Business Entities · Corporations in general

Liquidations and stock redemptions

A stock redemptionstock redemptionA corporation buying back its own stock from a shareholder. Depending on the details, it's taxed either like a sale of stock or like a dividend. looks like a sale and the Code starts from the opposite assumption. A corporation buying back its own stock is, by default, distributing its earnings — so IRC § 301 applies and the shareholder has a dividend, with no recovery of basis. Exchange treatment is the exception, available only if the redemption clears one of the five tests in IRC § 302(b), and every one of those tests is applied after attributing to the shareholder the stock owned by their family and by entities they are connected to. In a closely held corporation that attribution usually decides the answer before the arithmetic starts.

The rule

What is at stake. where a corporation redeems its stock and any of the five tests in IRC § 302(b) is met, the redemption is treated as a distribution in part or full payment in exchange for the stock — so the shareholder recovers basis and reports capital gain or loss rather than a dividend (IRC § 302(a))^TY2026Verified 2026-08-21IRC § 302(a), read at law.cornell.edu/uscode/text/26/302

Test one. exchange treatment applies where the redemption is not essentially equivalent to a dividend — a facts-and-circumstances test requiring a meaningful reduction in the shareholder proportionate interest (IRC § 302(b)(1))^TY2026Verified 2026-08-21IRC § 302(b)(1), read at law.cornell.edu/uscode/text/26/302

Test two. a redemption is substantially disproportionate where, immediately afterwards, the shareholder owns less than 50 percent of the total combined voting power of all voting classes, and the shareholder ratio of voting stock owned to all voting stock immediately after the redemption is less than 80 percent of that ratio immediately before — with the same 80 percent test also applied to common stock whether voting or non-voting, measured by fair market value where there is more than one class (IRC § 302(b)(2))^TY2026Verified 2026-08-21IRC § 302(b)(2), read at law.cornell.edu/uscode/text/26/302

Test three. exchange treatment applies where the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder (IRC § 302(b)(3))^TY2026Verified 2026-08-21IRC § 302(b)(3), read at law.cornell.edu/uscode/text/26/302

And the waiver that makes test three usable. 10 years — on a complete termination the family attribution rule in IRC § 318(a)(1) may be waived if immediately after the distribution the distributee has no interest in the corporation, including as officer, director or employee, other than as a creditor; acquires no such interest, other than stock acquired by bequest or inheritance, within 10 years; and files an agreement to notify the Secretary of any such acquisition and to retain the necessary records. Acquiring an interest within the 10 years extends the assessment and collection periods by one year from the notification (IRC § 302(c)(2))^TY2026Verified 2026-08-21IRC § 302(c)(2), read at law.cornell.edu/uscode/text/26/302

Whose stock you are treated as owning. an individual is considered to own stock owned by their spouse, other than one legally separated under a decree, and by their children, grandchildren and parents — a legally adopted child counting as a child by blood. Stock owned by a partnership or estate is owned proportionately by its partners or beneficiaries, stock owned by a trust by its beneficiaries in proportion to their actuarial interests, and stock owned by a grantor trust by the grantor (IRC § 318(a)(1), (2))^TY2026Verified 2026-08-21IRC § 318(a), read at law.cornell.edu/uscode/text/26/318

Complete liquidation defined. a distribution is treated as in complete liquidation of a corporation if it is one of a series of distributions in redemption of all of the stock of the corporation pursuant to a plan (IRC § 346(a))^TY2026Verified 2026-08-21IRC § 346(a), read at law.cornell.edu/uscode/text/26/346

The shareholder side. amounts received by a shareholder in a distribution in complete liquidation of a corporation are treated as in full payment in exchange for the stock, and IRC § 301 does not apply to such a distribution (IRC § 331(a), (b))^TY2026Verified 2026-08-21IRC § 331, read at law.cornell.edu/uscode/text/26/331

The corporate side. except as IRC § 336 or § 337 otherwise provides, gain or loss is recognised to a liquidating corporation on the distribution of property in complete liquidation as if the property were sold to the distributee at its fair market value (IRC § 336(a))^TY2026Verified 2026-08-21IRC § 336(a), read at law.cornell.edu/uscode/text/26/336

The recipient’s basis. where property is received in a distribution in complete liquidation and gain or loss is recognised on its receipt, the basis of that property in the distributee hands is its fair market value at the time of the distribution (IRC § 334(a))^TY2026Verified 2026-08-21IRC § 334(a), read at law.cornell.edu/uscode/text/26/334

And the exception for a subsidiary. no gain or loss is recognised to the liquidating corporation on the distribution to the 80-percent distributee of any property in a complete liquidation to which IRC § 332 applies — the corporate-level counterpart of the shareholder-level nonrecognition in § 332(a) (IRC § 337(a))^TY2026Verified 2026-08-21IRC § 337(a), read at law.cornell.edu/uscode/text/26/337

Current figures

How it works in practice

Attribute first. Before any test in IRC § 302(b) can be applied, work out what the shareholder is treated as owning: their own stock, plus stock owned by spouse, children, grandchildren and parents, plus proportionate shares of stock held by partnerships, estates and trusts they are connected to, plus stock held by corporations in which they have a large enough interest. Note the asymmetry in the family rule — it reaches down to children and grandchildren and up to parents, but there is no attribution between siblings and none from grandchildren to grandparents.

The substantially disproportionate test is arithmetic and is the one to reach for first because it is objective. Two conditions, both required. The shareholder must own less than half the voting power immediately after the redemption, and their percentage of voting stock afterwards must be under four-fifths of their percentage before. The second condition also has to be met for common stock, voting or not. A shareholder going from sixty to fifty-two fails on both limbs; one going from sixty to forty-five passes the voting limitation and needs forty-eight or less to pass the ratio.

The complete termination test is simpler and, in a family company, usually unavailable without the waiver. A parent redeeming their entire holding still constructively owns the stock held by their children, so nothing has terminated. IRC § 302(c)(2) allows the family attribution to be waived, on three conditions that have to be read exactly: no retained interest of any kind other than as a creditor — expressly including officer, director or employee — no acquisition of such an interest for ten years except by bequest or inheritance, and a filed agreement to notify the Secretary. The condition that catches people is the second word of “officer, director, or employee”: a retiring founder who stays on the board, or consults, has retained an interest and cannot waive.

The “not essentially equivalent to a dividend” test is the fallback and it is genuinely a facts test, requiring a meaningful reduction in the shareholder’s proportionate interest. It is the only route for a redemption that is neither large enough to be disproportionate nor complete, and it works best for a small minority holder with no control to lose.

liquidationliquidationDissolving a corporation and distributing what's left to its shareholders, generally treated for tax purposes as if each shareholder sold their stock back to the company.s are simpler because both sides recognise. The shareholder is treated as receiving full payment in exchange for the stock (IRC § 331(a)) and the corporation recognises gain or loss as if it had sold each asset to the distributee at fair market valuefair market valueWhat a willing buyer would pay a willing seller for something, with neither side being forced into the deal and both knowing the relevant facts. (IRC § 336(a)). The distributee takes fair market value as basis (IRC § 334(a)). Two levels of tax, which is the ordinary consequence of a C corporation ceasing to exist.

The exception is a subsidiary liquidating into a parent whose stock meets the IRC § 1504(a)(2) test. There IRC § 332(a) gives the parent nonrecognition on receipt and IRC § 337(a) gives the subsidiary nonrecognition on distribution — the two provisions are a matched pair, and the parent takes a carryover basis rather than fair market value under IRC § 334(b). Nothing is taxed because nothing has left the group.

Scenarios

How this has changed

The corporate-level recognition on liquidation is the reversal that shapes this topic. Before 1986 a liquidating corporation generally recognised no gain on distributing appreciated assets, so a C corporation could be unwound at one level of tax. IRC § 336(a) now requires recognition as if each asset had been sold to the distributee at fair market value, which — together with the matching rule for non-liquidating distributions in IRC § 311(b) — produced the modern double tax on getting appreciated property out of a corporation. Material describing corporate liquidations as a single-tax event is pre-1987, and the change is the single strongest argument for choosing a pass-through at formation.

The IRC § 302 tests themselves have not moved. The eighty percent ratios, the fifty percent voting limitation and the ten-year waiver period are all as enacted, and the attribution rules in IRC § 318 have been stable for decades.

What has changed around them is the rate environment. When dividends were taxed as ordinary income and capital gains were not, the difference between exchange and dividend treatment on a redemption was the whole of the planning. With qualified dividend income taxed at capital gain rates, the rate difference has narrowed sharply and what remains is the recovery of basis — a redemption treated as an exchange lets the shareholder recover stock basis before recognising anything, while a dividend does not. That is now the main prize, and it is a larger one for a shareholder with high basis than the rate difference ever was.

Exam focus

Every redemption question is answered in the same order. Attribute the stock. Compute the before and after percentages on the attributed figures. Test substantially disproportionate first, because it is objective. If it fails, consider complete termination and whether the waiver is available. If neither, ask whether there has been a meaningful reduction.

Two arithmetic points recur. The denominator changes: redeemed shares come out of the total as well as out of the shareholder’s holding. And exactly fifty percent fails the limitation, so a question that lands precisely on it is testing the word “less”.

On liquidations, expect a question that asks how many levels of tax there are. Two, unless the distributee is an eighty percent corporate parent, in which case none — and then the follow-up is usually the basis, which is carryover rather than fair market value.

Check yourself

1. A shareholder owns 500 of a corporation’s 1,000 voting shares. Her son owns 200. The corporation redeems 100 of her shares. Does IRC § 302(b)(2) apply?

Answer: no. Under IRC § 318(a)(1)(A)(ii) she is treated as owning her son’s 200 shares, so before the redemption she owns 700 of 1,000, or 70 percent. After it she owns 600 of 900, or 66.67 percent. That is not less than 80 percent of 70 percent, which is 56 percent, and she still owns more than half the voting power. Both limbs fail.

2. A shareholder’s percentage of voting stock falls from 40 percent to 31 percent on a redemption, and there is no attribution. Is the redemption substantially disproportionate?

Answer: yes. She owns less than 50 percent of the voting power immediately after, satisfying IRC § 302(b)(2)(B). And 31 percent is less than 80 percent of 40 percent, which is 32 percent, satisfying the ratio test in subparagraph (C). The margin is one percentage point, which is why these questions are worth computing rather than estimating.

3. A father has his entire holding redeemed and immediately becomes a paid consultant to the company. His daughter remains a shareholder. Can he waive family attribution?

Answer: no. IRC § 302(c)(2)(A)(i) requires that immediately after the distribution the distributee has no interest in the corporation, “including an interest as officer, director, or employee”, other than an interest as a creditor. A consultancy is the kind of continuing interest the provision excludes. Without the waiver he constructively owns his daughter’s stock and nothing has been terminated.

4. A C corporation liquidates, distributing assets worth $2,000,000 with a basis of $600,000 to an individual shareholder whose stock basis is $250,000. How many levels of tax arise?

Answer: two. The corporation recognises $1,400,000 of gain under IRC § 336(a) as if it had sold the assets to the shareholder at fair market value. The shareholder is treated under IRC § 331(a) as receiving full payment in exchange for the stock and recognises capital gain to the extent the amount received exceeds the $250,000 basis. The shareholder takes the assets at fair market value under IRC § 334(a).

5. A subsidiary wholly owned by a corporate parent liquidates into it. What does each recognise, and what basis does the parent take?

Answer: neither recognises anything, and the parent takes a carryover basis. IRC § 332(a) gives the parent nonrecognition on the receipt and IRC § 337(a) gives the subsidiary nonrecognition on the distribution to the 80-percent distributee. IRC § 334(b) gives the parent the subsidiary’s basis rather than fair market value, so the appreciation is preserved inside the group rather than eliminated.