A stock redemption occurs when a corporation acquires its own shares from a shareholder in exchange for money or property. Under IRC §302, a redemption is treated either as a sale or exchange or as a dividend, depending on how much ownership changes.
When a redemption is treated as a sale
A redemption receives sale or exchange treatment—resulting in capital gain or loss—if it meets any of the following tests:
- Not essentially equivalent to a dividend
- Substantially disproportionate
- After the redemption, the shareholder owns less than 50% of voting power
- Ownership percentage after redemption is less than 80% of the pre‑redemption percentage
- Complete termination of interest
Both direct and indirect ownership (family attribution, entity attribution) must be considered.
If a redemption qualifies as a sale, the shareholder recognizes capital gain or loss based on the difference between the redemption proceeds and stock basis.
When a redemption is treated as a dividend
If none of the sale tests are met, the redemption is treated as a dividend to the extent of the corporation’s Earnings & Profits (E&P) under IRC §301.
Dividend treatment applies even if the shareholder’s economic interest barely changes.
Liquidating Distributions
Liquidating distributions occur when a corporation partially or completely liquidates. Under IRC §331, shareholders treat liquidating distributions as payments in exchange for stock.
Tax treatment to shareholders
- Liquidating distributions are return of capital until basis is recovered
- After basis reaches zero, further distributions are capital gain
- If total liquidating distributions are less than basis, the shareholder recognizes a capital loss
- Losses are allowed, even between related parties (unlike non‑liquidating distributions)
The character of the gain or loss (long‑term or short‑term) depends on the shareholder’s holding period.
Corporate consequences
Under IRC §336, a corporation recognizes gain or loss on the distribution of property in liquidation as if the property were sold at FMV. This is different from non‑liquidating distributions, where losses are not recognized.
Summary
Stock redemptions and liquidating distributions follow strict rules:
- Redemptions are taxed as sales if ownership meaningfully decreases
- Otherwise, redemptions are dividends to the extent of E&P
- Liquidating distributions are always treated as sales or exchanges
- Shareholders recover basis first, then recognize gain
- Corporations recognize gain or loss on property distributed in liquidation
These rules come directly from IRC §302, §303, §331–§336 and IRS corporate distribution guidance.