Question

9. What is required for a stock redemption to be considered “not essentially equivalent to a dividend”? Attach Internal Revenue Code Section

Answer 1

Internal Revenue Code

The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code (USC). It is organized topically, into subtitles and sections, covering income tax (see Income tax in the United States), payroll taxes, estate taxes, gift taxes, and excise taxes; as well as procedure and administration. Its implementing agency is the Internal Revenue Service.

Redemptions Not Essentially Equivalent to Dividends

26 U.S. Code § 302 - Distributions in redemption of stock

If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), (3), (4), or (5) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock.

Redemptions not equivalent to dividends

Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend:-

1. If a payment is a dividend, it is subject to one set of tax rates. If a payment is proceeds of a sale or exchange, it is subject to another set of rates. Of course, many dividends today are taxed at the qualified dividend rate of 15 percent. For the moment, that is also the long-term capital gain rate. On the surface, this serendipity may make you think the distinction is unimportant. Some dividends do not qualify for the 15-percent rate. Even more obviously, if one receives sale or exchange treatment, payments can be a recovery of basis and therefore not be gain, in whole or in part. One may even have a loss. Thus, even assuming that the same 15-percent tax rate might apply to a dividend or the proceeds on a sale or exchange there may be a considerable difference. In these and other ways, we still care about dividend equivalency.
2. The development of rules for determining whether a distribution by a corporation in exchange for part of its outstanding stock is to be treated as producing dividend income or capital gain or loss to its shareholders is a most perplexing matter. If a corporation which has earnings or profits distributes cash or other property to its shareholders without the surrender of stock by the shareholders, it is clear that they have dividend income which is subject to tax at surtax rates. It is equally clear that if the shareholders sell their stock to third parties at a profit, the selling shareholders normally I realize capital gain even though the difference between the sales price and their cost for their stock is due solely to accumulated earnings in the corporation. But where the shareholder sells his stock back to the issuing corporation rather than to third parties, there may be difficulty in determining whether as a practical matter the surrender of the shares is a meaningless gesture or whether it is of such significance as to warrant treating the proceeds from the corporation as though they had been received on a sale to third parties. The Old Law.-The 1939 Code provided in Section 115(c) that "amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock." In Section 115(i) the phrase "amounts received in partial liquidation"e was defined to mean "a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock." It was then provided in Section 115(g) that "If a corporation cancels or redeems its stock . . . at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend," the amount so distributed would be treated as a taxable dividend to the extent it represents a distribution of earnings or profits accumulated after February 28, 1913.
3. Section 302 (b) (1) In the House bill, an attempt was made to eliminate the general language of Section 115(g) of the 1939 Code regarding essential equivalence to a dividend and to prescribe instead a series of definite rules for determining the situations in which redemptions of stock not in partial or complete liquidation give rise to capital gain or loss to the shareholder.' The Senate Finance Committee Report stated that the rules in the House bill "appeared unnecessarily restrictive, particularly, in the case of redemptions of preferred stock which might be called by the corporation without the shareholder having any control over when the redemption may take place." 10 The Report notes that, accordingly, the Committee "follows existing law by reinserting the general language indicating that a redemption shall be treated as a distribution in part or full payment in exchange for stock if the redemption is not essentially equivalent to a dividend." " The Report further stated: "In general, under this subsection your committee intends to incorporate into the bill existing law as to whether or not a reduction [sic] is essentially equivalent to a dividend under section 115(g) (1) of the 1939 Code, and in addition to provide three definite standards in order to provide certainty in specific instances."
4. The new statute eliminates the old words of Section 115(g) "at such time and in such manner," but the quoted excerpt from the Senate Report indicates that no change in result was intended. The new Section 302(b) (5) provides that the fact that the redemption fails to meet the specific requirements of Section 302 (b) (2), (3) and (4) "shall not be taken into account" in determining whether the redemption is not essentially equivalent to a dividend under Section 302(b) (1). The proposed Regulations restate this rule in somewhat different language by providing that "if a distribution is determined to be not essentially equivalent to a dividend, it is immaterial that it does not meet the requirements" of the three specific provisions.'- Literally, this wording is not as clear from the taxpayer's standpoint as the statute, but it is unlikely that any different result is intended in view of the specific provision in the statute itself.