December 30, 2019
In corporate tax, current profits are taxed at ordinary rates when distributed as dividends to current shareholders, while the sale of corporate stock – itself a capital asset – is taxed as a capital gain. With those corporate tax basics in mind, imagine two scenarios involving a closely-held C corporation. In one scenario, the corporation earns a nice profit, declares and pays an annual dividend, and that dividend is taxed as ordinary income to the receiving shareholders (though likely at a preferential rate). In the second scenario, a shareholder decides to leave the company and sell his stock to an outsider. There, the stock sale involves the disposition of a capital asset and the resulting gain to the selling shareholder is taxed as a long-term capital gain. The second scenario is no different if the corporation is the purchaser of the stock (a complete redemption).
But now imagine a situation involving a partial redemption by the corporation, where the selling shareholder is both a current shareholder and disposing of a capital asset. What tax treatment should apply?
The answer is found in Section 302 of the Internal Revenue Code, which gives us four different tests to determine whether or not stock redemptions should be treated as a sale of stock taxed as a capital gain or as a regular distribution (treated as a dividend) and taxed as ordinary income.1 While three of these tests are mechanical and objective, one of those tests – Section 302(b)(1) – is rather subjective and is the particular focus of this Insight.
The text of the Code labels the redemption test found Section 302(b)(1) as "redemptions not equivalent to dividends." Whether a redemption distribution is not essentially equivalent to a dividend is based entirely on the facts and circumstances of each case,2 and the focus of this test is on the effect the distribution has on the redeemed shareholder – in particular the control that shareholder has both pre- and post-redemption. The general rule is that a redemption must result in a "meaningful reduction" of the shareholder's interest to satisfy this "not essentially a dividend" requirement.3
The following is a summary of rulings that can serve as guideposts in determining (and making an argument for) whether or not a partial redemption is meaningful enough, and therefore "not essentially a dividend" under Section 302(b)(1).
Rev. Rul. 76-364
There are four shareholders in a corporation – A, B, C, and D. Shareholder A owns 27%, while Shareholders B, C, and D each own 24.3%. The corporation redeems some of A's stock, reducing A's share of the company to 22.7%, while increasing the proportionate control of B,C, and D. This particular reduction was meaningful (and therefore warranted capital gains treatment) because Shareholder A's vote and value in the corporation declined. Moreover, before the redemption, Shareholder A only needed to convince one other shareholder to vote with him to control the corporation. However, post-redemption, Shareholder A now has to convince 2 additional shareholders to vote with him to achieve a majority vote.
Rev. Rul. 75-502
A redemption distribution was a meaningful reduction (and therefore warranted capital gains treatment) for a shareholder whose interest in the corporation declined from 57% to 50% post-redemption. The key fact in this ruling is that there were only 2 total shareholders, and the reduction to 50% gave the other shareholder an effective veto over every decision within the corporation. Note how important the ability to control the corporation factors into the determination of meaningfulness.
Rev. Rul. 78-401
A 90% shareholder's stake was reduced to 60% after a partial redemption. This is not a meaningful reduction because the shareholder still maintains real control over the corporation. Unlike the prior two examples, while the reduction was significant, the shareholder did not relinquish control of the corporation.
Rev. Rul. 76-385
A shareholder of a publicly-traded corporation held an overall 0.0001118% interest in the corporation before the redemption and a 0.0001081% interest after the redemption. In other words, the shareholder had "nothing" before and "nothing" after. However, this reduction in interest was meaningful because there were too many shareholders to practically apply any of the other, more mechanical Section 302(b) tests. Therefore, the test under Section 302(b)(1) became the fallback, and it was held to be effective given the circumstances. This ruling is very helpful to taxpayers with interests in a public corporation (or private corporations with a large number of shareholders), but is less effective for more closely-held corporations.
In summary, when a corporation is considering partial redemptions for particular shareholders, care should be taken so as not to invite unexpected tax consequences. When planning a redemption, the focus should be on satisfying some other more definitive test under Section 302(b). Only when the other tests fail should an argument under Section 302(b)(1) be made. It is important to note that any "business purpose" behind a particular redemption is irrelevant in arguing for redemption treatment.4 Therefore, the above examples demonstrate that the only argument likely to be successful under Section 302(b)(1) is to demonstrate a significant decline in voting control in the corporation.
One parting note: as mentioned above, the reality is that many corporate dividends are treated as qualifying dividends which are taxed at the same capital gains rates.5 For most individual shareholders of domestic (any many foreign) corporations, outside of the ability to offset gains with basis and recognize losses, the failure to qualify a partial redemption for capital gains treatment is otherwise insignificant. However, for corporate shareholders and/or individual shareholders receiving non-qualifying dividends, this distinction remains very important.6
This Insight is intended only to provide an overview of the matters addressed herein and does not constitute legal advice. If you have any questions regarding a specific issue, please seek appropriate legal counsel.
1 The situation is more nuanced than described as Section 301 determines the tax treatment of all regular corporate distributions. To the extent the corporation has "earnings and profits," a current distribution is treated as a dividend. Otherwise, the distribution itself could constitute a tax-free return of basis or the sale and/ or exchange of a capital asset.
2Treas. Reg. § 1.302-2(b)(1).
3 U.S. v. Davis, 397 U.S. 301 (1970).
4 Davis, 397 U.S. at 312.
5 IRC § 1(h)(11).
6 Corporate shareholders can take advantage of the dividends received deduction (DRD) available under IRC § 243. Individual shareholders of non-qualifying foreign corporations (e.g., a Cayman Islands corporation) would be subject to ordinary income tax rates if a partial redemption failed to receive capital gains treatment.