20.6 Corporate Distributions, Dividends & Stock Redemptions
Key Takeaways
- Distributions are taxed as dividends to the extent of E&P.
- Property distributions are valued at FMV; corporation recognizes gain (but not loss) on appreciated property under §311(b).
- E&P is reduced by the greater of FMV or adjusted basis when property is distributed.
- Constructive dividends arise from improper benefits to shareholders (e.g., unreasonable comp, bargain sales, below-market loans).
- Stock dividends are generally tax-free under §305 unless an option to receive cash exists.
- Stock redemptions qualify for sale/exchange treatment under §302(b)(1)-(4) or §303 (deceased shareholder); otherwise treated as §301 distributions.
Why This Matters for the Exam
Understanding how distributions are taxed is fundamental to C corporation taxation. The exam tests property distributions, constructive dividends, the E&P effects, and the §302/§303 redemption rules that determine whether a redemption gets sale/exchange treatment or is treated as a dividend. None of these rules were changed by OBBBA.
Expect at least 3-4 questions on distributions and redemptions.
Basic Distribution Rules (§301)
| Distribution | To Shareholder |
|---|---|
| To extent of E&P | Dividend (taxable) |
| Exceeds E&P, reduces basis | Return of capital (not taxable) |
| Exceeds E&P and basis | Capital gain |
Property Distributions (§311)
When a corporation distributes property (not cash):
| Element | Rule |
|---|---|
| FMV to shareholder | Shareholder receives FMV as dividend (to extent of E&P) |
| Corporation's gain | Recognizes gain if FMV > basis (§311(b)) |
| Corporation's loss | Cannot recognize loss (§311(a)) |
| Shareholder's basis | FMV of property received |
| Liability-encumbered property | FMV treated as no less than the liability assumed by shareholder |
Property Distribution Example
| Item | Amount |
|---|---|
| Property basis (corporation) | $30,000 |
| Property FMV | $50,000 |
| Corporate gain | $20,000 |
| Dividend to shareholder | $50,000 (if E&P sufficient) |
| Shareholder's basis | $50,000 |
Loss on Property Distribution
| Rule | Treatment |
|---|---|
| If FMV < Basis | Corporation cannot recognize loss |
| Shareholder receives | FMV as dividend |
| Basis to shareholder | FMV |
| Built-in loss | Lost forever (consider §336 liquidation to capture loss instead) |
E&P Effect of Distributions
| Distribution Type | E&P Reduced By |
|---|---|
| Cash | Amount distributed |
| Property | Greater of FMV or adjusted basis (after §311(b) gain increases E&P) |
Constructive Dividends
Constructive dividends are benefits to shareholders that should have been treated as dividends:
| Constructive Dividend | Example |
|---|---|
| Unreasonable compensation | Excess salary to shareholder-employee |
| Bargain sale | Selling property to shareholder below FMV |
| Personal expenses | Corporation pays shareholder's personal bills |
| Below-market loans | Interest-free or low-interest loans to shareholders (§7872) |
| Personal use of property | Shareholder uses corporate property without arm's-length charge |
Constructive Dividend Consequences
| Party | Consequence |
|---|---|
| Shareholder | Dividend income |
| Corporation | May lose deduction (e.g., for excess compensation) |
| Corporation | E&P reduced |
Stock Dividends (§305)
| Type | Tax Treatment |
|---|---|
| Common on common (no option) | Tax-free; basis allocated across old + new shares |
| Cash or stock option | Taxable (entire distribution) |
| Preferred on common | Generally taxable ("§306 stock") |
| Disproportionate | Taxable |
Stock Redemptions (§§302, 303)
A redemption is the corporation's acquisition of its own stock from a shareholder. The default treatment under §302(d) is a §301 distribution (dividend to the extent of E&P). However, four §302(b) safe harbors and §303 allow sale or exchange treatment (capital gain or loss based on stock basis):
| Test | Requirement | Effect |
|---|---|---|
| §302(b)(1) Not essentially equivalent to a dividend | Meaningful reduction in shareholder's interest (facts & circumstances) | Sale/exchange |
| §302(b)(2) Substantially disproportionate | After redemption: <50% voting control AND <80% of pre-redemption voting AND <80% of pre-redemption common | Sale/exchange |
| §302(b)(3) Complete termination | All of shareholder's stock redeemed (family attribution can be waived under §302(c)) | Sale/exchange |
| §302(b)(4) Partial liquidation | Genuine contraction at corporate level (non-corporate shareholder) | Sale/exchange |
| §303 Deceased shareholder | Stock value > 35% of adjusted gross estate; redemption pays estate taxes/funeral/admin expenses | Sale/exchange |
§318 attribution rules treat stock owned by family members, entities, and option-holders as also owned by the shareholder when testing §302(b)(2) and §302(b)(3) — except family attribution can be waived under §302(c)(2) if the redeeming shareholder retains no interest other than as a creditor and files an agreement.
Redemption Example
Scenario: Shareholder A owns 60 of Corp's 100 outstanding shares. Basis $40/share. Corp redeems 30 shares from A at $100/share.
- After redemption: A owns 30 / 70 = 42.9% (below 50%).
- Pre-redemption voting: 60%. 80% of 60% = 48%. A's 42.9% < 48% → §302(b)(2) substantially disproportionate met.
- Result: Sale/exchange treatment. A recognizes capital gain = $3,000 - (30 × $40) = $1,800.
- If §302(b)(2) had not been met: $3,000 would be a §301 distribution (dividend to extent of E&P).
Real-World Scenario (TY 2025)
Scenario: A corporation with $100,000 E&P distributes property worth $80,000 (basis $50,000) to its sole shareholder.
- Corporate gain (§311(b)): $80,000 - $50,000 = $30,000.
- E&P effect: First, increase E&P by $30,000 gain = $130,000. Then decrease by $80,000 distribution = $50,000.
- Shareholder: $80,000 dividend (all from E&P).
- Shareholder basis in property: $80,000.
On the Exam
Expect 3-4 questions on distributions and redemptions, typically:
- Property Questions: "Corporation distributes appreciated property. What gain?"
- Constructive Dividend Questions: "Which is a constructive dividend?"
- E&P Questions: "How does distribution affect E&P?"
- Redemption Questions: "Does the redemption qualify as substantially disproportionate?"
The key is to remember: Property = FMV. Corp recognizes gain (not loss) under §311(b). Constructive dividends = hidden benefits. E&P reduced by greater of FMV or basis. Redemptions need §302(b)(1)-(4) or §303 for sale treatment.
Corp has $50k E&P, distributes $80k to shareholder with $20k basis. How is it taxed?
Corporation distributes property with basis $40k, FMV $70k. What is corporate gain?
Which is a constructive dividend?
Which §302(b) safe harbor allows a stock redemption to be treated as sale or exchange when ALL of a shareholder's stock is redeemed (with family attribution potentially waivable)?