Shareholder Selling Shares Back to the Company: Section 302 Tests

When a shareholder is selling shares back to the company, the tax bill turns on a single classification: the IRS either treats the payment as a stock sale, letting you subtract your basis and pay long-term capital gains rates on the profit, or as a dividend, taxing a much larger slice of the payment because your basis doesn’t offset the taxable amount the same way. The default is dividend treatment. Sale treatment applies only if the transaction clears one of the safe-harbor tests in IRC Section 302(b).¹

Why the Classification Is Where the Money Is

Pass a Section 302 test and you subtract your adjusted basis from the redemption price. The gain qualifies for long-term capital gains rates if you held the shares more than a year.²

Fail every test and the entire payment is reclassified as a distribution under IRC Section 301. The portion covered by the corporation’s accumulated earnings and profits is taxed as a dividend.³ For a C corporation, qualified dividends generally carry the same preferential rate as long-term capital gains, so the rate itself may not change. The damage is in the math. You lose the ability to offset the dividend portion with your basis. Someone with a $200,000 basis who receives $300,000 would owe tax on $100,000 of gain under sale treatment, but potentially on the full $300,000 under dividend treatment if earnings and profits are large enough.

Amounts that exceed the corporation’s earnings and profits reduce your stock basis dollar-for-dollar. Anything still left after basis hits zero is taxed as capital gain.³ In a company with little or no accumulated earnings, dividend treatment stings less. In a mature, profitable company with years of retained earnings, it is often brutal.

The Three Section 302 Tests

You only need to satisfy one. Clearing any single test converts the transaction from dividend treatment to sale-or-exchange treatment.

Substantially Disproportionate Redemption

This is a mechanical test with three requirements that must all hold immediately after the redemption:¹

You own less than 50% of the total voting power of all classes of voting stock.
Your percentage of voting stock is less than 80% of what it was before. If you held 60% of the vote beforehand, you must drop below 48% (80% of 60%).
The same 80% reduction applies separately to your ownership of common stock, whether voting or nonvoting.

The test works well when several shareholders exist and the redemption meaningfully shifts control. It does not apply if the redemption is part of a series of transactions that together fail to produce a substantially disproportionate result.

Complete Termination of Interest

If the company buys back every share you own, the redemption qualifies as a sale.¹ After closing you can’t retain any proprietary interest, including a role as officer, director, or employee. Creditor status is permitted, so holding a promissory note for the purchase price is fine.

This is the common path for owners exiting closely held businesses. The catch is that “complete” means complete after applying the constructive ownership rules below. If the IRS considers you to still own shares held by family members, your interest hasn’t truly terminated.

Not Essentially Equivalent to a Dividend

When the mechanical tests fail, a redemption can still qualify for sale treatment if it produces a meaningful reduction in your proportionate interest. The Supreme Court set this standard in United States v. Davis, looking at reductions in voting power, the right to participate in earnings, and the right to share in net assets on liquidation.

There’s no bright-line threshold here. A drop from 90% to 89% almost certainly fails. A drop from 27% to 22% in a company with a controlling majority shareholder has a much better chance. Relying on this test means accepting audit risk, which is why most tax advisors try to structure the transaction to clear one of the mechanical tests instead.

Constructive Ownership: Why the Tests Fail When the Numbers Look Fine

The Section 302 tests don’t look only at shares registered in your name. IRC Section 318 treats you as owning stock held by certain family members and entities. This constructive ownership routinely causes a redemption to fail the substantially disproportionate or complete-termination test when the raw numbers looked favorable.

Under the family attribution rules, you’re considered the owner of shares held by your spouse, children, grandchildren, and parents.⁴ Siblings are not included. Sell every share you personally own, but if your adult daughter still holds 30%, the IRS treats you as owning that 30%.

Entity attribution adds another layer. Shares held by a partnership or estate are attributed proportionally to each partner or beneficiary. Trust shares are attributed to beneficiaries based on their actuarial interest, and if you’re treated as the owner of a grantor trust, 100% of that trust’s shares are attributed to you.⁴ S corporations are treated the same way as partnerships here.

Attribution runs the other direction too. Stock you personally own is attributed back to entities in which you hold an interest. Chains stack. Stock attributed from an entity to an individual can then be re-attributed to that individual’s family members. Getting the arithmetic right generally requires professional help, especially in multi-generational family businesses that involve trusts and holding entities.

Waiving Family Attribution

Congress carved out one exception. For the complete-termination test only, you can ask the IRS to ignore family attribution if you accept three conditions:¹

Immediately after the redemption, you hold no interest in the corporation other than as a creditor.
You do not acquire any ownership interest (other than by inheritance) for the next 10 years.
You file a written agreement with your tax return for the year of the redemption, committing to notify the IRS if you violate the 10-year restriction and to keep the records the IRS needs to verify compliance.

Missing the filing deadline for that written agreement can convert the entire transaction into a dividend retroactively. If you plan to waive family attribution, treat the agreement as part of the closing package rather than an afterthought at tax time.

What You’ll Actually Pay in 2026

When the redemption qualifies as a sale, gain from shares held more than a year is taxed at long-term capital gains rates.² For 2026:

0% on taxable income up to $49,450 (single) or $98,900 (married filing jointly)
15% up to $545,500 (single) or $613,700 (married filing jointly)
20% above those thresholds

⁵

Shares held a year or less produce short-term gain, taxed at your ordinary income rate. For a departing owner of a closely held business who bought in years ago, long-term treatment is nearly always the case.

The gain itself is straightforward: cash received minus adjusted basis. Pay $50,000 for your shares and redeem them for $400,000, and you have a $350,000 long-term capital gain. Most falls in the 15% bracket, with the top slice at 20%.

The 3.8% Net Investment Income Tax

Higher-income taxpayers owe an additional 3.8% surtax on net investment income. It applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds the threshold for your filing status:⁶

$250,000 married filing jointly
$200,000 single or head of household
$125,000 married filing separately

The 3.8% surtax applies whether the redemption is classified as capital gain or dividend. A $400,000 redemption gain for a single filer with $250,000 in other income puts $450,000 over the threshold, triggering the surtax on a substantial portion of the gain. At the top, the effective rate on long-term gains reaches 23.8%.

If the Company Is an S Corporation

The Section 302 tests apply to S corporations the same way. What diverges is what happens when the redemption fails those tests and defaults to a distribution.

C corporations have earnings and profits, and failed redemptions are taxed as dividends to the extent of that pool. S corporations follow the ordering rules of IRC Section 1368:

The distribution first reduces the accumulated adjustments account (AAA) and is nontaxable to the shareholder to that extent.
If the S corporation has accumulated E&P from a prior C corporation period, the distribution is taxed as a dividend up to that E&P balance.
Any remaining amount reduces the shareholder’s stock basis.
Amounts exceeding basis are taxed as capital gain.

For an S corporation with a large AAA and no legacy C corporation earnings, failing Section 302 can actually produce a better result than sale treatment because the distribution is largely nontaxable up to AAA. Some S corporation shareholders deliberately structure a redemption that fails Section 302 for that reason, though the strategy carries risk if the IRS recharacterizes the transaction.

The Section 1202 Small Business Stock Exclusion

If you acquired your shares directly from a qualifying C corporation, you may be able to exclude some or all of the gain under IRC Section 1202.⁷ The One Big Beautiful Bill Act, signed on July 4, 2025, expanded eligibility and added a tiered exclusion for stock acquired after that date.

For shares acquired before July 5, 2025, the original rules apply. You must hold the stock at least five years, the corporation’s gross assets could not exceed $50 million at the time of issuance, and up to 100% of the gain is excluded (for stock acquired after September 27, 2010). The per-issuer cap is the greater of $10 million or ten times your adjusted basis.

For shares acquired on or after July 5, 2025, the updated rules provide a shorter path to partial exclusion:

Three or more years held: 50% of eligible gain excluded
Four or more years held: 75% excluded
Five or more years held: 100% excluded

The gross asset threshold rose to $75 million and the per-issuer cap to the greater of $15 million or ten times basis. Shares issued after July 4, 2025 won’t reach the three-year threshold by 2026, but shares acquired in 2022 or earlier under the original rules may satisfy the five-year holding period during 2026 or 2027, making the exclusion directly relevant to redemptions happening now.

Section 1202 applies only to C corporation stock, must have been acquired at original issuance rather than on the secondary market, and requires the corporation to be engaged in an active trade or business. Certain industries, including financial services, hospitality, and professional services, are excluded.

Taking Payment Over Time

A company that can’t or won’t pay the full price at closing may spread payments over several years using a promissory note. If the redemption qualifies as a sale, installment treatment under IRC Section 453 lets you recognize gain proportionally as you receive each payment rather than all at once.

Each payment splits into three components: return of basis (nontaxable), capital gain, and interest income. The gain portion is set by your gross profit ratio, which is total gain divided by total contract price. If gain represents 70% of the purchase price, 70 cents of every principal dollar you receive is taxable gain.

The note must carry interest at or above the applicable federal rate (AFR) published monthly by the IRS. If the stated rate is below the AFR, the IRS imputes interest at the federal rate, recharacterizing part of each payment from principal into interest income. For April 2026, the AFRs are approximately 3.59% for obligations of three years or less, 3.82% for obligations of three to nine years, and 4.62% for obligations exceeding nine years.⁸ The rate in effect when the note is issued controls.

Spreading recognition over years can keep you in lower brackets and reduce exposure to the 3.8% NIIT. The tradeoff is credit risk: if the company defaults, you’ve already paid tax on gain from earlier installments that you may not fully recover.

Getting the Price Right on Private Shares

For publicly traded stock the price is whatever the market says. For a private company, establishing fair market value takes real work, and pricing disputes are one of the most common triggers for IRS examination of redemptions.

If a shareholder agreement or buy-sell agreement already contains a valuation formula, following it is the simplest approach, provided the terms still reflect economic reality. A formula set 15 years ago that values the company at book value may badly understate current worth, and the IRS can challenge a price that doesn’t approximate fair market value.

When no formula exists, hiring an independent appraiser is standard practice. Appraisers typically look at projected cash flows, comparable company transactions, and net asset values. The final price often reflects discounts for lack of marketability and minority interest, since private shares can’t be easily sold and may not carry voting control. A formal appraisal gives both sides documentation to defend the number if the IRS questions it.

What the Corporation Owes and Reports

The company itself generally owes no federal income tax on a cash redemption; the corporation recognizes no gain or loss.⁹ The purchase price is not deductible. IRC Section 162(k) specifically disallows any deduction for amounts paid to reacquire the corporation’s own stock.¹⁰ Interest paid on a note funding the redemption is deductible under the normal interest-expense rules; the principal payments are a capital transaction.

A corporation that regularly redeems its own stock is treated as a broker for reporting purposes and files Form 1099-B to report proceeds.¹¹ If the redemption is classified as a dividend, the dividend portion is reported on Form 1099-DIV. Wrong classification on these forms creates matching-notice problems and potential audits for both parties, so confirm that the company’s reporting matches the position you’re taking on your return before anyone files.

1
Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock
2
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
3
Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property
4
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
5
Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
6
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
7
Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
8
Internal Revenue Service. Revenue Ruling 2026-7, Applicable Federal Rates
9
Office of the Law Revision Counsel. 26 USC 311 – Taxability of Corporation on Distribution
10
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
11
Internal Revenue Service. Instructions for Form 1099-B (2026)