Question

7. a. What is the general rule for taxation of distributions by a corporation in redemption of its stock? b. Identify the types of redemptions that will not be treated under the general rule. Attach the Internal Revenue Code Section

Answer 1

26 U.S. Code § 302 - Distributions in redemption of stock

(a)General rule

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

THE TAXATION OF STOCK REDEMPTIONS

1. When a shareholder transfers stock to the issuing corporation in exchange for money or other property, the transaction may resemble either an ordinary sale of stock to an outsider in an arm's length bargain or the receipt by the shareholder of a dividend from the corporation. The "sale" analogy is appropriate, for example, when the owner of preferred stock instructs his broker to sell his stock and the broker, by chance, effects a sale to the corporation, which happens to be buying up its preferred stock at the time. The preferred shareholder ought to be able to treat the transaction in the same manner as any other sale, reporting the difference between his adjusted basis and the sales price as capital gain or loss. On the other hand, when the owner 'of a one-man corporation having only common stock outstanding foregoes dividends for a period of years and then "sells" some of his shares to the corporation for cash, the transaction is more like a "dividend" than a "sale." Although the shareholder has surrendered some of his stock, his interest in the corporation's assets and his control of the corporation's fate are undisturbed. If the transaction were not taxed as a "dividend," moreover, the shareholder could enter upon a long-range program of intermittent transfers of stock to his corporation, employing tax-free stock dividends if necessary to replace his shares and to restore the corporation's stated capital for the benefit of nervous creditors. For shareholders who could adopt such a plan of intermittent "sales" of stock, the tax on dividend income would become a "dead letter."
2. It should not be surprising, then, that a "sale" of stock by a shareholder to his corporation is sometimes taxed as a "dividend" instead of as a "sale."1 The knotty problem that has faced Congress, the Treasury, and the courts over the years-to which there can never be a universally acceptable solution-is the determination of which transfers of stock are to be classified as "dividends" and which as "sales." For a period of more than 30 years, ending in 1954, the general rule was that such transactions were "sales" 2 unless the transaction was "essentially equivalent to the distribution of a taxable dividend," in which event the entire distribution was taxed as a dividend to the extent of current and post1913 earnings and profits.3 Although the 1954 Code seeks to provide a more reliable formula, it preserves this ancient and troublesome phrase and there is no escape from a few words of history before we turn to the statutory language of the 1954 Code.4

b) Types of redemption not treated under the general rule

Redemptions treated as exchanges

(1)Redemptions not equivalent to dividends

Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend.

(2)Substantially disproportionate redemption of stock

(A)In general

Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder.

(B)Limitation

This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.

(C)DefinitionsFor purposes of this paragraph, the distribution is substantially disproportionate if—

(i)

the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time,

is less than 80 percent of—

(ii)

the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time.

For purposes of this paragraph, no distribution shall be treated as substantially disproportionate unless the shareholder’s ownership of the common stock of the corporation (whether voting or nonvoting) after and before redemption also meets the 80 percent requirement of the preceding sentence. For purposes of the preceding sentence, if there is more than one class of common stock, the determinations shall be made by reference to fair market value.

(D)Series of redemptions

This paragraph shall not apply to any redemption made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect to the shareholder.

(3)Termination of shareholder’s interest

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

(4)Redemption from noncorporate shareholder in partial liquidationSubsection (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.

(5)Redemptions by certain regulated investment companiesExcept to the extent provided in regulations prescribed by the Secretary, subsection (a) shall apply to any distribution in redemption of stock of a publicly offered regulated investment company (within the meaning of section 67(c)(2)(B)) if—

(A)

such redemption is upon the demand of the stockholder, and

(B)

such company issues only stock which is redeemable upon the demand of the stockholder.

(6)Application of paragraphs

In determining whether a redemption meets the requirements of paragraph (1), the fact that such redemption fails to meet the requirements of paragraph (2), (3), or (4) shall not be taken into account. If a redemption meets the requirements of paragraph (3) and also the requirements of paragraph (1), (2), or (4), then so much of subsection (c)(2) as would (but for this sentence) apply in respect of the acquisitionof an interest in the corporation within the 10-year period beginning on the date of the distribution shall not apply.

(c)Constructive ownership of stock

(1)In general

Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining the ownership of stock for purposes of this section.

(2)For determining termination of interest

(A)In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if—

(i)

immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor,

(ii)

the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and

(iii)

the distributee, at such time and in such manner as the Secretary by regulations prescribes, files an agreement to notify the Secretary of any acquisition described in clause (ii) and to retain such records as may be necessary for the application of this paragraph.

If the distributee acquires such an interest in the corporation (other than by bequest or inheritance) within 10 years from the date of the distribution, then the periods of limitation provided in sections 6501 and 6502 on the making of an assessment and the collection by levy or a proceeding in court shall, with respect to any deficiency (including interest and additions to the tax) resulting from such acquisition, include one year immediately following the date on which the distributee (in accordance with regulations prescribed by the Secretary) notifies the Secretary of such acquisition; and such assessment and collection may be made notwithstanding any provision of law or rule of law which otherwise would prevent such assessment and collection.

(B)Subparagraph (A) of this paragraph shall not apply if—

(i)

any portion of the stock redeemed was acquired, directly or indirectly, within the 10-year period ending on the date of the distribution by the distributee from a person the ownership of whose stockwould (at the time of distribution) be attributable to the distributee under section 318(a), or

(ii)

any person owns (at the time of the distribution) stock the ownership of which is attributable to the distributee under section 318(a) and such person acquired any stock in the corporation, directly or indirectly, from the distributee within the 10-year period ending on the date of the distribution, unless such stock so acquired from the distributee is redeemed in the same transaction.

The preceding sentence shall not apply if the acquisition (or, in the case of clause (ii), the disposition) by the distributee did not have as one of its principal purposes the avoidance of Federal income tax.

(C)Special rule for waivers by entities

(i)In generalSubparagraph (A) shall not apply to a distribution to any entity unless—

(I)

such entity and each related person meet the requirements of clauses (i), (ii), and (iii) of subparagraph (A), and

(II)

each related person agrees to be jointly and severally liable for any deficiency (including interest and additions to tax) resulting from an acquisition described in clause (ii) of subparagraph (A).

 In any case to which the preceding sentence applies, the second sentence of subparagraph (A) and subparagraph (B)(ii) shall be applied by substituting “distributee or any related person” for “distributee” each place it appears.