| A stock redemption is the reacquisition of stock by a corporation in exchange for property, which includes money, securities, and indebtedness to the corporation. After a redemption, the stock may be canceled, retired, or held by the corporation as treasury stock. If the corporation redeems its stock in a manner that makes the distribution "equivalent" to a dividend distribution, then the amount received by the stockholder is a taxable dividend to the extent that it is paid out of earnings and profits.
The issue of whether a distribution resulting from a redemption of stock is equivalent to a taxable dividend is a question of fact in each case. In general, a cancellation or redemption of a part of the corporation's stock in a pro rata manner among all stockholders is considered a taxable dividend distribution.
The redemption of a corporation's stock may be entitled to treatment as an exchange rather than a dividend. The tax advantage of treatment as an exchange is that any gain recognized is a long-term capital gain rather than ordinary gain if the stock is a capital asset in the hands of the stockholder and meets certain holding period requirements.
In order to qualify for treatment as an exchange rather than as dividend, one of the following four tests must be met:
- The redemption is substantially disproportionate with respect to the stockholder. The test for determining whether a redemption is substantially disproportionate is a mechanical test that compares a stockholder's ownership percentages before and after the redemption;
- The redemption terminates the stockholder's entire interest in the corporation;
- The redemption is not substantially equivalent to a dividend; or
- The redemption is of stock held by a noncorporate stockholder and is made in partial liquidation of the redeeming corporation.
A redemption that is not essentially equivalent to a dividend must result in a meaningful reduction of the stockholder's proportionate interest in the corporation. The factors to be considered in determining whether there has been a meaningful reduction include the stockholder's ability to control the corporation, any retained rights to a share of the corporation's earnings, and any retained rights upon a corporate liquidation. A meaningful reduction in ownership often results from a redemption that fails to qualify either as a complete termination of a stockholder's interest or as a substantially disproportionate redemption.
Copyright 2010 LexisNexis, a division of Reed Elsevier Inc. |