A stock redemption in a closely held corporation is taxed as a sale when it passes at least one of four tests under Section 302 of the Internal Revenue Code; if it fails all four, the entire payment is treated as a corporate distribution. Passing lets you subtract your basis and pay tax only on the gain. Failing usually means a bigger tax bill, because you lose basis recovery entirely, even when the tax rate on the payment turns out to be the same.
That last point surprises people. For an individual receiving payments from a C corporation, qualified dividends are taxed at the same 0%, 15%, or 20% rates as long-term capital gains.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses The rate is often identical. What differs is what you get to subtract before applying it.
Sale Treatment vs. Distribution Treatment
Under sale treatment, you subtract your adjusted basis from the redemption proceeds and pay tax only on the profit. Receive $200,000 for shares with a $40,000 basis and you report $160,000 of long-term capital gain. High earners may also owe the 3.8% Net Investment Income Tax if modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly).2Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Fail every Section 302 test and the payment is reclassified as a distribution under Section 301.3Office of the Law Revision Counsel. 26 U.S. Code 301 – Distributions of Property To the extent the corporation has current or accumulated earnings and profits (E&P), that distribution is a dividend. In the example above, the full $200,000 would be taxable if the corporation has enough E&P. Your $40,000 basis does not reduce the taxable amount. It shifts instead to the basis of any shares you still hold, or, if the redemption emptied your direct holdings but was still treated as a dividend because of constructive ownership, to the shares of the related person whose ownership was attributed to you.4GovInfo. 26 CFR 1.302-2 – Redemptions Not Taxable as Dividends
For a corporate shareholder, the math can flip. A C corporation receiving dividend treatment on a failed Section 302 redemption may claim a dividends-received deduction that shelters 50% to 100% of the payment depending on ownership. That is one reason the IRS scrutinizes redemptions in both directions.
Constructive Ownership Comes First
Before you can apply any test, you have to calculate ownership the way the IRS does. Section 318 attributes stock owned by family members, entities, and option holders to you, and these rules are mandatory.5Office of the Law Revision Counsel. 26 U.S. Code 318 – Constructive Ownership of Stock Skipping this step is how shareholders miscalculate their post-redemption percentage and end up with dividend treatment they did not expect.
Family attribution is the usual obstacle in a closely held corporation. You are treated as owning all stock held by your spouse, children, grandchildren, and parents. The rules do not reach sideways: siblings, aunts, uncles, nieces, and nephews are excluded. A father who sells every share he personally owns back to the corporation still constructively owns his daughter’s shares, which can prevent a complete termination on its face.
Entity attribution runs through partnerships, estates, trusts, and corporations in both directions. Stock owned by a partnership or estate is attributed proportionately to its partners or beneficiaries, and stock owned by those individuals is attributed back up to the entity. For corporations, the threshold is higher: stock owned by a corporation is attributed to a shareholder only if that shareholder owns 50% or more of the corporation’s value, and then only in proportion to their ownership. S corporations are treated as partnerships for attribution purposes, so every S corp shareholder receives proportionate attribution regardless of percentage.
Option attribution treats anyone holding an option to acquire stock as already owning it, including chained options. Attribution can compound, with limits. Stock attributed to you through entity or option rules is treated as actually owned and can be attributed again to someone else. Stock attributed through family rules cannot be re-attributed through family rules a second time: your father’s shares reach you, but they do not then jump from you to your spouse through another family application. When stock could be attributed to you through both family and option rules, the option rule controls, which matters because option-attributed stock can be re-attributed further.
The Four Section 302 Tests
A redemption qualifies as a sale if it satisfies any one of four tests under Section 302(b).6Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock You only need one. In practice, planners try the bright-line tests first and reserve the subjective one for last.
Substantially Disproportionate Redemption
Section 302(b)(2) sets two numerical hurdles measured immediately after the redemption. First, you must own less than 50% of the total combined voting power. Second, your percentage of voting stock after the redemption must be less than 80% of your percentage before.7eCFR. 26 CFR 1.302-3 – Substantially Disproportionate Redemption Both must be satisfied.
If you own 60% before, you have to drop below 48% after (60% × 80%), and you also have to clear the 50% ceiling. Start at 45% and you need to fall below 36%, with the 50% ceiling already satisfied. All calculations use constructive ownership, not the certificate list.
Complete Termination of Interest
Section 302(b)(3) is met when the corporation redeems every share you actually and constructively own. It is the cleanest path to sale treatment, and it comes with a powerful advantage: you can waive family attribution. Without the waiver, a retiring parent who sells all personally owned shares would still constructively own the children’s stock and fail the test.
The waiver conditions are strict. Immediately after the redemption you can hold no interest in the corporation other than as a creditor: no officer, director, or employee role. You must agree to notify the IRS within 30 days if you reacquire any interest within ten years, and you must retain records for that full period.8Internal Revenue Service. Private Letter Ruling 202219011 Violate the ten-year restriction by picking up new shares or rejoining management, and the IRS can recharacterize the original redemption as a dividend and assess additional tax for the year of the redemption.
The waiver statement must be attached to a timely filed return for the year of the redemption. There is no mechanism to claim the waiver retroactively if you file without it. Missing this filing is a common and expensive mistake.
Partial Liquidation
The Section 302(b)(4) test is available only to noncorporate shareholders. Unlike the other tests, it is evaluated at the corporate level: the distribution qualifies when it is not essentially equivalent to a dividend as measured by what the corporation did, regardless of what happened to any particular shareholder’s percentage.
The most common path is terminating a qualified trade or business. If the corporation operated two separate business lines for at least five years and shuts one down, distributing the proceeds while continuing the other, the redemption qualifies. It can even be pro rata among all shareholders, which would doom any of the shareholder-level tests. Partnerships, estates, and trusts look through to their partners or beneficiaries for the noncorporate requirement.
Not Essentially Equivalent to a Dividend
Section 302(b)(1) is the subjective catch-all and the least predictable of the four. The Supreme Court held in United States v. Davis that a redemption qualifies only when it produces a “meaningful reduction” in the shareholder’s proportionate interest.9Justia Law. United States v. Davis, 397 U.S. 301 (1970) Courts weigh changes in voting power, the right to share in current earnings, and the right to share in assets on liquidation.
The standard has teeth when a shareholder crosses a control threshold. A drop from 51% to 49% is the textbook example, because losing majority control changes the shareholder’s practical relationship with the corporation. A drop from 85% to 80% changes the numbers without changing who runs the company, and the IRS is unlikely to view that as meaningful. Experienced practitioners avoid relying on this test when a bright-line test is available.
S Corporations Soften the Penalty for Failing
If your closely held corporation is an S corporation, a failed Section 302 redemption follows a different path. S corporations rarely carry accumulated earnings and profits unless they converted from C corporation status or acquired a C corporation. Without E&P, the distribution runs through the Section 1368 ordering rules rather than being immediately taxable as a dividend.
The distribution first reduces the accumulated adjustments account (AAA), tax-free to the shareholder. Next, any accumulated E&P from a prior C corporation period is taxed as a dividend. After E&P is exhausted, the distribution reduces stock basis tax-free, and only amounts above all those layers are taxed as capital gain. For an S corporation that has always been an S corporation, failing Section 302 often produces no immediate dividend income at all. The consequence is real but far less severe than in the C corporation setting.
If the Redemption Price Is Below Your Basis
A redemption at a price below basis will not generate a deductible loss in most closely held settings. Section 267 disallows losses on transactions between related parties, and if you own more than 50% of the corporation’s outstanding stock, counting direct and indirect ownership, the loss is disallowed entirely.10Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Persons The only statutory exception is a distribution in complete liquidation of the corporation.
Indirect ownership for this purpose uses rules similar to Section 318, so a shareholder who owns 30% directly can still exceed the 50% threshold if a spouse and children hold another 25%. Anyone planning a redemption at a price below basis needs to run those numbers before assuming a deductible loss exists.
The Installment Sale Trap
Closely held corporations often lack the cash to fund a full redemption at closing, so payments get stretched over years using a note. A redemption that qualifies as a sale under Section 302 can use installment reporting under Section 453 to spread gain recognition over the payment period, deferring tax until the cash arrives.
The note must carry adequate stated interest at or above the applicable federal rate the IRS publishes monthly.11Office of the Law Revision Counsel. 26 U.S. Code 483 – Interest on Certain Deferred Payments12Office of the Law Revision Counsel. 26 U.S. Code 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property The long-term AFR for December 2025 was 4.55% annually.13Internal Revenue Service. Revenue Ruling 2025-24
Here is the trap. If the redemption fails Section 302, the entire distribution is treated as a dividend in the year the obligation is created, not spread over the payment period. Installment reporting is available for sales, not distributions. You cannot fix the classification after closing, so getting it right in advance is essential.
Documentation That Protects the Classification
Closely held redemptions invite scrutiny because buyer and seller are related. Documentation is the primary defense against recharacterization.
The redemption agreement should specify the number of shares, the purchase price, payment terms, and any closing conditions. The board must adopt a formal resolution authorizing the redemption and confirming the corporation has the financial capacity to complete it under state law. Most states require payment from legally available funds and prohibit redemptions that would render the corporation insolvent; directors who approve payments in violation can face personal liability to creditors.
An independent valuation is essential because there is no public market price. A qualified professional should perform it and produce a written report explaining the methodology. The IRS will scrutinize a price that looks inflated (a disguised dividend) or deflated (a gift). Valuations for closely held corporations range from a few thousand dollars for simple businesses to $30,000 or more for complex entities.
For a complete termination that relies on a family attribution waiver, attach the waiver statement to a timely filed return for the year of the redemption. The statement confirms you hold no interest in the corporation other than as a creditor and agrees to the ten-year notification requirement. Without that attachment, the waiver is not available, and the constructive ownership of your relatives’ shares will pull the redemption back into dividend territory.