When a corporation buys back its own stock from a shareholder, the tax consequences depend entirely on whether the redemption qualifies as a "sale or exchange" - producing capital gain or loss - or fails to qualify, in which case the entire redemption proceeds are treated as a §301 distribution (a dividend to the extent of earnings and profits, then return of basis, then capital gain). The difference between exchange treatment (capital gain or loss, reduced by the shareholder's basis in the redeemed shares) and §301 treatment (a dividend to the extent of E&P with no immediate basis offset, taxed at the §1(h) capital gain rates if it is qualified dividend income and at ordinary rates if not) can be the most important tax question in the deal. The §318 constructive ownership attribution rules make many redemptions that appear to qualify as exchanges into dividends in disguise.
§302(b)(1) - Not essentially equivalent to a dividend: A facts-and-circumstances test. The redemption must produce a meaningful reduction in the shareholder's proportionate interest. Difficult to satisfy without significant percentage reduction.
§302(b)(2) - Substantially disproportionate: After the redemption, the shareholder owns less than 80% of the percentage of voting stock and of common stock owned before, and owns less than 50% of total combined voting power. Safe harbor with clear thresholds.
§302(b)(3) - Complete termination: The corporation redeems all of the shareholder's stock and the shareholder retains no interest in the corporation (other than as a creditor). The most reliable path to sale treatment.
§302(b)(4) - Partial liquidation: Distribution to a non-corporate shareholder in partial liquidation of the corporation (§302(e)) - requires a genuine contraction of the corporate business (for example, termination of a qualified trade or business actively conducted throughout the prior 5 years). Tested at the corporate level, not the shareholder level.
The §318 attribution rules attribute stock ownership between family members, between a shareholder and entities the shareholder controls, and between an entity and its owners. For redemption purposes: (1) a shareholder is deemed to own stock owned by their spouse, children, grandchildren, and parents; (2) a partner is deemed to own a proportionate share of the stock owned by the partnership (no 50% threshold); (3) a 50%+ shareholder in a corporation (by value) is deemed to own the corporation's stock in proportion to the shareholder's share of value; and (4) a trust beneficiary is deemed to own the trust's stock in proportion to the beneficiary's actuarial interest. Attribution also runs in the other direction (§318(a)(3)).
IRC §302(c)(2) provides an escape from family attribution in complete termination redemptions. If the redeemed shareholder: (1) retains no interest in the corporation (as officer, director, employee, or otherwise) other than as a creditor; (2) does not acquire any prohibited interest within 10 years; and (3) files an agreement with the IRS to notify the IRS if a prohibited interest is acquired within 10 years - then family attribution is waived and the complete termination qualifies as a sale. The waiver is the standard planning tool for family business buyouts where the departing shareholder is a parent or grandparent of continuing shareholders.
A redemption that fails all four §302(b) tests is treated as a §301 distribution - the same as a regular dividend. The distribution is: (1) a dividend (qualified dividend income taxed at the §1(h) capital gain rates if eligible; otherwise ordinary income) to the extent of the corporation's current and accumulated earnings and profits (E&P); (2) tax-free return of basis to the extent of the shareholder's basis in the redeemed stock; (3) capital gain for any excess. The shareholder's basis in the redeemed shares is not lost - under the IRS's position in Rev. Rul. 70-531, the basis shifts to the shareholder's remaining shares (if any) or to related parties whose shares caused the attribution.