The Redemption Riddle: Navigating Section 302 and the Dividend-Sale Divide
When a corporation buys back its own stock from a shareholder, it is called a "Redemption." You might assume this is always a sale, taxed at low capital gains rates. The IRS thinks differently. Under Section 302, a redemption is treated as a taxable dividend (taxed at ordinary rates and often without basis recovery) unless the shareholder can prove the redemption significantly changed their percentage of control over the company. If you own 100% of a company and "sell" 10% back to the company, the IRS views that cash as a dividend, because you still own 100% of what\'s left. Our Corporate Advisory Group specializes in architecting redemptions that qualify for "Sale or Exchange" treatment.
The "Substantially Disproportionate" Safe Harbor
To guarantee capital gains treatment, a redemption must meet one of the IRS "Safe Harbors." The most important is Section 302(b)(2): the **Substantially Disproportionate Redemption**.
To pass this mathematical test, the shareholder must own less than 50% of the voting power after the redemption, and their percentage ownership must have dropped by more than 20% compared to before. This is the gold standard for founder liquidity. We provide the "Cap Table Modeling" needed to ensure that buybacks are sized correctly to trigger the safe harbor, shielding millions from dividend-tax rates. Improper sizing can result in the entire payout being taxed at 37% without any offset for the basis of the shares surrendered—a devastating financial result for a long-time shareholder.
Family Attribution and the Waiver of Entity Rules
In family-owned businesses, a redemption is rarely as simple as it looks. Under Section 318, you are considered to own the shares of your spouse, children, and grandchildren.
If a father is redeemed out of the business, but his son still owns 100%, the IRS treats the father as still owning 100%. This makes it virtually impossible to achieve a "sale" treatment without executing a **Section 302(c) Waiver of Family Attribution**. This waiver requires the redeemed shareholder to completely sever all ties with the company (even as a consultant) for 10 years. We architect these "Succession Buybacks" and manage the 10-year compliance lookback, providing the evidentiary trail required to prove to the IRS that the transfer of wealth and control was authentic and final.