A founder retires and the company writes him a $4 million check to buy back his stock. He expects to pay long-term capital gains tax on the gain over his basis. Instead, the IRS sends a letter recharacterizing the entire $4 million as an ordinary dividend, taxing the gross proceeds without any basis recovery. The culprit? A 27-year-old son who happens to own 10% of the company.
That nightmare is exactly what Section 302 of the Internal Revenue Code is designed to prevent — or, when the rules are ignored, exactly what it inflicts. For closely-held C corporations, the line between "sale of stock back to the company" and "disguised dividend" is razor-thin, and crossing it incorrectly can transform a tax-favored exit into a financial disaster.
This guide walks through the three tests under Section 302(b), the brutal arithmetic of Section 318 attribution, the family-attribution waiver available for complete terminations, and the partial-liquidation safe harbor that quietly does a lot of heavy lifting in real-world transactions.
Why Section 302 Exists
When a corporation distributes cash to shareholders pro rata, the result is economically identical to a dividend — every owner gets paid in proportion to their stake. The Internal Revenue Code taxes those distributions as dividends to prevent corporations from disguising routine profit distributions as stock sales.
But not every redemption looks like a dividend. A departing shareholder selling all of their stock back to the company has genuinely exited the business. Treating that transaction as a dividend — taxing the full gross proceeds at ordinary rates with no basis recovery — would be punitive. Section 302 draws the line: redemptions that meaningfully change the redeemed shareholder's economic relationship with the corporation receive sale-or-exchange treatment. Everything else falls back to Section 301, where the corporation's earnings and profits balance determines dividend treatment.
The difference is significant. Under sale treatment, only the gain over basis is taxed, typically at long-term capital gains rates if the stock was held more than one year. Under dividend treatment, the full distribution amount is potentially ordinary income, with basis preserved in any remaining shares for use later.
The Three Tests Under Section 302(b)
A redemption qualifies for sale treatment if it satisfies any one of three tests. Each test has its own arithmetic and its own pitfalls.
Substantially Disproportionate Redemption — Section 302(b)(2)
This is the mechanical test most planners aim for. The redemption qualifies if, immediately after the transaction:
- The shareholder owns less than 50% of the total combined voting power, and
- The shareholder's percentage of voting stock is less than 80% of their pre-redemption percentage, and
- The shareholder's percentage of common stock (voting and nonvoting combined) is less than 80% of their pre-redemption percentage.
The 80% requirement applies separately to voting stock and to total common stock. Both must drop below 80% of the pre-redemption ratio.
Example. A shareholder owns 60% of a corporation's voting common stock. To satisfy the substantially disproportionate test, post-redemption ownership must be less than 48% (80% of 60%) and also less than 50% of total voting power. A redemption taking the shareholder to 45% satisfies both prongs.
The trap: ownership percentages are computed under Section 318 attribution rules, not based on actual share certificates. A shareholder who owns 40% directly but is deemed to own another 25% through family attribution starts at 65%, not 40%. The redemption math has to work against the attributed figure.
Complete Termination of Interest — Section 302(b)(3)
This test is conceptually the cleanest: the corporation redeems all of the shareholder's stock, and the shareholder walks away. Section 302(b)(3) treats the redemption as a sale automatically — there is no proportionality math to satisfy.
The challenge is making sure "all" really means "all," including attributed ownership. A shareholder who redeems every share they personally hold but is still deemed to own shares through a family member, partnership, trust, or estate has not completely terminated their interest. Without a waiver of family attribution (discussed below), the complete-termination test fails, and the redemption defaults to dividend treatment.
Not Essentially Equivalent to a Dividend — Section 302(b)(1)
The fallback test is subjective and risky. A redemption that fails the mechanical tests can still qualify for sale treatment if it is "not essentially equivalent to a dividend." The Supreme Court's United States v. Davis decision interpreted this as requiring a "meaningful reduction" in the shareholder's proportionate interest in the corporation.
What counts as meaningful? Courts and the IRS have generally accepted reductions in voting control, dividend rights, or liquidation preferences. A redemption that drops a 27% voting interest to 22% has been ruled meaningful in some private letter rulings; reductions for non-controlling minority shareholders are scrutinized more carefully.
Because the test is subjective, it is a poor first choice. Reserve it for situations where the substantially disproportionate test narrowly fails — for example, the post-redemption percentage is 49% instead of the required less than 48%.
The Section 318 Attribution Trap
Section 302 cannot be analyzed in isolation. Section 318 imposes constructive ownership rules that attribute stock between related parties for purposes of the redemption tests. There are four main attribution categories.
Family Attribution
An individual is deemed to own stock owned by their spouse, children, grandchildren, and parents. Siblings, cousins, in-laws, and grandparents do not trigger family attribution.
Entity-to-Owner Attribution
Stock owned by a partnership, S corporation, estate, or trust is attributed to the partners, shareholders, beneficiaries, or grantors in proportion to their economic interest.
Owner-to-Entity Attribution
Stock owned by a partner, shareholder, beneficiary, or grantor is attributed to the partnership, S corporation, estate, or trust — but for C corporations this attribution only applies if the shareholder owns at least 50% of the corporation's value.
Option Attribution
A taxpayer holding an option to buy stock is treated as owning the stock subject to the option.
Reattribution
Attribution can chain. Stock attributed from a child to a parent under family attribution can then be reattributed from the parent to a partnership the parent owns. The cascading effect makes ownership calculations in family-controlled businesses surprisingly complex.
Common failure scenario. A father owns 40% of a family C corporation. His daughter owns 20%. Attribution treats the father as owning 60%. The corporation redeems the father's entire 40% personal stake. Post-redemption, the father directly owns 0% but is still deemed to own his daughter's 20%. The complete-termination test fails. The substantially disproportionate test fails because 20% is more than 80% of 60% (48%). Result: the entire redemption is treated as a dividend.
Waiving Family Attribution Under Section 302(c)(2)
Because family attribution often defeats otherwise sensible redemptions, Section 302(c)(2) allows a former shareholder to waive family attribution for purposes of the complete-termination test. The waiver applies only to family attribution under Section 318(a)(1) — not entity attribution, option attribution, or other categories.
To qualify for the waiver:
- No retained interest. The redeemed shareholder must have no interest in the corporation immediately after the redemption other than as a creditor. They cannot be an officer, director, employee, or consultant.
- No reacquired interest for 10 years. The shareholder must not acquire any prohibited interest (other than by bequest or inheritance) during the 10 years following the redemption.
- Filed agreement. The shareholder must file a written agreement with the IRS, attached to the return for the year of the redemption, agreeing to notify the IRS if a prohibited interest is acquired within the 10-year period.
The 10-year rule is unforgiving. If the former shareholder returns as a paid consultant in year 7, the original redemption is retroactively recharacterized as a dividend. The statute of limitations on assessment is extended to one year after the IRS receives notice of the violation, so the agency does not lose the ability to collect.
Entity attribution can also be waived under Section 302(c)(2)(C), but the requirements are stricter and apply to the entity rather than the individual.
Partial Liquidations Under Section 302(b)(4)
Section 302(b)(4) provides an often-overlooked path to sale treatment for redemptions made in connection with a "partial liquidation." Unlike the other tests, the partial liquidation analysis focuses on what is happening at the corporate level rather than the shareholder level. Pro rata redemptions can qualify.
A partial liquidation exists when either:
- Safe harbor. The corporation ceases conducting one "qualified trade or business" and continues another. Both businesses must have been actively conducted for at least five years before the distribution. The distribution must occur within the same plan year or the year after.
- Corporate contraction. Without satisfying the safe harbor, the distribution must result from a "genuine contraction" of the corporate business. Private letter rulings have suggested that reductions of at least 20% in each of gross revenues, net asset value, and employee count signal a sufficient contraction.
The provision is restricted to non-corporate shareholders. Corporate shareholders receiving partial liquidation distributions fall under different rules.
Section 303 and Death-Tax Redemptions
Section 303 provides a parallel safe harbor specifically for redemptions used to pay estate taxes and related expenses after a shareholder dies. If certain value thresholds are met — generally, the corporation's stock must comprise more than 35% of the decedent's adjusted gross estate — the corporation can redeem stock from the estate up to the total of federal and state death taxes plus deductible funeral and administration expenses. The redemption receives sale treatment without satisfying the Section 302(b) tests, and because the estate's basis is stepped up under Section 1014, the redemption typically generates little or no gain.
Practical Planning Considerations
For closely-held C corporations contemplating a redemption, several planning steps are essential:
- Map attribution before structuring the deal. Build a stock ownership chart that shows actual ownership and attributed ownership for every shareholder involved. The math has to work on the attributed figures.
- Decide which test you are aiming for. If complete termination with a waiver is the goal, the shareholder cannot retain any officer or employee role. If substantially disproportionate is the goal, the percentage math has to satisfy both the voting and total-common-stock prongs.
- Document the redemption agreement carefully. Boards should approve the redemption, the price should be supported by valuation evidence, and the shareholder waiver agreement should be filed with the relevant tax return.
- Consider partial liquidation when business lines are being shed. Selling off a division and distributing the proceeds is a common transaction where Section 302(b)(4) is overlooked. Document the cessation of the qualified trade or business and the continued operation of another.
- Beware of mid-stream changes. Adding back the former shareholder as a director or consultant within 10 years of a complete termination redemption blows up the waiver.
Accurate bookkeeping is critical at every stage. The corporation needs to track its earnings and profits, the shareholders' stock basis, and any redemption-related adjustments to additional paid-in capital. When the IRS audits a redemption, the existence of clean, reconcilable books often determines whether the transaction is respected as structured.
Keep Your Corporate Books Ready for Scrutiny
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