C and S Corporations for Estate Planners: Substantially Disproportionate Redemptions

Deciphering IRC Section 302(b)(2), with examples

This is the tenth installment of C and S corporations for estate planners.

For the prior article in this series, click here.

For the first article in this series and a series index, click here.

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AUTHOR’S NOTE: In creating this series, my vision was to take the level of instruction I received in my tax LL.M. program many years ago and condense it down to elements that might be applicable to those unfamiliar with corporate taxation. While I refer to “estate planners” in the title, please note that all of the material in this series can be applicable to any professional of any stripe who needs to learn corporate tax. So, for example, if you are a student pursuing an accounting degree or your J.D. or LL.M., this material can supplement your education as well. Likewise, if you are early in your career and have been thrown into the deep end of tax or M&A, this is for you.

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Table of Contents

1. Intro and Recap

2. Substantially Disproportionate Redemptions - Disqualifiers

3. Mathematical Requirements

4. Examples

   1. Example 1

   2. Example 2

   3. Example 3

   4. Example 4

   5. Example 5

5. Conclusion

Intro and Recap

Now that we have spent some time in eligible-shareholder land for S corporations, it is time to end the tangent and jump back to the core issue with C corporations (that may create different outcomes for S corporations) – the rules around distributions of earnings and profits (E&P).  Recall that redemptions not complying with the terms of IRC Sections 302(b), or 303, are treated as dividends. 

Even worse, noncomplying redemptions do not meet the requirements for qualified dividends.  The outcome is ordinary income treatment on a redemption of C corporation stock, to the extent of the lesser of E&P or stock basis.  This gets exacerbated where a decedent’s estate holds stepped-up basis C corporation stock, as the return of basis gets taxed as ordinary income.  However, in the case of an S corporation, we get the benefit of exhausting the lesser of shareholder basis, or AAA, before looking at capital gain treatment (if AAA remains) or ordinary income (if AAA is exhausted and we are now dipping into old and cold E&P). 

In the last two articles about redemptions, we explored complete redemptions – which may not be possible in estate planning contexts when we apply the family attribution rules or exception thereto – along with Code Section 303 redemptions to the extent of transfer taxes and funeral/administrative expenses.  There were some threads, however, which were not closed. 

For one, a 303 redemption and complete redemption can be stacked with one another at a decedent’s death.  There could be some strategy in first deploying 303 to reduce family attribution.  Then, as a backup, a 302 complete redemption could be used. 

What we tabled, however, was another commonly-used outcome which still uses the family attribution rules but could still leave us with some wiggle room, whether we are making a redemption during life or after death.  That outcome is the substantially disproportionate redemption. 

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Substantially Disproportionate Redemptions - Disqualifiers

IRC Section 302(b)(2) grants sale or exchange treatment for redemptions that are “substantially disproportionate” when comparing the redeemed shareholder to all other shareholders.  While this test is done on a shareholder-by-shareholder basis, it is important to start with the qualifier that this exception (to dividend treatment) does not apply if the redemption in question is one in a series of redemptions pursuant to a “plan” that would result in one or more individual redemptions not being substantially disproportionate. 

In other words, if you redeemed one shareholder in a way that passed the substantially disproportionate test, then soon after redeemed another shareholder or the same shareholder (whether or not the test was passed for the second redemption), we may need to count the second redemption for purposes of determining whether the first is substantially disproportionate. 

Also, it is important to note that the attribution rules of IRC Section 318 apply to the substantially disproportionate test.  This article includes a very generic example of how these rules may disqualify an otherwise respected redemption, but unlike a complete redemption there is no exception to the family attribution rules for a substantially disproportionate redemption.

Mathematical Requirements

In general, a substantially disproportionate redemption focuses primarily on voting stock to start with.  Then, we look to all other classes of common (but not preferred) nonvoting stock.  Under both tests, there must be a meaningful reduction of the ratio of the shareholder’s shares owned to shares outstanding, among voting shares and (if any are redeemed) nonvoting common shares, before and after the redemption.  This “ratio” is somewhat similar to percent ownership within each class, but where there are multiple classes of common stock, the total fair market value of the common stock before and after redemption, as opposed to common stock in all classes issued and outstanding, becomes the metric. 

The meaningful reduction is defined as resulting in a ratio of share ownership after redemption that is less than 80% of the share ownership before redemption. 

But, this is not the end point.  There is also a requirement that, post-redemption, the redeemed shareholder must own less than 50% of the combined voting power of the corporation across all classes of stock. 

Examples