Corporate Tax | Just Tax

Stock Redemption Analysis (§§ 302, 318; Davis; Zenz v. Quinlivan)

This checklist guides the analysis of whether a corporate stock redemption qualifies for sale-or-exchange treatment under § 302(a) or is treated as a dividend distribution under § 302(d). Use it whenever a corporation acquires its stock from a shareholder in exchange for property. The analysis covers the five redemption tests of § 302(b), the constructive ownership rules of § 318, the family attribution waiver under § 302(c)(2), and all supporting authorities needed to complete the analysis without reference to any other source.

Step 1. The § 302 Framework and the Five Redemption Tests

"If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), (3), (4), or (5) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock." (§ 302(a))

• The general rule of § 302(a).
  • Gain or loss is recognized on a redemption if one of the five § 302(b) tests applies. (§ 302(a))
  • The character of gain or loss is determined under § 1222 (capital gain or loss treatment).
  • The shareholder's adjusted basis in the redeemed stock offsets the amount realized.
  • § 302(a) is the gateway provision. It applies only if a § 302(b) test is satisfied.
• The five tests for exchange treatment.
  • § 302(b)(1). The redemption is "not essentially equivalent to a dividend." This is a facts-and-circumstances test. (§ 302(b)(1)) (Treas. Reg. § 1.302-2(b))
  • § 302(b)(2). The redemption is "substantially disproportionate" with respect to the shareholder. This is a purely mechanical numerical safe harbor. (§ 302(b)(2))
  • § 302(b)(3). The redemption is in "complete redemption of all of the stock of the corporation owned by the shareholder." (§ 302(b)(3))
  • § 302(b)(4). The distribution is to a non-corporate shareholder "in partial liquidation of the distributing corporation." (§ 302(b)(4))
  • § 302(b)(5). The redemption is by a publicly offered regulated investment company upon the demand of the stockholder. Added by the RIC Modernization Act of 2010, Pub. L. 111-325, § 306(a). (§ 302(b)(5))
• The § 302(d) fallback.
  • If NONE of the five § 302(b) tests applies, the redemption is treated as a distribution of property to which § 301 applies. (§ 302(d))
  • Under § 301(c), the distribution is taxed in three tiers. (1) Dividend income to the extent of the corporation's current and accumulated earnings and profits. (2) Return of capital (tax-free basis recovery) to the extent the distribution exceeds E&P. (3) Capital gain to the extent the distribution exceeds both E&P and the shareholder's stock basis. (§ 301(c)(1)-(3)) (§ 316)
  • TRAP. When § 302(d) applies, the shareholder does NOT recover basis in the redeemed shares directly. The basis of the redeemed stock attaches to the shareholder's remaining shares under Treas. Reg. § 1.302-2(c). This is sometimes called the "mystery of the disappearing basis." (Treas. Reg. § 1.302-2(c)) (Notice 2001-45, 2001-2 C.B. 129)
• Coordination among the tests.
  • A redemption that fails the mechanical tests of § 302(b)(2), (3), or (4) can still qualify under the facts-and-circumstances test of § 302(b)(1). (§ 302(b)(6))
  • If a redemption meets both § 302(b)(3) (complete termination) and another test, the 10-year look-forward rule of § 302(c)(2)(A)(ii) does not apply. (§ 302(b)(6))
• The definition of "redemption."
  • A redemption is a corporation's acquisition of its stock from a shareholder in exchange for property, whether or not the stock is cancelled, retired, or held as treasury stock. (§ 317(b))
  • The form of the acquisition does not matter. The corporation may cancel the stock, retire it, or hold it as treasury stock. (§ 317(b))

Step 2. § 318 Constructive Ownership Rules

"Section 318(a) shall apply in determining the ownership of stock for purposes of this section." (§ 302(c)(1))

• The § 318 rules apply to ALL § 302 determinations.
  • A redemption that looks disproportionate on its face may be pro rata after attribution, making it automatically a dividend equivalent. (United States v. Davis, 397 U.S. 301, 90 S. Ct. 1041 (1970))
  • Always apply § 318 attribution BEFORE running the § 302(b)(2) numbers or assessing complete termination.

Step 2A. Family Attribution Under § 318(a)(1)

• Family members whose stock is attributed.
  • An individual is treated as owning stock owned by his or her spouse. (§ 318(a)(1)(A)(i))
  • An individual is treated as owning stock owned by his or her children (including legally adopted children), grandchildren, and parents. (§ 318(a)(1)(A)(ii)) (§ 318(a)(1)(B))
  • CAUTION. Siblings, grandparents, aunts, uncles, nieces, nephews, cousins, and in-laws are NOT covered. Step-children are NOT covered absent legal adoption. (Treas. Reg. § 1.318-2)
• The direction of family attribution.
  • Spousal attribution is mutual and bidirectional. (§ 318(a)(1)(A)(i))
  • Parent-to-child attribution runs downward. A parent is treated as owning stock owned by his or her child. (§ 318(a)(1)(A)(ii))
  • Child-to-parent attribution runs upward. A child is treated as owning stock owned by his or her parent. (§ 318(a)(1)(A)(ii))
  • Grandchild-to-grandparent attribution runs upward ONLY. A grandchild is treated as owning stock owned by his or her grandparent. Stock owned by a grandparent is NOT attributed to the grandchild. (Treas. Reg. § 1.318-2(b))
  • TRAP. If grandfather and grandson each own 100 shares, grandfather is deemed to own 200 shares while grandson owns only 100 shares. The attribution is one-way only.
• The legally separated spouse exception.
  • A spouse who is legally separated from the individual under a decree of divorce or separate maintenance is excluded from spousal attribution. (§ 318(a)(1)(A)(i))
  • An interlocutory decree of divorce does NOT trigger the exception. Only a final decree qualifies. (Commissioner v. Ostler, 237 F.2d 501 (9th Cir. 1956))

Step 2B. Attribution From Entities Under § 318(a)(2)

• Partnership, estate, and trust attribution from entities.
  • Stock owned by a partnership or estate is treated as owned proportionately by its partners or beneficiaries. (§ 318(a)(2)(A))
  • Stock owned by a trust is treated as owned by its beneficiaries in proportion to their actuarial interest in the trust. (§ 318(a)(2)(B)(i))
  • Stock owned by a grantor trust is attributed to the person treated as the owner under subpart E of subchapter J. (§ 318(a)(2)(B)(ii))
  • Exception for qualified employee trusts described in § 401(a). (§ 318(a)(2)(B)(i))
• Trust attribution detail.
  • Stock owned by a trust is treated as owned by its beneficiaries in proportion to their actuarial interest in the trust. (§ 318(a)(2)(B)(i))
  • Exception for qualified employee trusts described in § 401(a). (§ 318(a)(2)(B)(i))
  • Stock owned by a grantor trust is attributed to the person treated as the owner under subpart E of subchapter J. (§ 318(a)(2)(B)(ii))
• Corporate attribution from entity to owner.
  • If 50% or more in value of a corporation's stock is owned by a person, that person is treated as owning the stock owned by the corporation in proportion to the value of stock the person owns. (§ 318(a)(2)(C))
  • The 50% threshold is measured by value, not voting power. A shareholder with 50% or more of the value but less than 50% of voting power still triggers attribution. (§ 318(a)(2)(C))

Step 2C. Attribution To Entities Under § 318(a)(3)

• Partnership, estate, and trust attribution to entities.
  • Stock owned by a partner or beneficiary is treated as owned by the partnership or estate. (§ 318(a)(3)(A))
  • Stock owned by a trust beneficiary is treated as owned by the trust, unless the beneficiary's interest is a "remote contingent interest" with actuarial value of 5% or less. (§ 318(a)(3)(B)(i))
  • Stock owned by a grantor trust's deemed owner is treated as owned by the trust. (§ 318(a)(3)(B)(ii))
• Trust attribution to entity detail.
  • Stock owned by a trust beneficiary is treated as owned by the trust, unless the beneficiary's interest is a "remote contingent interest" (actuarial value of 5% or less under maximum trustee discretion). (§ 318(a)(3)(B)(i))
  • Stock owned by a grantor trust's deemed owner is treated as owned by the trust. (§ 318(a)(3)(B)(ii))
• Corporate attribution to entity.
  • If 50% or more in value of a corporation's stock is owned by a person, the corporation is treated as owning the stock owned by that person. (§ 318(a)(3)(C))
  • A corporation does not own its own stock by reason of this rule. Treas. Reg. § 1.318-1 clarifies that a corporation shall not be considered to own its own stock by reason of § 318(a)(3)(C). (Treas. Reg. § 1.318-1)

Step 2D. Option Attribution Under § 318(a)(4)

• Options are treated as actual ownership.
  • If any person has an option to acquire stock, such stock is treated as owned by that person. (§ 318(a)(4))
  • This includes options to acquire options and each one of a series of such options. (§ 318(a)(4))
  • EXAMPLE. If A has an option to acquire 25 shares and an option to acquire a further option for 25 shares, A is deemed to own all 50 shares.

Step 2E. Operating Rules Under § 318(a)(5)

• Reattribution of constructively owned stock.
  • Stock constructively owned by a person is treated as actually owned for purposes of further attribution, except as provided in subparagraphs (B) and (C). (§ 318(a)(5)(A))
  • This enables multi-layer attribution chains. For example, stock owned by Corporation X can be attributed to A (a 50%+ shareholder), then A's ownership can be attributed to B (A's spouse), then B's ownership to Partnership (if B is a partner). (§ 318(a)(5)(A))
• Double-family attribution is eliminated.
  • Stock constructively owned by an individual under § 318(a)(1) (family attribution) is NOT treated as actually owned by that individual for purposes of reapplying § 318(a)(1) to make another family member a constructive owner. (§ 318(a)(5)(B))
  • EXAMPLE. Father F owns stock. Son A is attributed F's stock. That constructively owned stock cannot be reattributed from A to A's brother B. However, F's direct ownership CAN be attributed to both A and B.
• Sidewise attribution through entities is eliminated.
  • Stock constructively owned by a partnership, estate, trust, or corporation under § 318(a)(3) is NOT treated as actually owned by that entity for purposes of applying § 318(a)(2) to make another person a constructive owner. (§ 318(a)(5)(C))
  • EXAMPLE. Partner 1's stock is attributed to the partnership under § 318(a)(3). The partnership cannot then attribute that stock to Partner 2 under § 318(a)(2).
• Option attribution takes precedence over family attribution.
  • If stock may be considered as owned under either § 318(a)(1) (family) or § 318(a)(4) (option), the option rule governs. (§ 318(a)(5)(D))
  • This enables reattribution that § 318(a)(5)(B) would otherwise block.
• S corporation partnership treatment.
  • An S corporation is treated as a partnership, and its shareholders as partners, for attribution purposes. (§ 318(a)(5)(E))
  • This does NOT apply for determining whether stock in the S corporation itself is constructively owned. A shareholder's ownership of S corporation stock is determined without reference to this rule. (§ 318(a)(5)(E))
• § 318 constructive ownership is NOT elective.
  • The rules apply mechanically regardless of actual family harmony or disharmony. (United States v. Davis, 397 U.S. 301 (1970))
  • The "family hostility" exception recognized in Robin Haft Trust v. Commissioner, 510 F.2d 43 (1st Cir. 1975) is limited to the First Circuit and has been rejected by the IRS. Outside the First Circuit, family discord does not override § 318 attribution. (Rev. Rul. 75-502, 1975-2 C.B. 111)

Step 3. The § 302(b)(1) Meaningful Reduction Test

"Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend." (§ 302(b)(1))

• The Davis test.
  • In United States v. Davis, 397 U.S. 301, 90 S. Ct. 1041 (1970), the Supreme Court established that a redemption qualifies under § 302(b)(1) only if it results in a "meaningful reduction of the shareholder's proportionate interest in the corporation." (397 U.S. at 313)
  • The Court held that § 318(a) attribution rules apply strictly to § 302(b)(1). Davis was treated as the sole shareholder because his wife's and children's stock was attributed to him under § 318(a)(1). His redemption of preferred stock was essentially equivalent to a dividend because there was no meaningful reduction in his proportionate interest. (United States v. Davis, 397 U.S. 301 (1970))
  • The Court held that business purpose is irrelevant in determining dividend equivalence. The presence or absence of a genuine business purpose does not affect whether a redemption is essentially equivalent to a dividend. (United States v. Davis, 397 U.S. 301 (1970))
  • Three Justices dissented, arguing that the majority's strict application of attribution rendered § 302(b)(1) "meaningless." (United States v. Davis, 397 U.S. 301, 318-323 (1970) (Douglas, J., dissenting))
• The three components of a shareholder's interest.
  • In Rev. Rul. 75-502, 1975-2 C.B. 111, the IRS identified three attributes of a shareholder's proportionate interest. (1) The right to vote and thereby exercise control. (2) The right to participate in current earnings and accumulated surplus. (3) The right to share in net assets on liquidation.
  • Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964) held that a meaningful reduction can be based on a reduction in economic rights (rights to participate in earnings and share in net assets on liquidation) even where voting power is unchanged.
  • The IRS announced in Rev. Rul. 85-106, 1985-2 C.B. 116 that it would not follow Himmel and that "in cases involving voting stock, the effect of the redemption on the taxpayer's control of the corporation is considered the most significant factor."
  • For nonvoting stock, economic rights may still support a meaningful reduction finding, but the practitioner should be aware of the IRS position.
• What constitutes a meaningful reduction.
  • A sole shareholder (including by attribution) can NEVER have a meaningful reduction under § 302(b)(1) because there is no change in proportionate interest. (United States v. Davis, 397 U.S. 301 (1970))
  • A reduction that leaves the shareholder with majority control is generally NOT meaningful. (Rev. Rul. 77-218, 1977-1 C.B. 81) (Rev. Rul. 78-401, 1978-2 C.B. 127) (Estate of Schneider v. Commissioner, 88 T.C. 906 (1987), aff'd, 855 F.2d 435 (7th Cir. 1988))
  • A reduction from 50/50 equal control to minority status CAN be meaningful. (Sorem v. Commissioner, 334 F.2d 275 (10th Cir. 1964))
  • A reduction from 57% to 50% (creating a veto situation) WAS meaningful. (Rev. Rul. 75-502, 1975-2 C.B. 111)
  • A reduction from 30% to 24.3% WAS meaningful for a minority shareholder. (Rev. Rul. 75-512, 1975-2 C.B. 112)
  • A reduction from 27% to 22.27% WAS meaningful. (Rev. Rul. 76-364, 1976-2 C.B. 91)
  • A reduction of a de minimis public shareholder interest WAS meaningful. (Rev. Rul. 76-385, 1976-2 C.B. 92)
  • A reduction from 85% to 61.7% WAS meaningful because the shareholder lost the ability to unilaterally approve mergers and liquidations requiring a supermajority vote. (Wright v. United States, 482 F.2d 600 (8th Cir. 1973))
  • A reduction from 90% to 60% was NOT meaningful because the taxpayer still controlled the corporation. (Rev. Rul. 78-401, 1978-2 C.B. 127)
  • A pro rata redemption of all shareholders is ALWAYS essentially equivalent to a dividend because no shareholder experiences any change in proportionate interest. (Rev. Rul. 72-472, 1972-1 C.B. 80) (Rev. Rul. 81-289, 1981-2 C.B. 82)
  • A reduction from 80% to 63% WAS meaningful. (Patterson Trust v. United States, 729 F.2d 1089 (6th Cir. 1984))
  • A reduction from 98.5% to 98.05% was NOT meaningful where the Tax Court applied the step-transaction doctrine to recharacterize stock sales to an ESOP as a constructive corporate redemption. (Estate of Schneider v. Commissioner, 88 T.C. 906 (1987), aff'd, 855 F.2d 435 (7th Cir. 1988))
• The family hostility exception.
  • Estate of Squier v. Commissioner, 35 T.C. 950 (1961) held that "sharp cleavage" between an executor and family members could make a redemption not essentially equivalent to a dividend despite the attribution rules. The IRS originally acquiesced but later withdrew its acquiescence. (A.O. NNA-3, 1972-2 C.B. 4)
  • Robin Haft Trust v. Commissioner, 510 F.2d 43 (1st Cir. 1975) held that family discord can "negate the presumption" of community interest that justifies attribution, making it a relevant factor under § 302(b)(1). The First Circuit vacated and remanded the Tax Court's decision for the Commissioner.
  • CAUTION. The family hostility exception is limited to the First Circuit. The IRS has nonacquiesced. Outside the First Circuit, do not rely on family hostility to override § 318 attribution.
• The § 302(b)(1) determination and earnings and profits.
  • Treas. Reg. § 1.302-2(b) provides that the determination of whether a redemption is essentially equivalent to a dividend "depends upon the facts and circumstances of each case" and is made without regard to whether the corporation has earnings and profits. (Treas. Reg. § 1.302-2(b))
  • A redemption can be essentially equivalent to a dividend even when the corporation has no E&P. The presence of E&P affects only the § 301(c) tax consequences if the redemption fails § 302(b), not whether § 302(b)(1) itself is satisfied. (Treas. Reg. § 1.302-2(b))

Step 4. The § 302(b)(2) Substantially Disproportionate Redemption

"Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder." (§ 302(b)(2)(A))

• The three mechanical tests.
  • A redemption is substantially disproportionate only if ALL three tests are satisfied. If ANY test fails, § 302(b)(2) does not apply. (§ 302(b)(2)(B)-(C))
  • § 302(b)(2) is an objective safe harbor. Unlike § 302(b)(1), it does not require a facts-and-circumstances analysis. The numbers control.

Step 4A. The 50-Percent Voting Power Test

• Post-redemption ownership must be below 50%.
  • The shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote immediately after the redemption. (§ 302(b)(2)(B))
  • This is a hard threshold. A shareholder who owns exactly 50% after the redemption does NOT satisfy this test.
  • § 318(a) constructive ownership rules apply in making this calculation. (§ 302(c)(1))

Step 4B. The 80-Percent Voting Stock Test

• The after/before ratio must be less than 80%.
  • The ratio of voting stock owned by the shareholder immediately after the redemption to all voting stock at that time must be less than 80% of the same ratio immediately before the redemption. (§ 302(b)(2)(C)(i)-(ii))
  • EXAMPLE. Shareholder owns 80 of 100 voting shares (80%) before redemption. Corporation redeems 30 shares from the shareholder. After redemption, shareholder owns 50 of 70 (71.4%). The after/before ratio is 71.4/80 = 89.3%. Because 89.3% is NOT less than 80%, the test is NOT satisfied.
  • EXAMPLE. Shareholder owns 70 of 100 voting shares (70%) before redemption. Corporation redeems 30 shares from the shareholder. After redemption, shareholder owns 40 of 70 (57.1%). The after/before ratio is 57.1/70 = 81.6%. Because 81.6% is NOT less than 80%, the test is NOT satisfied.
  • EXAMPLE. Shareholder owns 70 of 100 voting shares (70%) before redemption. Corporation redeems 40 shares from the shareholder. After redemption, shareholder owns 30 of 60 (50%). The after/before ratio is 50/70 = 71.4%. Because 71.4% IS less than 80%, this test IS satisfied (and the 50% test is also satisfied).

Step 4C. The 80-Percent Common Stock Test

• The same 80% test applies to common stock ownership.
  • No distribution is treated as substantially disproportionate unless the shareholder's ownership of common stock (whether voting or nonvoting) after and before the redemption also meets the 80% requirement. (§ 302(b)(2)(C), flush language)
  • If there is more than one class of common stock, the determination is made by reference to fair market value.
  • TRAP. Many practitioners remember the 50% and 80% voting tests but forget this third common stock test. All three must be satisfied.

Step 4D. Additional Rules and Traps

• The series of redemptions rule.
  • § 302(b)(2)(D) provides that the test is not satisfied if the redemption is made pursuant to a plan the purpose or effect of which is a series of redemptions that, in the aggregate, is not substantially disproportionate.
  • TRAP. If a corporation implements a plan to redeem shares from multiple shareholders in stages, each individual redemption may be disproportionate even though the aggregate effect is not. In such cases, § 302(b)(2)(D) disqualifies all the redemptions.
  • Bleily & Collishaw, Inc. v. Commissioner, 72 T.C. 751 (1979), aff'd without published opinion, 647 F.2d 169 (9th Cir. 1981) held that a series of redemptions executed pursuant to a fixed plan to terminate the shareholder's interest may be treated as parts of a single redemption.
• Redemptions of nonvoting and preferred stock.
  • Treas. Reg. § 1.302-3 provides that § 302(b)(2) does not apply to a redemption solely of nonvoting preferred stock if the shareholder's voting power is unchanged. (Treas. Reg. § 1.302-3)
  • However, if the common stock test is satisfied, a redemption of voting preferred stock can qualify as substantially disproportionate. A redemption of nonvoting common stock can also qualify if the common stock ownership ratio meets the 80% test. (Treas. Reg. § 1.302-3)

Step 5. § 302(b)(3) Complete Termination and the Zenz Doctrine

"Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder." (§ 302(b)(3))

• The general rule.
  • Exchange treatment applies when a shareholder's entire direct stock interest is redeemed. (§ 302(b)(3))
  • Because § 318(a) constructive ownership rules apply (§ 302(c)(1)), a shareholder is often treated as owning stock of family members even after their own shares are redeemed. Family attribution can defeat what appears to be a complete termination.
• The Zenz v. Quinlivan doctrine.
  • In Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), Mrs. Zenz was the sole shareholder of a corporation. She sold 47 of her 108 shares to a competitor and three weeks later the corporation redeemed her remaining 61 shares. (213 F.2d at 915)
  • The IRS argued the redemption was essentially equivalent to a dividend, contending the two steps should be integrated and treated as a dividend. (213 F.2d at 915)
  • The Sixth Circuit reversed. The court held that "where the taxpayer effects a redemption which completely extinguishes the taxpayer's interest in the corporation, and does not retain any beneficial interest whatever, that such transaction is not the equivalent of the distribution of a taxable dividend as to him." (213 F.2d at 916)
  • The court reasoned that dividend equivalence presupposes the shareholder remains in the corporation. When the taxpayer completely exits, dividend equivalence is inapplicable.
  • The significance of Zenz is that a redemption completely terminating a shareholder's interest, when undertaken pursuant to a binding obligation or integrated plan to dispose of ALL shares, qualifies for exchange treatment under § 302(b)(3). The order of steps does not matter.
  • CAUTION. Zenz applies when the shareholder ACTUALLY owns all shares being redeemed and there is no family attribution problem. If a parent redeems all shares while a child still owns stock, Zenz does NOT apply. The § 302(c)(2) waiver is needed instead.
• Extension of Zenz to substantially disproportionate redemptions.
  • Rev. Rul. 75-447, 1975-2 C.B. 113 extended the Zenz rationale to § 302(b)(2). When a redemption is combined with a stock issuance or sale as part of an integrated plan, the combined effect of all steps is measured against the § 302(b)(2) tests. (Rev. Rul. 75-447, 1975-2 C.B. 113)
  • Situation 1 of the ruling. Corporation X issued new shares to C, then redeemed shares from A and B. If the integrated transaction results in a substantially disproportionate reduction, § 302(b)(2) applies. (Rev. Rul. 75-447, 1975-2 C.B. 113)
  • Situation 2 of the ruling. A and B sold shares to C, and X redeemed part of the remaining shares from A and B. The before/after ownership is measured considering all steps of the integrated transaction. (Rev. Rul. 75-447, 1975-2 C.B. 113)
• Redemptions where no attributed stock remains outstanding.
  • Where no stock remains outstanding after the redemption the ownership of which would be attributed to the redeeming shareholder, the waiver requirements of § 302(c)(2) do not apply. (Rev. Rul. 76-524, 1976-2 C.B. 94)
  • A shareholder whose actual stock interest is completely terminated and who has no constructive ownership after redemption qualifies under § 302(b)(3) regardless of whether the shareholder retains a position as officer or director. (Rev. Rul. 76-524, 1976-2 C.B. 94)
  • EXAMPLE. A sole shareholder redeems all shares and there are no family members whose stock would be attributed. The shareholder may continue as an officer or director because § 302(c)(2) waiver is not required. (Rev. Rul. 76-524, 1976-2 C.B. 94)

Step 6. § 302(c)(2) Waiver of Family Attribution

"In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply." (§ 302(c)(2)(A))

• When the waiver is needed.
  • The waiver is necessary only when § 318(a)(1) family attribution would prevent a complete termination. (§ 302(c)(2)(A))
  • If the shareholder redeems all directly owned shares and no family member owns stock that would be attributed, § 302(c)(2) is unnecessary. The shareholder already has a complete termination under § 302(b)(3).
  • TRAP. Only family attribution under § 318(a)(1) can be waived. Entity attribution under § 318(a)(2) and § 318(a)(3) and option attribution under § 318(a)(4) CANNOT be waived. If a trust, estate, partnership, or corporation blocks complete termination, the § 302(c)(2) waiver will not help.

Step 6A. The Three Core Requirements

• No interest after the distribution.
  • Immediately after the distribution the distributee must have no interest in the corporation, including no interest as officer, director, or employee, other than an interest as a creditor. (§ 302(c)(2)(A)(i))
  • "Creditor" status requires that the rights of the person are not greater or broader in scope than necessary for enforcement of the claim. The claim must not be proprietary and must not be subordinate to general creditors. Principal or interest payments cannot be contingent on earnings. (Treas. Reg. § 1.302-4(d))
  • A note term exceeding 15 years may be treated as equity rather than debt.
  • TRAP. Post-redemption employment as officer, director, or employee is explicitly prohibited. In Seda v. Commissioner, 82 T.C. 484 (1984), parents redeemed all stock but the father continued as an employee for two years at a fixed salary. The Tax Court held this constituted a prohibited interest and denied capital gain treatment.
  • TRAP. Independent contractor status is ALSO a prohibited interest. In Lynch v. Commissioner, 801 F.2d 1176 (9th Cir. 1986), the Ninth Circuit rejected the Tax Court's "financial stake or control" test and held that a taxpayer providing post-redemption services as an independent contractor holds a prohibited interest. The court reasoned that the parenthetical in § 302(c)(2)(A)(i) ("including an interest as officer, director, or employee") merely provides examples of prohibited interests, not an exhaustive list. All noncreditor service interests are prohibited.
  • CAUTION. The Lynch approach (per se prohibition on all service relationships) applies in the Ninth Circuit. Estate of Lennard v. Commissioner, 61 T.C. 554 (1974) held the opposite for independent contractors with no financial stake, but this has been superseded in the Ninth Circuit. Best practice. Do NOT retain any service relationship, whether as employee or independent contractor.
  • An arm's-length lease of property to the corporation is permissible. (Rev. Rul. 77-467, 1977-2 C.B. 92) (Hurst v. Commissioner, 124 T.C. 16 (2005))
  • Retention of pension rights is NOT a prohibited interest. (Rev. Rul. 84-135, 1984-2 C.B. 80)
  • A board "observer" with non-voting status may be permissible. (Rev. Rul. 59-119, 1959-1 C.B. 63)
  • Having a nominee (including an attorney) on the board of directors is a prohibited interest. (Rev. Rul. 59-119, 1959-1 C.B. 63)
• The 10-year look-forward prohibition.
  • The distributee must not acquire any prohibited interest within 10 years from the date of the distribution, except stock acquired by bequest or inheritance. (§ 302(c)(2)(A)(ii))
  • If the distributee acquires a prohibited interest within 10 years, the statute of limitations extends to one year after the IRS is notified, and the IRS may recompute the tax for the redemption year treating the redemption as a § 301 distribution. (§ 302(c)(2)(A)(ii), flush language)
  • If the distributee never notifies the IRS, the statute of limitations remains open indefinitely.
• The waiver agreement filing requirement.
  • The distributee must file an agreement with the Secretary at the time and in the manner prescribed by regulations. (§ 302(c)(2)(A)(iii))
  • Treas. Reg. § 1.302-4(a) requires the distributee to include a written statement on or with the first return for the taxable year in which the § 302(b)(3) distribution occurs. The statement must represent that (1) the distributee has not acquired any prohibited interest since the distribution, and (2) the distributee will notify the IRS of any acquisition within 30 days if it occurs within 10 years.
  • TRAP. The agreement must be filed with the timely-filed return for the year of redemption. Late filing requires IRS consent.
  • Treas. Reg. § 1.302-4(b) requires the distributee to retain records as may be necessary for the application of § 302(c)(2).

Step 6B. The 10-Year Lookback Prohibition

• Disqualifying transfers.
  • The waiver does not apply if any portion of the stock redeemed was acquired within the 10-year period ending on the date of distribution from a person whose stock would be attributable to the distributee under § 318(a). (§ 302(c)(2)(B)(i))
  • The waiver also does not apply if any person owns stock at the time of distribution that is attributable to the distributee under § 318(a), and such person acquired stock from the distributee within the 10-year period, unless such acquired stock is redeemed in the same transaction. (§ 302(c)(2)(B)(ii))
• The tax-avoidance exception.
  • The preceding rules do not apply if the acquisition or disposition did not have "as one of its principal purposes the avoidance of Federal income tax." (§ 302(c)(2)(B), flush language)
  • Rev. Rul. 77-293, 1977-2 C.B. 91 held that a gift from father to son to permit the son to take over the family business was NOT principally for tax avoidance. The purpose was genuine succession planning.
  • Rev. Rul. 85-19, 1985-1 C.B. 94 held that a child inheriting stock and receiving a gift of additional stock from a parent was not a tax avoidance purpose.
  • Treas. Reg. § 1.302-4(g) provides that "a tax avoidance purpose is not inferred merely because the transferee is in a lower income tax bracket than the transferor."

Step 6C. Entity Waivers

• § 302(c)(2)(C) special rule.
  • Entities (partnerships, estates, trusts, and corporations) may waive family attribution if the entity AND each related person meet the requirements of § 302(c)(2)(A)(i)-(iii), and each related person agrees to be jointly and severally liable for any deficiency resulting from an acquisition within 10 years. (§ 302(c)(2)(C))
  • This provision was added by TEFRA in 1982 to overrule judicial decisions that had reached differing results on entity waivers. Before 1982, trusts could not waive family attribution. (David Metzger Trust v. Commissioner, 693 F.2d 459 (5th Cir. 1982))
  • Rev. Rul. 71-562 provides that if family attribution is waived under § 302(c)(2), a subsequent acquisition of stock by the waived family member within 10 years is disregarded for purposes of § 302(c)(2)(A)(ii). The waiver shields against post-redemption acquisitions by waived family members.

Step 7. § 302(b)(4) Partial Liquidation

"Subsection (a) shall apply to a distribution if such distribution is (A) in redemption of stock held by a shareholder who is not a corporation, and (B) in partial liquidation of the distributing corporation." (§ 302(b)(4))

• Scope of § 302(b)(4).
  • This provision gives exchange treatment to NON-CORPORATE shareholders when a distribution is made in partial liquidation of the corporation. Corporate shareholders cannot use § 302(b)(4). (§ 302(b)(4)(A))
  • Unlike the other § 302(b) tests, § 302(b)(4) looks at the CORPORATE-LEVEL event (whether there has been a genuine contraction of the corporation's business) rather than the shareholder-level interest reduction. (§ 302(e)(1)(A))
• The definition of "partial liquidation."
  • A distribution is treated as in partial liquidation if (A) it is "not essentially equivalent to a dividend" determined at the corporate level, and (B) it is pursuant to a plan adopted within the taxable year or the succeeding taxable year. (§ 302(e)(1))
  • The determination of whether a distribution is "not essentially equivalent to a dividend" is made at the corporate level by examining whether there has been a genuine contraction of the corporation's business. (§ 302(e)(1)(A))
• The termination-of-business safe harbor.
  • A distribution qualifies as a partial liquidation if (A) it is attributable to the corporation's ceasing to conduct a "qualified trade or business" (or consists of assets of such business), and (B) immediately after the distribution, the corporation is actively engaged in conducting another qualified trade or business. (§ 302(e)(2))
  • A "qualified trade or business" means any trade or business that has been actively conducted throughout the 5-year period ending on the redemption date and that was not acquired by the corporation in a taxable transaction during that 5-year period. (§ 302(e)(3))
  • TRAP. The acquired business must have been conducted by the corporation itself for 5 years. A business acquired in a taxable transaction during the 5-year period does not qualify.
• Pro rata distributions can qualify.
  • Pro rata partial liquidation distributions.
  • Under § 302(e)(4), the partial liquidation determination is made without regard to whether the redemption is pro rata. This is unique among the § 302(b) tests. Even a pro rata distribution to all non-corporate shareholders can qualify as a partial liquidation. (§ 302(e)(4))
  • This is the only § 302(b) test where a pro rata distribution can qualify for exchange treatment. All other tests require some disproportionality or complete termination at the shareholder level.
• Historical note.
  • Historical background on partial liquidations.
  • Before TEFRA 1982, partial liquidations were governed by § 346 and applied to all shareholders including corporate shareholders. (Former § 346, repealed by TEFRA, Pub. L. 97-248, § 222)
  • TEFRA repealed § 346 as a standalone provision and added § 302(b)(4) and § 302(e), limiting partial liquidation treatment to non-corporate shareholders only. Corporate shareholders receiving distributions in partial liquidation are subject to § 301 treatment. (TEFRA, Pub. L. 97-248, § 222)
  • Corporate shareholders receiving partial liquidation distributions may claim the dividends received deduction under § 243. (§ 243)

Step 8. § 301 Distribution Treatment When § 302(b) Fails

"Except as otherwise provided in this chapter, a distribution of property made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c)." (§ 301(a))

• The three-tier taxation framework.
  • When no § 302(b) test applies, § 302(d) treats the redemption as a distribution to which § 301 applies. (§ 302(d))
  • § 301(c) provides a mandatory three-tier ordering. (1) That portion of the distribution which is a dividend under § 316 is included in gross income. (2) That portion which is not a dividend is applied against and reduces the adjusted basis of the shareholder's stock. (3) That portion which exceeds both the dividend amount and basis is treated as gain from the sale or exchange of property. (§ 301(c)(1)-(3))
• Dividend treatment to the extent of E&P.
  • A distribution is a dividend under § 316 to the extent of the corporation's current and accumulated earnings and profits. (§ 316(a))
  • The "nimble dividend" rule of § 316(a)(2) allows current-year E&P to dividend-ize distributions even if accumulated E&P is negative.
  • Current E&P is measured at year-end with appropriate adjustments. The precise computation follows the rules of § 312 and the regulations thereunder.
• Basis recovery and capital gain.
  • To the extent the distribution exceeds the dividend amount, the excess reduces the shareholder's basis in the retained stock. (§ 301(c)(2))
  • Any amount remaining after basis reduction is capital gain. (§ 301(c)(3))
  • TRAP. The shareholder does NOT apply the basis of the redeemed shares against the distribution amount. The basis of the redeemed shares transfers to the shareholder's remaining shares (or to attributed shares) under Treas. Reg. § 1.302-2(c).
• Corporate shareholders and the dividends received deduction.
  • Corporate shareholders may benefit from the dividends received deduction under § 243. A 50% DRD applies to dividends from corporations that are not members of the same affiliated group. (§ 243(a)(1))
  • A 65% DRD applies if the recipient owns 20% or more of the distributing corporation. (§ 243(a)(2))
  • A 100% DRD applies to dividends from affiliated group members. (§ 243(a)(3))

Step 9. § 304 Redemptions Through Related Corporations

"If one or more persons are in control of each of two corporations, and in return for property, one of the corporations acquires stock in the other corporation from the person so in control, then such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock." (§ 304(a)(1))

• § 304 prevents taxpayers from avoiding dividend treatment by selling stock to a related corporation.
  • Instead of treating the transaction as a sale to an unrelated party (which would generate capital gain with basis offset), § 304 recharacterizes the transaction as a redemption.
  • § 304 applies only when the same person or group controls both corporations, using a 50% vote-or-value test.

Step 9A. Brother-Sister Controlled Group Redemptions

• § 304(a)(1).
  • If one or more persons are in control of each of two corporations, and one corporation acquires stock in the other from the person in control, the property received is treated as a distribution in redemption of the stock of the corporation acquiring the stock. (§ 304(a)(1))
  • The 1997 amendment added flush language providing that to the extent the distribution is treated as a § 301 distribution, the transferor and acquiring corporation are treated as if the transferor had transferred the target stock to the acquirer in a § 351(a) exchange and then the acquirer immediately redeemed the hypothetical stock.

Step 9B. Parent-Subsidiary Redemptions

• § 304(a)(2).
  • If one corporation acquires stock in another corporation from a shareholder of the other corporation, and the issuing corporation controls the acquiring corporation, the property received is treated as a distribution in redemption of the stock of the issuing corporation. (§ 304(a)(2))
  • The deemed redemption is of the PARENT corporation's stock, not the subsidiary's stock.

Step 9C. Determining Control and Applying § 302(b)

• The § 302(b) tests are applied by reference to the issuing corporation.
  • § 304(b)(1) requires that determinations under § 302(b) be made by reference to the stock of the issuing corporation.
  • In applying § 318(a) for this purpose, §§ 318(a)(2)(C) and 318(a)(3)(C) are applied without regard to the 50% limitation. This dramatically expands constructive ownership.
  • § 304(c)(3)(B) modifies the 50% threshold to 5% for § 304 purposes. Attribution from a corporation applies if a person owns at least 5% of the stock, not 50%.
• Earnings and profits sourcing in § 304 transactions.
  • The acquirer's E&P is tapped first to determine dividend treatment. If the acquirer's E&P is insufficient, the issuing corporation's E&P is used. (§ 304(b)(2))
  • This sequencing can affect source-of-income characterizations. For example, if the acquirer is a foreign corporation and the issuer is domestic, the foreign E&P is considered first for foreign tax credit and withholding purposes. (§ 304(b)(2))
• The § 302(b) tests in § 304 transactions.
  • Because of the expanded attribution rules (removing the 50% limitation and substituting 5%), the § 302(b) tests typically fail, resulting in § 301 dividend treatment. (§ 304(c)(3)(B))
  • TRAP. Practitioners should assume that § 304 transactions will produce dividend treatment unless specific facts strongly support exchange treatment. The mechanical § 302(b)(2) safe harbor is almost impossible to satisfy once the 5% attribution threshold applies. (§ 304(c)(3)(B))

Step 10. § 306 Disqualified Stock

"If a shareholder receives stock in a distribution or exchange to which section 305(a) applies, and such stock is not common stock with respect to which there has been a distribution of common stock, then such stock shall be treated as section 306 stock." (§ 306(c)(1)(A))

• § 306 prevents shareholders from converting dividend income into capital gain through stock dividends and recapitalizations.
  • When a shareholder receives "§ 306 stock" (typically preferred stock distributed in a recapitalization or stock dividend), that stock is "tainted." On disposition, proceeds are generally taxed as ordinary income rather than capital gain.
  • § 306 was enacted to close the "preferred stock bailout" loophole, where shareholders would receive tax-free preferred stock dividends and then sell or redeem the preferred at capital gain rates instead of dividend rates. (§ 306(a)(1))
• Definition of § 306 stock.
  • § 306 stock includes stock (other than common stock issued with respect to common stock) that was distributed to the shareholder where, by reason of § 305(a), the distribution was not includible in gross income. (§ 306(c)(1)(A))
  • It also includes non-common stock received in a recapitalization (Type E reorganization), a § 355 spin-off, or in exchange for existing § 306 stock. (§ 306(c)(1)(B))
  • Any stock the basis of which is determined by reference to § 306 stock (e.g., gifts of § 306 stock) is also § 306 stock. (§ 306(c)(1)(C))
  • The "common on common" exception is critical. Common stock issued with respect to common stock is NOT § 306 stock. (§ 306(c)(1)(A))
  • § 306 stock transferred by gift REMAINS § 306 stock in the donee's hands. However, a step-up in basis at death under § 1014 "cleanses" the taint. (§ 306(c)(1)(C))
• Redemption of § 306 stock.
  • Under § 306(a)(2), a redemption of § 306 stock is treated as a distribution of property to which § 301 applies (full three-tier § 301(c) treatment).
  • Exception. If the redemption qualifies under § 302(b)(3) (complete termination) or § 302(b)(4) (partial liquidation), the § 306(a) taint does not apply and the redemption is treated as an exchange. (§ 306(b)(1)(B)) (§ 302(f)(2))
  • § 306(b)(4) provides a further exception if the taxpayer establishes to the Secretary's satisfaction that the distribution and redemption were not in pursuance of a plan having tax avoidance as a principal purpose.

Step 11. Corporate-Level Consequences of Redemptions

"No gain or loss shall be recognized to a corporation on the distribution (not in complete liquidation) with respect to its stock of (1) money, (2) property, or (3) its own obligations." (§ 311(a))

• § 311 governs corporate gain or loss on distributions.
  • The general rule is nonrecognition. No gain or loss is recognized on the distribution of money, property, or the corporation's own obligations. (§ 311(a))
  • However, § 311(b)(1) requires gain recognition if the fair market value of distributed property exceeds its adjusted basis. The corporation recognizes gain as if the property were sold to the distributee at its fair market value.
  • The gain is computed on an asset-by-asset basis. Gains on appreciated property are NOT offset by losses on depreciated property distributed in the same transaction. (Morris Investment Corp. v. Commissioner, 156 F.2d 748 (3d Cir. 1946)) (Rev. Rul. 76-377, 1976-2 C.B. 95)
  • § 311(b)(2) provides that the amount of gain is determined without regard to any liability to which the property is subject or which is assumed by the distributee. This is a TRAP. Even if the liability exceeds the property's basis, the corporation recognizes the FULL gain.
  • No loss is recognized on distributions of depreciated property. The corporation should sell depreciated property to an unrelated party to recognize the loss, then distribute the cash. (§ 311(a))
• § 312 governs the effect on earnings and profits.
  • Under § 312(a), a distribution reduces E&P by the sum of money distributed, the principal amount of obligations distributed, and the adjusted basis of other property distributed. E&P cannot be reduced below the amount of gain recognized under § 311(b).
  • Under § 312(b), when appreciated property is distributed, E&P is first INCREASED by the built-in gain (FMV minus basis), then DECREASED by the FMV of the property. The net effect is a reduction of E&P equal to the property's basis, after the gross-up.
  • Under § 312(c), proper adjustment is made for liabilities assumed by the shareholder or to which the distributed property is subject.
  • § 162(k) provides that expenditures incurred in purchasing a corporation's stock are non-deductible, non-amortizable capital expenditures. Legal fees, accounting fees, and other costs of a redemption are not deductible.

Step 12. § 267 Related Party Loss Disallowance and § 1059 Extraordinary Dividends

"No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b)." (§ 267(a)(1))

• § 267(a)(1) disallows losses on sales or exchanges between related parties.
  • No deduction is allowed for any loss from the sale or exchange of property between persons specified in § 267(b). (§ 267(a)(1))
  • This applies even if the sale is bona fide and at arm's length. Intent is irrelevant.
  • § 267(b) defines 13 categories of related parties, including family members (brothers, sisters, spouse, ancestors, and lineal descendants), an individual and a more-than-50%-owned corporation, controlled group corporations, and various trust and estate relationships. (§ 267(b)(1)-(13))
  • TRAP. Siblings are related parties under § 267(b)(1) but are NOT subject to family attribution under § 318(a)(1). A shareholder could have a sale to his sister disallowed under § 267 while the same sister's stock ownership would not be attributed under § 318 for redemption purposes.
  • § 267(c) provides constructive ownership rules for § 267 purposes. Stock owned by a corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or beneficiaries. (§ 267(c)(1)) Family attribution includes brothers and sisters. (§ 267(c)(2))
  • § 267(c)(5) provides a limited reattribution rule. Stock constructively owned under § 267(c)(1) (entity attribution) is treated as actually owned for reapplication of § 267(c)(1)-(3), but stock constructively owned under § 267(c)(2) or (c)(3) (family or partner attribution) is NOT reattributed.
  • § 267(d) provides a partial gain offset rule. If a loss was disallowed under § 267(a)(1) and the related party later sells at a gain, the gain is recognized only to the extent it exceeds the previously disallowed loss.
  • § 267(f) provides that for controlled group members, losses are not disallowed but are deferred until the property leaves the controlled group.
• § 1059 can trigger basis reduction for extraordinary dividends received by corporate shareholders.
  • § 1059(a) requires a corporate shareholder that receives an "extraordinary dividend" on stock held for two years or less to reduce its basis in the stock by the "nontaxed portion" of the dividend (i.e., the amount sheltered by the dividends received deduction).
  • An extraordinary dividend is any dividend that equals or exceeds 5% of adjusted basis (for preferred stock) or 10% of adjusted basis (for other stock). (§ 1059(c)(2))
  • TRAP. Under § 1059(e)(1), for non-pro-rata redemptions and partial liquidations, the 2-year holding period requirement is DISREGARDED. The basis reduction applies automatically. This means a corporate shareholder that receives a redemption dividend must reduce its basis in any remaining shares without regard to how long it held the stock.
  • § 1059 applies only to corporate shareholders. Individual shareholders are not subject to basis reduction.

Step 13. Step-Transaction and Anti-Abuse Doctrines

"The question whether a given claim is one for the allowable deduction of a loss resulting from a closed transaction require[s] an analysis of the transaction as a whole." (Gregory v. Helvering, 293 U.S. 465, 469-70 (1935))

• The step-transaction doctrine can integrate separate steps.
  • Where a redemption is part of a larger integrated plan that includes other transactions (a sale to a third party, an issuance of new shares, a merger, or another redemption), the step-transaction doctrine may treat all steps as a single transaction for purposes of § 302.
  • Three tests for step-transaction have been articulated. (1) The binding commitment test. (2) The mutual interdependence test. (3) The end result test. (Commissioner v. Gordon, 391 U.S. 83, 96 (1968)) (Penrod v. Commissioner, 88 T.C. 1415, 1429 (1987))
  • If steps are integrated, the § 302(b) tests are applied to the combined result. A redemption that would fail when viewed alone may qualify if the integrated transaction produces a meaningful reduction or complete termination. (Rev. Rul. 75-447, 1975-2 C.B. 113)
  • Conversely, if a redemption that would qualify standing alone is part of a plan that produces a different result, the step-transaction doctrine may cause it to fail.
• The economic substance doctrine.
  • A transaction that lacks economic substance apart from its tax benefits may be disregarded. (Gregory v. Helvering, 293 U.S. 465 (1935))
  • Codified at § 7701(o), which provides that a transaction has economic substance only if (1) the transaction meaningfully changes the taxpayer's economic position, and (2) the taxpayer has a substantial purpose for the transaction apart from federal income tax effects. (§ 7701(o))
  • A stock redemption that has genuine economic effect (an actual change in ownership structure, a genuine payment, a legally binding agreement) will generally satisfy the economic substance requirement.
• Substance over form.
  • The IRS may recharacterize a transaction according to its substance rather than its form. (Gregory v. Helvering, 293 U.S. 465 (1935))
  • If a redemption is in substance a dividend (for example, where the shareholder is obligated to recontribute the proceeds or where the redemption is a sham), the IRS may assert that § 302(b) does not apply.

Step 14. Documentation and Reporting Obligations

"Every person required to file a return shall keep such records as shall be sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such return." (Treas. Reg. § 1.6001-1(a))

Step 14A. Corporate Documentation

• Corporate authorizing documents.
  • Adopt a board resolution at a properly convened meeting or by unanimous written consent. The resolution should specify the number and class of shares to be redeemed, the redemption price per share, the source of funds, and the date of redemption.
  • Record the cancelled shares and update the stock transfer ledger and ownership percentages immediately after the redemption.
  • Document the business purpose for the redemption, shareholder identities, voting, and any relationship between the redemption and other transactions in the corporate minutes.
• Tax computation and valuation documentation.
  • Maintain current E&P calculations to determine the taxability of any distribution that fails § 302. Attach a computation of current and accumulated E&P to the corporate return when nondividend distributions are made.
  • If property other than cash is distributed, obtain an independent appraisal. Document the FMV methodology, the corporation's adjusted basis in the property, and attach a statement to the appropriate form showing both tax basis and FMV.
• § 302(c)(2) waiver agreement and related documentation.
  • File the written statement required by Treas. Reg. § 1.302-4(a) with the timely-filed return for the year of redemption. Late filing requires IRS consent. (Treas. Reg. § 1.302-4(a))
  • Maintain documentation that no prohibited interest is retained after the redemption, including employment records showing termination of any officer, director, or employee relationship.
  • Document the 10-year stock acquisition history to verify that no disqualifying transfers occurred.
  • For entity waivers under § 302(c)(2)(C), obtain joint and several liability agreements from all related persons.
• Plan of partial liquidation documentation.
  • Adopt a written plan of partial liquidation before the distribution. The plan must be adopted within the taxable year of the distribution or the succeeding taxable year. (§ 302(e)(1)(B))
  • Document that the qualified trade or business was actively conducted for 5 years and was not acquired in a taxable transaction during that period. (§ 302(e)(3))
  • Document that the corporation continues to conduct another qualified trade or business after the distribution. (§ 302(e)(2))

Step 14B. Forms and Filing Obligations

• Form 8937 (Report of Organizational Actions Affecting Basis).
  • Issuers of specified securities must file Form 8937 within 45 days following a stock redemption (or by January 15 of the following year, if earlier). (§ 6045B)
  • The issuer must also provide a statement to each security holder of record. Posting on the issuer's public website satisfies the statement requirement and must remain accessible for 10 years.
  • Exception for S corporations. An S corporation that reports the effect on a timely filed Schedule K-1 for each shareholder is exempt from Form 8937.
  • Exception for dividends reported on Form 1099-DIV. Do not report a dividend distribution on Form 8937.
  • Penalty for failure to file is $100 per form and issuer statement.
• Form 1099-DIV (Dividends and Distributions).
  • If a redemption is treated as a dividend distribution (fails § 302), report the distribution on Form 1099-DIV.
  • Box 9 reports cash liquidation distributions. Box 10 reports noncash liquidation distributions.
  • If the redemption qualifies under § 302(a) as a sale or exchange, Form 1099-DIV reporting is generally not required.
• Form 5452 (Corporate Report of Nondividend Distributions).
  • File if the corporation made nondividend distributions under § 301. Attach to the income tax return for the year of distribution.
  • TRAP. Form 5452 does NOT include distributions in redemptions or liquidations in its definition of "nondividend distributions." If a redemption is treated as a sale or exchange under § 302(a), Form 5452 is not required for that redemption.
• Schedule D for shareholder gain or loss reporting.
  • The shareholder reports gain or loss on a qualifying redemption on Schedule D (Form 1040 for individuals, Form 1120 for corporations). (Schedule D instructions)
  • The shareholder's basis in the redeemed stock is subtracted from the amount realized to determine gain or loss. (§ 1001(a))
  • Short-term or long-term capital gain treatment depends on whether the redeemed stock was held for more than one year. (§ 1222)
• Form 1120 (Corporate Income Tax Return).
  • Answer "Yes" to the question about an 80%-or-more change in ownership if the redemption produces such a change.
  • Report gain under § 311(b) if appreciated property was distributed.
  • Deductible expenditures of a redemption are limited by § 162(k), which denies deductions for amounts paid or incurred in connection with stock redemptions.
• Schedule K-1 (Form 1120S) for S corporation redemptions.
  • Report distributions in Box 16, Code D. Attach a statement providing the date property was acquired, date distributed, FMV on distribution date, and corporation's basis.
  • § 1377(a)(2) election. If a shareholder's interest is terminated (including through redemption), the corporation may elect to allocate income and expenses as if the tax year consisted of two separate years. This requires a statement attached to the timely filed return with consent of all affected shareholders. A redemption of at least 20% of outstanding stock in any 30-day period that qualifies under § 302(a) or § 303(a) is a "qualifying disposition" permitting this election.
• Form 966 for corporate dissolution or liquidation.
  • Under § 6043(a), a corporation must file Form 966 within 30 days after adopting a resolution or plan of dissolution or liquidation. This includes partial liquidations. (§ 6043(a))
  • Attach a certified copy of the board resolution and all amendments to the Form 966 filing. (Form 966 instructions)
  • File an amended Form 966 within 30 days if the plan is modified. (Form 966 instructions)
• Rev. Proc. 2024-3 no-rule areas.
  • The IRS will not issue rulings on whether § 302(b) applies when consideration consists of corporate notes and the shareholder's stock is held in escrow as security. (Rev. Proc. 2024-3, § 3.01(50))
  • The IRS will not issue rulings when consideration is contingent on future earnings, working capital levels, or similar contingencies. (Rev. Proc. 2024-3, § 3.01(51))
  • The IRS will not issue rulings when the corporation uses property owned by the redeemed shareholder after the redemption and payments are dependent on future earnings. (Rev. Proc. 2024-3, § 3.01(52))
  • The IRS has listed "treatment of basis in a § 302 or § 304 redemption" as an area under study in which rulings will not be issued until resolved. (Rev. Proc. 2024-3, § 5.01(1))