Although qualified dividend income is taxed at the same rate as long -term

capital gain (see § 1(h)(11)), it is not capital gain. For example, capital loss generally

cannot offset qualified dividend income.

Sec. 5.01

INTRODUCTION

143

As this example demonstrates, qualifying for exchange treatment

can mean, for the devisee of stock, the difference between taxation on

the entire amount distributed and no taxation at all.

Section 302 is structured as follows. Exchange treatment is

given to the recipient shareholder under § 302(a) if and only if

4

the

redemption qualifies under one of the provisions of § 302(b). Thus,

one obtains the benefit of § 302(a) by qualifying under § 302(b). A

redemption that fails to qualify under § 302(b) is subjected to the

distribution rules of § 301 pursuant to § 302(d). Thus, subsections (a)

and (d) are the taxing provisions while subsection (b) contains the

qualifying rules.

Subsection (b)(1) gives (shareholder-level) exchange treatment

to redemptions “not essentially equivalent to a dividend.” Until

enactment of the 1954 Code, only this ambiguous language

distinguished qualifying from non-qualifying redemptions. As you

might expect, substantial litigation and transactional uncertainty

resulted.

5

Congress responded by creating the safe harbor provisions

now found in § 302(b)(2)–(5),

6

provisions giving exchange treatment

to redemptions based upon more objective criteria. These rules are

explored in detail in Section 5.02 below. Section 302(b)(1) now is a

residuary provision, a last resort for taxpayers who fail to navigate

into the safe harbors of § 302(b)(2)–(5).

In focusing on the effect of a redemption on the recipient

shareholder’s stock interest in the distributing corporation, Congress

recognized that stock owned by a relative of the recipient shareholder

might appropriately be imputed to the recipient shareholder. For

example, if B and C are equal co-owners of X Corp., the redemption

by X of all of B’s stock has a substantial effect on B’s control of the

corporation if B and C are strangers but perhaps only a nominal

effect if B and C are husband and wife. Accordingly, Congress

provided in § 302(c) that a set of attribution rules are applied to

determine qualification under § 302(b), attribution rules that are

exceedingly complex and that apply with varying degrees of rigor.

These rules also impute stock ownership from (and to) entities

4

See also § 303 (exchange treatment for certain redemptions used to pay

death taxes). The text does not discuss § 302(b)(5), which provides that a shareholder

treats the redemption of stock of a “publicly offered” regulated investment company

(RIC) as a sale or exchange under § 302(a) if the redemption is upon the demand of

the shareholder and the company issues only stock redeemable upon demand of the

shareholder owning that stock. § 302((b)(5). See also § 67(c)(2)(B)(i) (defining a

publicly offered RIC as a RIC, the shares of which are continuously offered pursuant

to a public offering, regularly traded on an established securities market, or held by

at least 500 persons at all times during the taxable year).

5

See, e.g., B. Bittker & J. Eustice, Federal Income Taxation of Corporations

and Shareholders ¶ 9.01 (7th ed. 2000).

6

The safe harbor provision for partial liquidations in § 302(b)(4) was, until

1982, found in § 346.