Stock Redemptions (§ 302)

When a corporation repurchases its own stock from a shareholder, IRC § 302 determines whether the payment is a capital gain (exchange treatment — the shareholder offsets basis and pays capital gains rates only on the net gain) or a dividend (ordinary distribution treatment under § 301 — taxable to the extent of the corporation's earnings and profits, potentially at qualified dividend rates for individuals or ordinary income rates for corporations receiving the distribution). The distinction is enormous: exchange treatment allows the shareholder to recover their full investment cost tax-free before paying any tax, while dividend treatment taxes the entire payment to the extent of earnings and profits with no basis offset. For a shareholder with a $1 million basis in stock and a $1.5 million redemption price, exchange treatment means $500,000 of gain; dividend treatment means potentially $1.5 million of taxable income (to the extent of E&P). Section 302 provides four tests for when a redemption qualifies for exchange treatment — complete termination of the shareholder's interest, substantially disproportionate redemption, partial liquidation, and "not essentially equivalent to a dividend" — and the constructive ownership rules of § 318 apply when testing whether any threshold has been met, making it possible for a shareholder to fail these tests even after all their directly owned shares are redeemed if family members continue to hold stock.

Current Law (2026)

Key Mechanics

Section 302 governs whether a corporation's redemption of its own stock is taxed to the shareholder as a dividend (ordinary income) or as an exchange (capital gain or loss). The default rule under § 301 treats any corporate distribution as a dividend to the extent of earnings and profits — which is generally the worse tax outcome. Section 302 rescues qualifying redemptions from dividend treatment by characterizing them as exchanges: the shareholder is treated as selling stock back to the corporation, generating capital gain (or loss) measured against the stock's tax basis. The four qualifying tests (§ 302(b)): (1) Substantially disproportionate (§ 302(b)(2)) — the shareholder must own less than 50% of total combined voting power after the redemption, AND the shareholder's post-redemption percentage must be less than 80% of the pre-redemption percentage; mathematically the most precise test; (2) Complete termination (§ 302(b)(3)) — all of the shareholder's stock is redeemed; but § 318 constructive ownership rules attribute stock held by family members and related entities, which can prevent "complete" termination unless the § 302(c) family attribution waiver is filed; (3) Not essentially equivalent to a dividend (§ 302(b)(1)) — a "meaningful reduction" in the shareholder's proportionate interest; vague and rarely successfully invoked alone; (4) Partial liquidation (§ 302(b)(4)) — the redemption is made in partial liquidation of the corporation under § 302(e), meaning a genuine contraction of the corporate business. Constructive ownership (§ 318): stock owned by a spouse, children, grandchildren, parents, and related entities is attributed to the shareholder for purposes of § 302 tests; a shareholder who thinks she terminated her interest may still be deemed to own stock through family attribution. § 302(c) waiver: to escape family attribution for a complete termination, the shareholder must have no remaining interest in the corporation (except as a creditor), not reacquire any stock for 10 years, and file a written waiver agreement with the IRS. Failure to qualify under any § 302(b) test results in the entire distribution being taxed as a dividend under § 301 to the extent of E&P.

Legal Authority

• 26 U.S.C. § 302(a) — Distributions qualifying as exchange treatment: if one of the four tests is met, the distribution is treated as full payment in exchange for the stock (capital gain/loss treatment)
• 26 U.S.C. § 302(b)(1) — Not essentially equivalent to a dividend: the "meaningful reduction" test; requires a genuine reduction in proportionate interest including voting power; rarely sufficient without meeting another test
• 26 U.S.C. § 302(b)(2) — Substantially disproportionate redemption: shareholder must own less than 50% of total combined voting power after the redemption AND the post-redemption percentage must be less than 80% of the pre-redemption percentage
• 26 U.S.C. § 302(b)(3) — Complete termination: all shareholder's stock is redeemed; constructive ownership under § 318 may prevent this test from being satisfied
• 26 U.S.C. § 302(b)(4) — Partial liquidation: redemptions treated as made in partial liquidation under § 302(e) qualify as exchanges
• 26 U.S.C. § 302(c) — Constructive ownership waiver: a shareholder who completely terminates direct ownership can waive family attribution under § 318(b) if she has no interest in the corporation (other than as a creditor), does not reacquire stock for 10 years, and files a waiver agreement with the IRS
• 26 U.S.C. § 301 — Default rule: if § 302 tests are not met, the distribution is treated as a dividend under § 301 to the extent of earnings and profits, then a return of basis, then capital gain
• 26 U.S.C. § 302 (DB) — Distributions in redemption of stock: partnerships, estates, and trusts are treated as holding stock for their partners or beneficiaries when testing ownership percentages; a "qualified trade or business" means a business run actively for the prior 5 years and not bought in a taxable acquisition; a partial liquidation must be under a plan and happen in the same taxable year or the next; special rules cover redemptions to pay death taxes and certain types of stock
• 26 U.S.C. § 301 (DB) — Distributions of property: the distribution amount is cash received plus fair market value of other property, reduced by liabilities assumed or to which distributed property is subject; for corporate shareholders owning at least 20% of voting power or stock value, § 312 is applied with certain modifications; the starting tax basis of distributed property received by the shareholder equals its fair market value

How It Works

Why the distinction matters: Exchange treatment under § 302 gives the shareholder dollar-for-dollar basis recovery — every dollar of basis offsets the redemption price before any tax is computed. If the shareholder has a $500,000 basis and receives $800,000 in a qualifying redemption, they owe capital gains tax only on the $300,000 net gain. Dividend treatment under § 301 provides no such offset: the entire $800,000 is taxable as a dividend to the extent of the corporation's earnings and profits (and the basis is recovered only if the distribution exceeds E&P). For corporate shareholders, dividend treatment triggers the dividends received deduction (DRD) — potentially eliminating 50-65% of the dividend from tax — while exchange treatment produces capital gain with no DRD. This reversal of incentives (individuals prefer exchange; corporations may prefer dividend) is why § 302 planning depends heavily on the identity of the shareholder.

Test 1 — Complete Termination (§ 302(b)(3)): The most reliable test. If all of the shareholder's stock — direct and constructive — is redeemed, the distribution qualifies as an exchange. The challenge is constructive ownership: under § 318, a shareholder is deemed to own stock held by their spouse, children, grandchildren, and parents. A father cannot "completely terminate" his interest if his wife, children, or grandchildren own stock — the attribution rules deem him to still own their shares. To escape family attribution in a complete termination, the father must meet the family attribution waiver requirements of § 302(c): he must have no interest in the corporation other than as a creditor for 10 years (no employment, no director position, no consulting fee), must not reacquire any stock for 10 years, and must file a written agreement with his tax return promising compliance. The waiver must be filed timely — filing late is fatal.

Test 2 — Substantially Disproportionate (§ 302(b)(2)): A mathematical test with two prongs. After the redemption, the shareholder must (a) own less than 50% of the total combined voting power, and (b) own less than 80% of the percentage they owned before the redemption. Example: a shareholder who owns 60% before the redemption and 45% after does not qualify because 45% > 80% of 60% (which is 48%). A shareholder who owns 60% before and 40% after qualifies — she is below 50%, and 40% < 48% (80% of 60%). Constructive ownership applies in computing these percentages, which means family members' shares are attributed when calculating pre- and post-redemption ownership.

Test 3 — Not Essentially Equivalent to a Dividend (§ 302(b)(1)): A facts-and-circumstances test that requires a "meaningful reduction" in the shareholder's proportionate interest in the corporation, including voting power. The Supreme Court in United States v. Davis (1970) held that this test is not met by a pro rata redemption where all shareholders are redeemed equally — since proportionate interests don't change. A small reduction in a minority shareholder's interest (e.g., from 27% to 24.3%) has been held sufficient in some cases, particularly where the reduction crosses from majority to minority status (crossing the 50% line is always meaningful). As a standalone test, this is the least reliable basis for exchange treatment.

Test 4 — Partial Liquidation (§ 302(b)(4)): Applies to redemptions made in partial liquidation of the corporation — specifically, a distribution attributable to the genuine termination of a qualified trade or business conducted throughout the prior 5 years. This is a corporate-level test (looking at the corporation's business activities) rather than a shareholder-level test. The most common example: a corporation operating two distinct businesses terminates one, distributes the assets (or proceeds from selling them) to shareholders in redemption of their stock. Not available for personal holding companies or investment companies.

Closely-held business buyouts: Section 302 is particularly important in family business succession planning. When a family corporation wants to buy out one family member's interest, the § 318 attribution rules frequently cause the buyout to fail the § 302 tests — if the departing family member's children or spouse retain shares, constructive ownership attribution defeats the complete termination test. The family attribution waiver is essential in these transactions: the departing shareholder must genuinely sever all ties with the corporation for 10 years. A parent who remains as an advisor, consultant, or de facto manager after the "redemption" risks IRS challenge to the waiver.

How It Affects You

If you're a shareholder in a closely held corporation being bought out: Whether your buyout qualifies for exchange treatment under § 302 depends on your remaining ownership after the transaction — including stock attributed to you from your family members. Before completing the buyout, map every family member who owns stock in the corporation and run the constructive ownership analysis. If family attribution prevents you from satisfying the complete termination or substantially disproportionate tests, consider whether the § 302(c) family attribution waiver is available and appropriate — it requires a genuine 10-year arm's-length separation from the company, which may not be compatible with your transition plans if you want to remain involved as an advisor.

If you're planning to use a redemption to shift ownership in a family business: A series of redemptions that gradually reduce one family member's stake while increasing others' effective ownership can achieve succession goals while maintaining § 302 exchange treatment on each step. Work through the substantially disproportionate test on each redemption — each redemption must independently meet the 50%/<80% tests. Redemptions from different family members at different times are analyzed separately. A comprehensive succession plan should model the ownership percentages (actual and constructive) at each redemption step to ensure exchange treatment is available.

If you're a corporate shareholder receiving a redemption: The § 302 analysis runs in reverse from the individual shareholder's perspective. Corporate shareholders benefit from the dividends received deduction (DRD) — which excludes 50-65% of qualifying dividends from tax — so dividend treatment under § 301 may actually be preferable to exchange treatment for corporate shareholders. An inter-corporate redemption that fails the § 302 tests is a dividend eligible for the DRD; one that succeeds is a capital gain with no DRD. Tax advisors for corporate shareholders sometimes structure redemptions to fail the § 302 tests intentionally.

If the redemption is funded by corporate life insurance: A common family business succession technique uses corporate-owned life insurance (COLI) to fund a redemption agreement: the corporation buys life insurance on each shareholder, and upon death, uses the proceeds to redeem the deceased shareholder's stock from the estate. These "entity purchase" or "stock redemption" plans have § 302 and § 318 implications — the surviving shareholders don't directly receive the redeemed shares, but their proportionate ownership increases as the decedent's shares are retired. Careful structuring is required to avoid inadvertently triggering the substantially disproportionate test in a way that is tax-inefficient.

State Variations

Most states with corporate income taxes follow federal § 302 treatment — they respect the exchange vs. dividend characterization from federal law and apply state capital gains or dividend rates accordingly. States that impose separate rates on capital gains vs. dividends (unusual — most states tax both as ordinary income) would apply their respective rates. Some states have their own dividends received deductions for corporate shareholders that may differ from the federal DRD.

Implementing Regulations

• 26 CFR 1.302-1 — General rules for stock redemptions; § 302(a) exchange treatment conditions
• 26 CFR 1.302-2 — Redemptions not essentially equivalent to dividends; the meaningful reduction test
• 26 CFR 1.302-3 — Substantially disproportionate redemptions; calculation of the 50% and 80% tests
• 26 CFR 1.302-4 — Termination of shareholder's interest; complete termination; family attribution waiver requirements and mechanics
• 26 CFR 1.302-5 — Partial liquidation rules; qualifying termination of a trade or business

Pending Legislation

No significant § 302 reform legislation is pending as of 2026. Proposals to equalize capital gains and ordinary income tax rates (which would eliminate most of the practical significance of the exchange vs. dividend distinction for individual shareholders) appear periodically in Democratic tax proposals but have not been enacted. Corporate tax reform discussions involving dividend taxation and the DRD occasionally touch on § 302.

Recent Developments

• S corporation redemption complications: Unlike C corporation redemptions (which involve earnings and profits analysis), S corporation redemptions must be analyzed under § 302's tests without the E&P framework. S corporation distributions in excess of basis are capital gain; the § 302 tests determine whether a redemption is exchange or distribution treatment. Post-TCJA, the accumulated adjustments account (AAA) rules create additional complexity in S corporation redemptions, particularly for shareholders with different stock purchase dates.
• ESOP transactions: Employee Stock Ownership Plans that purchase shares from closely held corporation shareholders must navigate § 302 to determine whether the ESOP sale qualifies as an exchange (capital gain to the seller) or a dividend. Most ESOP transactions involving selling shareholders who completely terminate their interest are structured to qualify as exchange treatment under § 302(b)(3).
• Built-in gains tax interaction: For S corporations that converted from C corporations within the preceding 10 years, a redemption that triggers the sale of appreciated assets may also trigger the built-in gains tax (§ 1374) at the corporate level — creating a double tax if not properly planned. The § 302 analysis determines the shareholder's tax treatment, while the § 1374 built-in gains analysis is a separate corporate-level concern.