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 1st test treats the stock redemption as a sale if it terminates the shareholder's entire interest in the corporation.
The 2nd 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:
- the redemption decreases the shareholders voting power to less than 50% of corporation's outstanding stock; or,
- 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.
Thus, noting that the total outstanding stock declines by the number of redeemed stock, the following equation must be true in regards to voting power and to stock value to satisfy Test #2:
|Stock Voting Power and Value AFTER Redemption|
Total Outstanding Voting Power and Value AFTER Redemption
|<||80%||×||Stock Voting Power and Value BEFORE Redemption|
Total Outstanding Voting Power and Value BEFORE Redemption
Some shareholders have argued in court that redemption should be treated as a sale because it is not equivalent to a dividend; however, acceptance of this argument by the Internal Revenue Service (IRS) and the courts has varied.
Stock Ownership Attribution Rules
Because the tax treatment of a stock redemption is determined by the stockholder's ownership percentage of the corporation, IRC §318 lists 4 rules to determine if there is any indirect ownership, or constructive ownership, of the stock, which is includable in the percentages.
- The family attribution rule: an individual indirectly owns any stock owned by the taxpayer's spouse, children, grandchildren, and parents.
- The attribution-from-an-entity rule: any shares of stock owned by a partnership, limited liability company (LLC), or an S corporation are considered owned proportionately by the owners of the entity. This attribution-from-an-entity rule also applies to a shareholder who owns more than 50% of a C corporation. So if a partnership owns 1000 shares of a corporation, a partner who owns 20% of the partnership is deemed to indirectly own 200 shares of the corporation.
- The attribution-to-an-entity rule attributes indirect ownership of a corporation by a business entity to the partners, members, or shareholders of the business entity, or, if the business entity is a C corporation, to any shareholder with a majority interest. So if ABC Corporation owns 25% of DEF corporate stock, and you own 51% of ABC Corporation, then you are considered to own indirectly 25% of DEF stock.
- Any person who owns an option to acquire the stock is also considered to indirectly own the stock.
IRC §318 provides a waiver of the family attribution rule, where a stock redemption will be considered a sale if it terminates the stockholder's entire direct interest in the corporation, but only if the following 3 conditions are also satisfied:
- the individual has no other relationship with the corporation, other than as a creditor, after the redemption, which includes working as an employee, or as an officer or director of the corporation;
- the individual cannot acquire any interest in the corporation, unless it is by inheritance, for 10 years after the redemption; and
- the taxpayer must notify the IRS of any prohibited acquisition within the 10-year period.
The waiver can be extended to business entities if all individuals who are deemed to own the stock join in the waiver and that neither the entity nor any of the individuals may acquire an interest in the corporation for at least 10 years. But if they do acquire such an interest, then they must notify the IRS. Additionally, there is joint and several liability for any back taxes and penalties if any business interest is reacquired within 10 years.
Corporate Tax Consequences
Payment of cash to redeem stock has no effect on taxable income of the corporation, but if it distributes property, then it must recognize a gain, but not losses, as if the property were sold for the fair market value to the stockholder. The reduction in the corporation's earnings and profit (E&P) depends on the tax consequences to the shareholder. If it is deemed a sale, then E&P is reduced by the ratable portion of the E&P that is attributable to the redeemed shares. However, if redemption payment is treated as a dividend, then the entire amount is subtracted from E&P.
So if a corporation with E&P equal to $1,000,000 redeems 25% of its outstanding stock by paying $400,000 and the redemption is treated as a stock sale, then its E&P is reduced to $250,000 ($1,000,000 × 25%). If the stock redemption is treated as a dividend payment, then the entire $400,000 can be used to reduce E&P.
Stock Redemptions by S Corporations
Subchapter S provides no special rules for stock redemptions, so Subchapter C rules apply. For redemptions considered as stock sales, the shareholder must recognize a capital gain or loss equal to the redemption payment minus the adjusted basis of the surrendered shares. If the redemption payment is treated as a distribution, then Subchapter S distribution rules apply.
If an S corporation has accumulated E&P from a prior existence as a C corporation, then S corporation earnings must be tracked using an accumulated adjustment account (AAA). The stock redemption rules also apply to the AAA, except that a stock redemption that is treated as a dividend distribution cannot reduce the AAA below 0.
However, for a stock sale, both the AAA and E&P are reduced proportionately to the reduction in the number of outstanding shares. So if a corporation had $100,000 in its AAA account and $300,000 in its E&P account, and a stock redemption was used to retire ½ of the number of outstanding shares, then the AAA is reduced to $50,000 and E&P is reduced to $150,000.
Stock Redemptions Where the Stockholder is an Estate
A redemption of stock that was included in the gross estate of the decedent qualifies as an exchange if it is used to pay estate taxes and expenses. The redemption must have been made by the earlier of 90 days after the period of limitations on the assessment of the federal estate tax – 3 years after the return is filed — or within 60 days after a final decision by the tax court if a petition for the redetermination of a tax deficiency has been filed. The value of the decedent's stock in a closely held corporation must exceed 35% of the gross estate after funeral and administration expenses and losses have been deducted. Otherwise, the redemption will be treated as a dividend.