What Is a Stock Redemption? Rules and Tax Treatment

A stock redemption occurs when a corporation repurchases its own shares directly from a shareholder in a private exchange. This differs from a stock sale on the open market where shares are traded between investors. The tax consequences of a redemption depend on its structure.

For the shareholder, the money received may be treated as proceeds from a sale, resulting in a capital gain or loss, or it could be taxed as a dividend. For the corporation, redeeming stock is a strategic financial decision that affects its capital structure and accounting records.

Corporate Motivations for Stock Redemptions

Corporations engage in stock redemptions for several strategic reasons. A primary motivation, especially in closely held corporations, is to consolidate ownership. Buying out a specific shareholder can increase the ownership percentage and control of the remaining owners, a common strategy to resolve shareholder disputes or facilitate a business succession plan without introducing outside parties.

Another reason for redemptions is to return capital to shareholders, serving as an alternative to dividends. This method is sometimes preferred because it can offer a more favorable tax outcome for the shareholder and signals management’s confidence that the company’s stock may be undervalued. By reducing the number of shares outstanding, a redemption also boosts financial metrics like earnings per share (EPS), which can increase the market price of the remaining shares.

For shareholders in private companies with no public market for their stock, a redemption provides a source of liquidity. It offers a formal mechanism for an investor to cash out their equity position, which would otherwise be difficult to sell. Companies also use redemptions to manage their equity compensation programs, accumulating a supply of stock for employee plans while avoiding the dilution from issuing new shares.

Tax Treatment for the Redeemed Shareholder

The tax implications for a shareholder depend on whether the redemption is treated as a sale of stock or a distribution of corporate profits. This determines if the shareholder reports a capital gain or loss, or receives dividend income. Sale treatment is often more advantageous, as the shareholder can offset the proceeds with their tax basis in the stock, and any gain is typically taxed at lower long-term capital gains rates if the stock was held for more than one year.

To qualify for sale treatment, the redemption must meet one of the tests in Internal Revenue Code Section 302. The first is the “substantially disproportionate” redemption. This requires that after the redemption, the shareholder owns less than 50% of the corporation’s voting power and their ownership percentage is less than 80% of what it was before the transaction. For example, if a shareholder owned 40% of a company, they must own less than 32% after the redemption to qualify.

A more straightforward path to capital gains treatment is a “complete termination” of the shareholder’s interest, where the corporation redeems all shares owned by the shareholder. When the first two objective tests are not met, a shareholder may still qualify under the more subjective “not essentially equivalent to a dividend” test. This is a facts-and-circumstances analysis that focuses on whether there has been a “meaningful reduction” in the shareholder’s interest.

A complication in applying these tests is stock attribution, or constructive ownership, under IRC Section 318. These rules treat a shareholder as owning stock that is actually owned by certain family members (spouse, children, grandchildren, and parents) or related entities like partnerships or estates. Because of these attribution rules, a complete redemption of a shareholder’s directly owned stock might fail the tests if a related party continues to own shares. If none of these tests for sale treatment are met, the entire payment is treated as a dividend to the extent of the corporation’s earnings and profits, resulting in ordinary income with no recovery of stock basis.

Accounting and Tax Impact on the Corporation

A stock redemption has distinct accounting and tax consequences for the corporation. On the tax side, a corporation generally does not recognize a taxable gain or loss when it repurchases its own stock with cash. The transaction is viewed as a return of capital to the shareholder.

The accounting for a redemption impacts the shareholders’ equity section of the balance sheet. Corporations typically use one of two methods: the treasury stock method or the retirement method. Under the treasury stock method, repurchased shares are recorded at cost and held as “treasury stock.” This account is a deduction from total shareholders’ equity, and the shares are considered issued but not outstanding, with the potential to be reissued for purposes like employee compensation or raising capital.

Alternatively, the corporation can use the retirement method, where repurchased shares are permanently canceled and cannot be reissued. The accounting entry reduces the capital stock accounts, such as common stock and additional paid-in capital, that were credited when the shares were first issued. Both methods reduce the corporation’s total assets (cash) and shareholders’ equity. The transaction also reduces the corporation’s accumulated earnings and profits (E&P), a measure used to determine the taxability of future distributions.

Redemptions to Pay Death Taxes

Internal Revenue Code Section 303 provides relief for the estates of deceased shareholders in closely held businesses. This provision allows an estate to redeem a portion of the decedent’s stock to cover certain expenses without the proceeds being taxed as a dividend. This can prevent the forced sale of a family business to pay estate taxes, funeral costs, and administrative expenses.

To qualify for this treatment, the value of the corporation’s stock in the decedent’s gross estate must exceed 35% of the adjusted gross estate’s value. This ensures the rule is targeted at estates where a significant portion of the value is tied up in a private business. The amount of the redemption qualifying is limited to the sum of all federal and state death taxes, plus the funeral and administrative expenses allowable as deductions for the estate.

If these conditions are met, the redemption is treated as a sale or exchange. This is beneficial because the stock receives a “step-up” in basis to its fair market value at the date of death. As a result, there is typically little to no capital gain to be taxed when the shares are redeemed. This special treatment applies even if the redemption would have failed the standard tests for sale treatment.