S-Corp Shareholder Redemption: The Sale vs. Dividend Trap
When an S-corp buys back a departing owner’s stock, the payout doesn’t get taxed the same way every time. A shareholder redemption can come back as a capital gain taxed at preferential rates, or it can be reclassified as a dividend taxed as ordinary income up to the corporation’s earnings and profits. Which one happens isn’t up to what the buyout agreement calls the payment. It turns on a set of mechanical tests buried in the Code, and a shareholder who assumed they were “selling their shares” can find out at filing time that the IRS saw a distribution instead.
Why the IRS Cares How a Shareholder Redemption Is Taxed
The default answer under Section 302(d) is dividend treatment, not sale treatment. Unless a shareholder redemption qualifies under one of the exchange tests in IRC Section 302(b), the payment is taxed as an ordinary distribution — which, for a C-corp, means a taxable dividend to the extent of earnings and profits. For most S-corps with no accumulated C-corp earnings, the distinction has less bite, since Section 1368 basis-offset rules apply either way. But for an S-corp that converted from a C-corp or inherited earnings and profits through a merger, failing Section 302(b) can mean ordinary income on money the exiting shareholder expected to report as a capital gain. This is a narrower question than selling the whole company — a redemption buys out one owner while the business keeps running.
The Three Tests That Decide a Shareholder Redemption
A stock redemption gets exchange (sale) treatment if it clears one of three tests. Not essentially equivalent to a dividend is the loosest and least predictable — a facts-and-circumstances standard courts apply when a redemption meaningfully reduces a shareholder’s proportionate interest, even if it misses the bright-line tests below. Substantially disproportionate redemption is the mechanical test most buyouts are built around: immediately after the redemption, the shareholder must own less than 50% of total voting power, and their post-redemption ownership percentage — tested separately for voting stock and for common stock — must be less than 80% of what they owned before. Complete termination of interest is the cleanest test of all: the corporation redeems every share the shareholder owns, actually and constructively, leaving no stake behind. A fourth test, partial liquidation, is tested at the corporate level and rarely applies to a single-shareholder buyout.
The Family Attribution Trap
Section 318 attributes a shareholder’s family stock to them for purposes of these tests, counting shares owned by a spouse, children, grandchildren, and parents as if the redeemed shareholder still held them — siblings are not included. This quietly defeats what looks like a complete termination: if a departing shareholder’s spouse or adult child keeps even a small stake, the IRS treats the “exiting” shareholder as constructively still owning it. Congress built in a waiver for exactly this situation. Under Section 302(c)(2), family attribution doesn’t apply to a complete termination if the distributee retains no interest in the corporation other than as a creditor, acquires no such interest for 10 years (except by bequest or inheritance), and files a statement with their return for the year of the redemption agreeing to notify the IRS of any disqualifying acquisition. That statement isn’t a numbered IRS form — the regulations at Treas. Reg. §1.302-4 spell out its required title and content as an attachment to the return. The waiver is also unavailable if, within the 10 years ending on the redemption date, the redeemed stock was acquired from a related party, or the departing shareholder transferred stock to a related party and that stock isn’t redeemed in the same transaction — absent a showing that tax avoidance wasn’t a principal purpose.
What Happens If the Shareholder Redemption Fails All Three Tests
A shareholder redemption that clears none of Section 302(b)’s tests falls back to Section 301 distribution treatment. For an S-corp with no accumulated earnings and profits, this changes less than it sounds like it should. Section 1368(b) applies the same way regardless of the redemption’s classification: the distribution reduces stock basis tax-free first, and only the excess over basis is taxed, as capital gain. The sale-versus-dividend question only has real teeth for an S-corp carrying earnings and profits from a prior C-corp life or an acquisition. There, Section 1368(c) ordering applies: the distribution comes out of the Accumulated Adjustments Account tax-free to the extent of basis first, then is taxed as a dividend to the extent of the corporation’s earnings and profits, with any remainder again applied against basis and then capital gain. When a redemption does qualify as an exchange under Section 302(a), the AAA itself is reduced on a pro-rata basis under Section 1368(e)(1)(B) — proportionate to the number of shares redeemed, not the dollar amount paid.
Structuring a Buyout to Land Where You Expect
A full buyout aimed at the complete termination test is the most reliable path to exchange treatment, but only if the family attribution waiver is actually available and properly filed — skip it, or let a spouse keep a side consulting arrangement that counts as a prohibited “interest,” and the termination test fails quietly. A partial buyout has to clear the substantially disproportionate math precisely: run the before-and-after voting and common stock percentages before the closing date, not after, because there’s no do-over once the shares change hands. Every multi-shareholder S-corp planning a buy-sell agreement or a shareholder’s exit should run these numbers alongside a review of basis and AAA under how AAA and stock basis work, since both questions are decided by the same transaction.
Where This Gets Complicated
The clean cases above assume a single redemption with no side agreements, no installment note, and no family members quietly holding stock. Real buyouts rarely look that tidy — there’s often a note payable over several years (which raises its own open-transaction and imputed interest questions), a shareholder who stays on as a consultant, or a redemption layered on top of a larger ownership restructuring. None of that changes the underlying tests, but it changes which facts control them. This is a transaction worth getting a second set of eyes on before signing anything. Contact us before you redeem a shareholder’s stock, not after, so the 302(b) analysis and the 10-year waiver paperwork are both locked down while there’s still time to fix a structure that doesn’t test the way you assumed.