Redemptions and disappearing basis.

• Author: McKeague, Rory J.

Under Sec. 302(b), a corporation's redemption of stock from a shareholder for property is treated as a sale or exchange if one of the following applies:

1. The redemption is not essentially equivalent to a dividend.

2. The distribution of property is substantially disproportionate with respect to the shareholder.

3. The redemption is in complete termination of the shareholder's interest.

4. The distribution is in redemption of a noncorporate shareholder and is in partial liquidation of the distributing corporation.

For all the above tests, the Sec. 318 stock attribution rules apply.

Tax Ramifications

If a corporation purchases its stock back from a shareholder, and the transaction fits one of the above classifications, the shareholder will recognize gain or loss on the redemption under Sec. 1001. Thus, the shareholder will compare the fair market value of property and/or cash received to the basis in the redeemed shares. The corporation will recognize no gain or loss on the redemption, unless it has distributed appreciated property to the shareholder; see Sec. 311(b).

If a corporation purchases its stock back from a shareholder, and the transaction does not fit one of the listed circumstances, the distribution will be characterized as either a dividend, a return of capital or capital gain under Sec. 301. Under Secs. 301(c)(1) and 316(a), the distribution is a dividend up to the amount of the corporation's accumulated and current earnings and profits (E&P). According to Sec. 301(c)(2), if the distribution exceeds E&P, it is a return of capital up to the shareholder's basis in the redeemed stock. Finally, under Sec. 301(c)(3), if the distribution exceeds both E&P and the shareholder's basis, the excess distribution is capital gain.

Basis Disappearance

A problem that occurs when Sec. 301 applies to a dividend-equivalent redemption is "basis disappearance." As described above, if a corporation purchases its stock back flora a shareholder and Sec. 301 applies, the distribution can be characterized as a dividend, return of capital or capital gain. However, what happens to the basis of the shares actually redeemed by the corporation for the property received? Does it just "disappear" and produce no benefit to the shareholder? The IRS initially addressed the disappearing-basis issue in Sec. 302 regulations issued in 1955; see TD 6152 (12/2/55).

Example 1: Individual A purchased all 100 outstanding shares of X Corp. stock for $60. Two years later, X...