IRC 304: Redemption Through Use of Related Corporations

IRC Section 304 stops shareholders from converting what should be dividend income into capital gain by moving cash between corporations they control. If you sell stock of one controlled corporation to another corporation you also control, Section 304 ignores the sale label and treats the payment as a deemed stock redemption, then runs it through the dividend-testing rules of Section 302.¹ In most related-party fact patterns those tests fail, and the full amount you received becomes an ordinary dividend rather than a capital gain.

The Two Transactions Section 304 Covers

Section 304 reaches two structures. The first, under Section 304(a)(1), is the brother-sister acquisition: one or more people control two corporations, and one of those corporations buys stock of the other from the controlling shareholder for cash or property. If you own all of Corporation X and Corporation Y and sell your X stock to Y, that is the classic case. The cash Y paid is treated as a distribution in redemption of Y’s stock, and Y is the acquiring corporation.¹

The second, under Section 304(a)(2), is the parent-subsidiary acquisition: a subsidiary buys stock of its parent from a shareholder of the parent. Here the deemed redemption is of the parent’s stock, not the subsidiary’s. The parent-subsidiary rule takes priority when a transaction could fit either pattern.¹

What “Control” Means

Section 304 applies only when the same person or group controls both corporations. Control is ownership of stock representing at least 50% of the total combined voting power of all voting classes, or at least 50% of the total value of all classes. Either prong is enough.¹

Section 304(c)(1) also runs control through corporate chains. If you control Corporation A, and A owns at least 50% of the vote or value of Corporation B, you are treated as controlling B. That reach can extend several corporate layers deep.¹

The Attribution Rules Pull In More Owners Than You Think

Whether the 50% threshold is met turns on constructive ownership under Section 318(a), not just shares you hold in your own name. You are treated as owning stock held by your spouse (unless legally separated by a decree of divorce or separate maintenance), your children, grandchildren, and parents. Adopted children count as children by blood. Siblings are not on the list. Stock attributed to you through one family member cannot be re-attributed through you to another.²

The 5% Corporate Attribution Rule

The most aggressive piece of Section 304 is how it modifies corporate attribution. Under standard Section 318, corporate attribution kicks in only at 50% ownership. Section 304(c)(3)(B) replaces every “50 percent” in that rule with “5 percent” for purposes of the control test.¹ Own 5% of a corporation and you are treated as owning a proportionate slice of whatever stock that corporation holds. The reverse also applies: a corporation is treated as owning a proportionate share of its 5%-or-greater shareholders’ stock. Shareholders who would never be treated as related under ordinary rules can trip Section 304 in a transaction they thought was a plain stock sale.

Why the Result Is Almost Always a Dividend

Once Section 304 recharacterizes the sale as a deemed redemption, the shareholder gets capital gain treatment only if the redemption passes one of three Section 302(b) tests, measured against the shareholder’s interest in the issuing corporation:³

Not essentially equivalent to a dividend, which requires a meaningful reduction of the shareholder’s proportionate interest and is read narrowly.
Substantially disproportionate, which requires the shareholder to end up below 50% of voting power and to see voting and common stock percentages each drop by more than 20%.
Complete termination of the shareholder’s interest, with family attribution waivable under specific conditions.

In related-party transactions these tests almost always fail. The constructive ownership rules keep the shareholder’s deemed interest in the issuing corporation roughly where it was before the transaction, so a “meaningful reduction” is nearly impossible to show. The payment is then a distribution under Section 301.

How Much Becomes a Dividend

When distribution treatment applies, the amount taxed as a dividend is set by the combined earnings and profits of both corporations. The distribution is sourced first from the acquiring corporation’s E&P, and then from the issuing corporation’s E&P.¹ Sell stock for $100 with $60 of E&P in the acquirer and $50 in the issuer, and the entire $100 is a dividend: $60 sourced from the acquirer, $40 from the issuer.

Anything paid over the two corporations’ combined E&P reduces your stock basis, and whatever is left after basis is exhausted is capital gain.⁴

Foreign Acquiring Corporations

Section 304(b)(5)(B) shuts down a common workaround. If the acquiring corporation is foreign, its E&P is disregarded entirely when more than 50% of the dividends arising from the acquisition would neither be subject to U.S. tax in the year they arise nor be included in the earnings and profits of a controlled foreign corporation.¹ The rule prevents routing a Section 304 transaction through a foreign subsidiary sitting on E&P to generate dividends that escape current U.S. tax.

Basis and the Deemed Section 351 Exchange

Section 304 layers a fictional Section 351 contribution on top of the deemed redemption. When the transaction produces dividend treatment, the statute treats you as first contributing the issuing corporation’s stock to the acquiring corporation in a tax-free Section 351 exchange, and then having the acquiring corporation redeem the stock it was deemed to issue.¹ The acquiring corporation takes a carryover basis in the transferred stock under Section 362(a).⁵

For you as the shareholder, dividend treatment means your basis in the transferred stock is not used to offset the distribution. That unrecovered basis is added to your basis in the remaining stock you hold in the acquiring corporation. If you no longer hold any acquiring corporation stock, the basis shifts to your issuing corporation stock instead. The basis is preserved somewhere; it is not lost.

The Anti-Avoidance Regulation

Treasury Regulation Section 1.304-4 lets the IRS look through structures built to sidestep Section 304. It targets two moves:⁶

Inserting a low-E&P shell as the acquiring corporation to shrink the dividend. If a corporation is created, organized, or funded with a principal purpose of avoiding Section 304’s application to another corporation that actually controls the acquiring entity, the IRS can treat the controlling corporation as the acquiring corporation.
Restructuring so a high-E&P entity stays out of the E&P stacking calculation. If the issuing corporation acquires stock of a subsidiary in connection with the transaction and a principal purpose is to keep Section 304 from reaching that subsidiary, the subsidiary is treated as the issuing corporation.

The trigger is “principal purpose,” not sole purpose or lack of economic substance. If avoiding Section 304 was one of the driving reasons behind the structure, the regulation applies and the transaction is recast to pull in the entity the taxpayer tried to leave out.

1
Office of the Law Revision Counsel. 26 USC 304 – Redemption Through Use of Related Corporations
2
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
3
Office of the Law Revision Counsel. 26 USC 302 – Distributions in Redemption of Stock
4
Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
5
Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations
6
eCFR. 26 CFR 1.304-4 – Special Rules for the Use of Related Corporations