Question

What is a stock redemption? What are some reasons for redeeming stock? Why are some redemptions treated as sales and others as dividends?

Answer 1

A stock redemption is an acquisition by a corporation of its own shares in exchange for cash or property, for the purpose of either retiring the shares or holding them as treasury stock. Common reasons for redemptions include:

• an obligation under a buy-sell agreement to purchase stock of any shareholder who offers it for sale;
• to be able to provide stock for employees exercising stock options;
• to go private by redeeming all shares traded publicly, thereby restricting ownership to private investors;
• to gain a bargain if the corporation feels that the shares are trading below their intrinsic value;
• to increase the market price of the stock;
• to eliminate dissident minority shareholders;
• to pay estate taxes;
• to prevent a takeover of the company, or
• to retire preferred stock so as to eliminate the dividend payments.

The tax consequences of the stock redemption depend on whether the relative equity interest of a stockholder is the same or significantly less after the redemption. If a stockholder's equity interest relative to other stockholders in the corporation remains the same, then the stock redemption is treated as a dividend payment (deemed dividend redemption) in so far as it can be paid out of earnings and profit (E&P).

If the stock redemption significantly decreases the stockholder's equity stake in the corporation, then the stock redemption is treated as a capital sale, in which a stockholder will either have a capital gain or loss, just as if the stock was sold on the market.

Redemptions as Stock Sales

To determine whether a redemption is a stock sale, IRC 302 provides for 2 objective tests. The 1^st test treats the stock redemption as a sale if it terminates the shareholder's entire interest in the corporation.

The 2^nd test treats a substantially disproportionate redemption, where the redemption significantly reduces the stockholder's equity stake in the corporation, as a stock sale if the following 2 requirements are met:

1. the redemption decreases the shareholders voting power to less than 50% of corporation's outstanding stock; or,
2. the shareholder's percentage interest in the voting stock falls to less than 80% of the percentage interest before the redemption; if the stock is nonvoting, then the redemption is treated as a stock sale if the fair market value of the common stock as a percentage of the total stock outstanding falls below 80% of what the stockholder owned previous to the redemption.

On the Other Hand , if the Test are nor met , then the same will be treated as a dividend payout