Daily Archives: November 16, 2010

Why You Should Be Aware of § 302 of the Internal Revenue Code

I’d like to follow up on something that was briefly discussed in last week’s blog: when a stock redemption will be treated as an exchange under § 302 of the Internal Revenue Code.  Because tax season is right around the corner it’s important to know if you’ve planned properly before filing your 1120.  At first blush, one might ask, “why does it matter if a stock redemption is treated as a dividend or an exchange since both are taxed at preferential rates?”  The answer is that when the shareholder gets exchange treatment they can back out the basis of their stock1 before determination of the taxable gain and the gain can be offset by any capital losses which are otherwise only allowable up to $3,000.

Now, I realize this topic is rather technical, but I’m going to spare you the pain and suffering required to navigate the rule (far too much information for a “blog”) and simply give you a brief overview so you can be aware of how these transactions can develop into a tax deficiency.  Much of the information is especially relevant to closely held and family owned corporations, which is therefore relevant to many Northern Michigan businesses.

Say you own stock in Corporation C.  C has 100 shares of outstanding common stock and you own 20 of these.  Four other individuals own the other 80 shares equally.  You decide you’re going to get out of the business so C buys all 20 shares from you.  Capital gain, right?  Reduce the gain by backing out your basis in the stock and potentially use up some of those capital losses you incurred.  If you’ve planned well you’ll avoid any tax at all this way. Unfortunately, if certain other aspects are present in this transaction (for example, the other shareholders are certain family members), then the IRS has other ideas.  Since the development of corporations and therefore the development of the double tax on dividends, shareholders have been inventing ways to avoid dividend treatment on money they extract from corporations.  This was especially important when dividends were taxed at ordinary income rates (which, by the way, could theoretically happen again when the preferred rates on dividends expire, making these transactions even more important).  Enter § 302, promulgated by the Service in response to repeated attempts by taxpayers to avoid dividends.  Unless the requirements of this Code provision are satisfied, your redemption will be taxed as a distribution (dividend) under § 301.

It is especially important to be aware of the attribution rules governed by § 318 when seeking capital gain treatment.  Under § 318, stock owned by your spouse, children, parents, and grandchildren, some trusts, and even by certain partnerships and corporations you own, can be attributed to you and will affect your § 302 treatment.  If stock is attributed to you because other family members own the corporation, you’ll essentially be required to wash your hands of any involvement in the corporation for the 10 years following the redemption of your stock.  Otherwise the IRS can re-categorize your redemption as a dividend.

Sound confusing?  We can help you with any issues arising under this provision and many more.  If you have any questions or concerns regarding the legal needs of your business, please don’t hesitate to contact us.

1 excluding from the conversation, for simplicity, §301(c)(2), where distributions in excess of E&P can also reduce basis