10.2 Stock Redemptions (§302) & Corporate Liquidations (§331/§336)

Stock Redemptions: Exchange Treatment vs. Dividend Distribution (IRC §302)

Under IRC §317(b), a stock redemption occurs when a corporation acquires its own stock from a shareholder in exchange for property (whether cash or other assets), regardless of whether the redeemed shares are canceled, retired, or held as treasury stock. The central tax dilemma in any redemption is determining the statutory character of the transaction:

1. Sale or Exchange Treatment (IRC §302(a)): The redemption is treated as a sale of stock to a third party. The shareholder offsets their adjusted tax basis in the surrendered shares against the proceeds received under IRC §1001, recognizing capital gain or capital loss. Capital gain may be offset by capital losses, and long-term capital gain qualifies for preferential tax rates.
2. Distribution Treatment (IRC §302(d) & §301): The entire redemption proceeds are treated as a §301 property distribution. Under the three-tier waterfall, the distribution is taxed as a taxable dividend dollar-for-dollar to the extent of corporate E&P, without any offset for the shareholder's stock basis. The basis of the surrendered shares does not vanish; it is transferred to the shareholder's remaining shares (or to the shares of related parties under Treas. Reg. §1.302-2(c)).

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Constructive Ownership & Attribution Rules (IRC §318)

To prevent taxpayers from siphoning corporate earnings at capital gains rates while maintaining indirect economic control, Congress enacted the attribution rules of IRC §318. In testing whether a redemption qualifies for exchange treatment under §302(b), a shareholder is treated as owning not only their direct shares, but also shares owned by related individuals and entities:

IRC §318 Constructive Ownership Rules
  ├── Family Attribution (§318(a)(1))
  │     └── Spouse, Children, Grandchildren, and Parents (NO siblings or grandparents)
  ├── Entity-to-Owner Attribution (§318(a)(2))
  │     ├── Partnerships & Estates: Pro-rata to partners/beneficiaries
  │     ├── Trusts: Pro-rata based on actuarial interest
  │     └── Corporations: Pro-rata to 50%-or-more shareholders
  ├── Owner-to-Entity Attribution (§318(a)(3))
  │     ├── Partners & Beneficiaries: 100% of stock attributed to partnership/estate/trust
  │     └── 50%-or-more Shareholders: 100% of stock attributed to corporation
  └── Option Attribution (§318(a)(4))
        └── Option to acquire stock treated as actual ownership of the underlying stock

[!CRITICAL] Family Attribution Boundaries on the EA Exam: Family attribution under §318(a)(1) applies ONLY to spouses, children, grandchildren, and parents. It does NOT apply between siblings (brothers and sisters) or from grandparents to grandchildren (a grandchild's stock is attributed to the grandparent, but a grandparent's stock is NOT attributed to the grandchild). In-laws and step-relations are also excluded.

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The Four Section 302(b) Safe Harbors for Exchange Treatment

Under IRC §302(b), a redemption is treated as an exchange under §302(a) if it satisfies any one of four statutory safe harbors:

1. Substantially Disproportionate Redemption (IRC §302(b)(2))

A redemption qualifies as substantially disproportionate if the shareholder's interest is meaningfully diluted under two mandatory mathematical tests, evaluated immediately after the redemption:

• Test 1 (50% Absolute Voting Power Limit): Immediately after the redemption, the shareholder must own (directly and constructively under §318) less than 50% of the total combined voting power of all classes of stock entitled to vote.
• Test 2 (80% Relative Voting Stock Rule): The shareholder's percentage of voting stock immediately after the redemption must be less than 80% of their percentage of voting stock owned immediately before the redemption:

$\frac{\text{Post-Redemption Shares Owned}}{\text{Post-Redemption Total Shares Outstanding}} < 0.80 \times \left( \frac{\text{Pre-Redemption Shares Owned}}{\text{Pre-Redemption Total Shares Outstanding}} \right)$

• Test 3 (80% Relative Common Stock Rule): The shareholder's percentage of common stock (voting and nonvoting) must also be less than 80% of their pre-redemption percentage.

2. Complete Termination of Shareholder's Interest (IRC §302(b)(3))

Exchange treatment applies if the corporation redeems all of the stock of the corporation owned by the shareholder, both directly and constructively under §318.

Waiver of Family Attribution (IRC §302(c)(2)): If the shareholder completely terminates their direct ownership, but family members (spouse, children, grandchildren, parents) continue to own stock, the family attribution rules of §318(a)(1) can be waived, allowing the redemption to qualify as a complete termination, provided the shareholder meets three strict statutory conditions:

1. No Retained Interest: Immediately after the redemption, the redeemed shareholder must retain no interest in the corporation (including an interest as an officer, director, employee, or consultant), other than an interest as a pure creditor.
2. 10-Year Look-Forward Rule: The redeemed shareholder cannot acquire any prohibited interest in the corporation (or its parent, subsidiary, or successor) within 10 years from the date of the distribution, except by bequest or inheritance (§302(c)(2)(A)(ii)).
3. IRS Notification Agreement: The shareholder must attach a signed agreement to their timely filed tax return for the year of redemption, promising to notify the IRS within 30 days if they acquire a prohibited interest within the 10-year window, and agree to keep relevant tax records.

3. Partial Liquidation of Noncorporate Shareholder (IRC §302(b)(4))

A redemption qualifies for exchange treatment if the distribution is in partial liquidation of the distributing corporation and the shareholder is a noncorporate shareholder (individual, trust, or estate). Under IRC §302(e), a distribution qualifies as a partial liquidation if:

• It is not essentially equivalent to a dividend (tested at the corporate level, representing a genuine corporate contraction, such as the destruction of a major division without replacement); or
• It satisfies the safe harbor termination of business test: the distribution is attributable to the corporation ceasing to conduct a qualified trade or business that was actively conducted throughout the 5-year period preceding the distribution, provided the corporation continues to actively conduct another 5-year active trade or business.

4. Not Essentially Equivalent to a Dividend (IRC §302(b)(1))

A redemption qualifies under this subjective standard if it results in a "meaningful reduction of the shareholder's proportionate interest in the corporation" (United States v. Davis, 397 U.S. 301 (1970)). Section 318 attribution applies fully. A sole shareholder (directly or constructively) can never satisfy this test because their economic control remains 100%.

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Corporate Liquidations: Complete Dissolution under IRC §§331 & 336

A complete corporate liquidation occurs when a corporation ceases to be a going concern, winds up its business operations, pays off creditor claims, and distributes all remaining net cash and property to shareholders in complete cancellation of all outstanding corporate stock.

Shareholder Tax Consequences (IRC §331)

Under IRC §331(a), amounts distributed in complete liquidation of a corporation are treated as full payment in exchange for the shareholder's stock:

$\text{Shareholder Recognized Gain or Loss} = \text{FMV of Cash and Property Received} - \text{Adjusted Stock Basis}$

• The gain or loss is capital gain or loss (assuming the stock is a capital asset in the shareholder's hands).
• The character is long-term (held > 1 year) or short-term (held ≤ 1 year).
• Under IRC §334(a), the shareholder's tax basis in distributed property is its Fair Market Value (FMV) on the date of distribution.
• The shareholder's holding period in the distributed assets begins on the day after the distribution.

Corporate Tax Consequences (IRC §336)

Under IRC §336(a), a liquidating C corporation recognizes taxable gain OR loss on the distribution of property in complete liquidation as if such property were sold to the shareholders at its fair market value.

• Liability in Excess of FMV (§336(b)): If distributed property is subject to a liability that exceeds its FMV, the deemed FMV for calculating corporate gain or loss is treated as not less than the liability amount.

Statutory Limitations on Corporate Loss Recognition (§336(d))

Congress enacted two anti-abuse rules under IRC §336(d) to prevent corporations from manufacturing artificial losses on liquidation:

1. Related-Person Disallowance (§336(d)(1)): A liquidating corporation recognizes $0 loss on distributions of property to a related person (under IRC §267, owning directly or constructively > 50% of the corporation) if:
   • The distribution is not pro-rata among all shareholders; OR
   • The distributed property is disqualified property (property acquired by the corporation in an IRC §351 exchange or capital contribution within the 5-year period ending on the distribution date).
2. The Anti-Stuffing Rule (§336(d)(2)): Prevents shareholders from "stuffing" built-in loss property into a corporation shortly before liquidation. If property was acquired in a §351 transfer or capital contribution within 2 years prior to adopting the plan of liquidation (or where the principal purpose was tax avoidance), the corporation's basis in the property for computing deductible loss on liquidation is reduced by the amount of the built-in loss at the contribution date.

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Subsidiary Liquidations: Nonrecognition under IRC §§332 & 337

A critical exception to the double-taxation rule applies when a parent corporation liquidates an 80%-or-more owned subsidiary:

IRC §§332 / 337 Subsidiary Liquidation Framework
  ├── Parent Corporation (§332): Recognizes \$0 Gain or Loss on Receipt of Sub Assets
  ├── Liquidating Subsidiary (§337): Recognizes \$0 Gain or Loss on Distribution to 80% Parent
  ├── Parent Asset Basis (§334(b)(1)): Carryover Basis (Subsidiary's Adjusted Inside Basis)
  └── Tax Attribute Carryover (§381): Parent Inherits Sub's NOLs, E&P, and Capital Losses

The 80% Ownership Requirement (IRC §1504(a)(2))

To qualify for tax-free treatment under §332, the parent corporation must own at least 80% of the total voting power AND at least 80% of the total value of the subsidiary's outstanding stock continuously from the date the liquidation plan is adopted until the final distribution.

Tax Consequences to Parent and Subsidiary

• Parent Nonrecognition (IRC §332): The parent recognizes no gain or loss on receipt of property in complete liquidation of the subsidiary.
• Subsidiary Nonrecognition (IRC §337(a)): The liquidating subsidiary recognizes no gain or loss on distributions of appreciated or depreciated property to the 80% parent.
• Asset Basis (IRC §334(b)(1)): The parent takes a carryover basis in the subsidiary's assets equal to the subsidiary's adjusted tax basis immediately prior to liquidation. (The parent's basis in the subsidiary stock disappears permanently).
• Carryover of Tax Attributes (IRC §381): The parent inherits all major corporate tax attributes of the subsidiary, including Net Operating Loss (NOL) carryforwards, capital loss carryforwards, and accumulated E&P balances.

Treatment of Minority Shareholders

If minority shareholders own the remaining stock (< 20%):

• Minority Shareholders: Section 332 applies only to the 80% parent. Minority shareholders are fully taxable under IRC §331, recognizing capital gain or loss and taking an FMV basis under §334(a).
• Subsidiary Distribution to Minority Shareholders: The liquidating subsidiary must recognize gain on appreciated property distributed to minority shareholders under §336(a). However, under IRC §336(d)(3), the subsidiary cannot recognize loss on distributions of depreciated property to minority shareholders!

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Comprehensive Worked Numerical Examples

Worked Example 1: Substantially Disproportionate Redemption (§302(b)(2))

Scenario: Metro Corporation has 1,000 shares of single-class voting common stock outstanding. Prior to the redemption, Victor owns 300 shares (30%). Metro redeems 100 of Victor's shares for $150,000 cash. Victor is unrelated to any other Metro shareholder. Victor's basis in the 100 redeemed shares is $40,000.

Testing the Safe Harbor Tests:

1. Post-Redemption Ownership Share:
   • Victor's remaining shares: 300 - 100 = 200 shares.
   • Metro's remaining outstanding shares: 1,000 - 100 = 900 shares.
   • Victor's post-redemption percentage: 200 / 900 = 22.22%.
2. Test 1: 50% Absolute Voting Power Limit:
   • Is 22.22% < 50.0%? YES. (Satisfied).
3. Test 2: 80% Relative Ownership Rule:
   • Victor's pre-redemption percentage: 300 / 1,000 = 30.0%.
   • Benchmark threshold: 80% × 30.0% = 24.0%.
   • Is Victor's post-redemption percentage (22.22%) strictly less than 24.0%? YES. (Satisfied).

Result: The redemption qualifies as substantially disproportionate under IRC §302(b)(2). Victor receives sale or exchange treatment:

• Amount Realized: $150,000
• Less Stock Basis: ($40,000)
• Recognized Capital Gain: $110,000 (Long-Term Capital Gain if held > 1 year). Victor's basis in his remaining 200 shares remains unchanged.

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Worked Example 2: Complete Corporate Liquidation (§331 / §336)

Scenario: Falcon Corporation adopts a plan of complete liquidation. Falcon distributes all assets to its sole shareholder, Sophia (adjusted stock basis = $120,000). Falcon distributes:

• Cash: $30,000
• Marketable Securities: Basis $40,000, FMV $70,000
• Warehouse: Basis $110,000, FMV $80,000 (purchased 8 years ago; no §336(d) loss limits apply)

Calculations:

1. Falcon Corporation Level (§336(a)):
   • Securities Gain: $70,000 (FMV) - $40,000 (Basis) = +$30,000 Capital Gain.
   • Warehouse Loss: $80,000 (FMV) - $110,000 (Basis) = -$30,000 Section 1231 Loss.
   • Falcon recognizes both the $30,000 gain and $30,000 loss on its final Form 1120.
2. Sophia Shareholder Level (§331 & §334(a)):
   • Total FMV Received: $30,000 (Cash) + $70,000 (Securities) + $80,000 (Warehouse) = $180,000.
   • Sophia's Recognized Gain: $180,000 (FMV Received) - $120,000 (Stock Basis) = $60,000 Capital Gain.
   • Sophia's Basis in Distributed Assets (§334(a)): Cash $30,000; Securities $70,000; Warehouse $80,000.

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Comparison Table: Redemptions vs. Liquidations