Taxation of a Stock Redemption in a Closely Held Business
David owns 60% of XYZ Inc., a C corporation. His basis in the stock is $100,000. The corporation has accumulated earnings and profits (E&P) of $200,000. David's sister, Lisa, owns the remaining 40%. David wants to retire and have XYZ Inc. redeem all his shares for $500,000. The redemption is not substantially disproportionate, and David does not meet the complete termination of interest rules because Lisa continues to own stock. David has no other transactions with the corporation. Assume the redemption is treated as a dividend distribution to the extent of E&P.
1. What are the federal income tax consequences to David of the $500,000 redemption?
Read the worked answer
Because the redemption does not qualify as a sale or exchange under Section 302 (not substantially disproportionate, no complete termination), it is treated as a distribution under Section 301. David is treated as receiving a dividend to the extent of the corporation's E&P. XYZ Inc. has $200,000 of E&P, so $200,000 is taxed as a qualified dividend (assuming holding period met) at preferential rates. The remaining $300,000 is a return of capital to the extent of David's basis of $100,000, reducing basis to zero. The excess $200,000 is capital gain, taxed as long-term capital gain if the stock was held more than one year. Thus, David reports $200,000 dividend income and $200,000 long-term capital gain, and his basis becomes zero.
2. How would the answer change if the redemption had qualified as a sale or exchange under Section 302?
Read the worked answer
If the redemption qualified as a sale or exchange, David would recognize capital gain on the entire $500,000 minus his basis of $100,000, resulting in $400,000 long-term capital gain. The corporation's E&P would not be relevant. The entire gain would be taxed at capital gains rates, potentially more favorable than dividend treatment. However, the redemption did not qualify, so dividend treatment applies.