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It's a Good Time for Stock Redemptions for Business Owners

If you're a shareholder of a closely held corporation, you may be interested in converting your ownership interest into cash with a so-called "stock redemption." That's where your company buys back (redeems) some or all of your shares. If you're interested in using this strategy, you should consider redeeming your shares while the individual federal income tax rates are relatively low by historical standards. Here's how to make this strategy work for you.

Important: The favorable individual federal income tax rates established by the Tax Cuts and Jobs Act (TCJA) will be in place at least through the end of 2025. With Republicans controlling Congress and the White House, it's expected that the TCJA tax rates will be extended beyond 2025 — or possibly made permanent or reduced even further. However, Congress hasn't yet passed any tax legislation.  

C Corporation Stock Redemption Basics

The general federal income tax rule is that cash payments by a C corporation to redeem shares are treated as corporate distributions to the recipient shareholder. So, if your corporation redeems your shares, the payments will be treated as taxable dividends paid to you to the extent of your corporation's current or accumulated earnings and profits (E&P). E&P is a tax accounting concept similar to the financial accounting concept of retained earnings.

Once a corporation's E&P has been exhausted, any remaining stock redemption payments will reduce the recipient shareholder's tax basis in the redeemed shares. After the recipient shareholder's tax basis has been exhausted, any remaining redemption payments will be considered capital gain. This corporate distribution treatment applies unless an exception is available under the tax code. Slightly different rules apply to redemptions of S corporation shares. (See "S Corporation Stock Redemption Basics" at right.)

5 Possible Exceptions to Corporate Distribution Treatment

Under current tax law, there are five exceptions to the general rule that C corporation stock redemption payments are treated as corporate distributions:

1. When the redemption payment isn't substantially equivalent to a dividend,
2. When there's a substantially disproportionate redemption of the shareholder's stock,
3. When the stock of a noncorporate shareholder is redeemed as part of a partial liquidation,
4. When the redemption payments are used to pay death taxes or certain funeral and administrative expenses of a deceased shareholder, and
5. When all your stock in the corporation is redeemed.

If an exception applies, stock redemption payments will be treated as proceeds from a garden-variety stock sale. Stock sale treatment is usually the preferred tax outcome because your basis in the redeemed shares can offset the redemption payments.

Of these five exceptions, you're most likely to qualify for the last one — and it's the only one you can generally rely on with an adequate degree of certainty. A complete termination happens when all your stock in the corporation is redeemed. However, beware: This exception can be negated by stock ownership attribution rules that treat you as constructively owning stock owned by another party.

Stock Ownership Attribution Rules

The stock ownership attribution rules stipulate that, for federal income tax purposes only, you're deemed to constructively own stock that your spouse, parents, children or grandchildren actually own. Additionally, you may be deemed to constructively own stock that's actually owned by certain related entities, such as a partnership in which you own an interest or another corporation you control.

You're ineligible for the complete termination exception if you actually or constructively own any stock in the redeeming corporation after completing the redemption transaction. That means the stock redemption payments will be taxed under the general corporate distribution rules (unless another stock sale exception applies).

Fortunately, a special family attribution waiver rule can often be used to make shareholders in family corporations eligible for the complete termination stock sale exception. Contact your tax advisor for details about the family attribution waiver rule. 

Corporate Distributions vs. Stock Sales

Suppose you don't have a significant tax basis in the redeemed shares or any significant capital losses. In that case, there's usually only a minor distinction between dividend treatment and stock sale treatment under today's individual federal income tax rate structure. Under current tax law, both dividends and long-term capital gains (LTCGs) are taxed at the same maximum federal rate of 23.8%. This includes the 20% maximum rate for LTCGs and qualified dividends, plus another 3.8% for the net investment income tax (NIIT). This maximum rate applies only to high-income taxpayers. Here are the thresholds for the maximum rate for 2025:

2025 Taxable Income Thresholds for 20%

Long Term Gains and Qualified Dividends Tax Rate

 

Most people are subject to a 15% LTCG and qualified dividend tax rate, plus 3.8% for the NIIT if applicable. Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately) are subject to the extra 3.8% NIIT on the lesser of their net investment income or the amount by which their MAGI exceeds the applicable threshold. Net investment income can include capital gains, dividends, interest and other investment-related income (but not self-rental income from an active trade or business).

Timing Issue

An individual C corporation shareholder will get relatively favorable federal income tax treatment for stock redemption payments received in 2025, even if they're treated as corporate distributions. However, depending on tax law changes, the tax treatment of stock redemption payments received in future years may not be as favorable. Today's favorable rates are expected to remain at least until after the 2028 general election, but that's not yet a certainty. Higher maximum federal income tax rates could apply in later years.  

It's possible that the maximum federal rate on redemption payments classified as dividends could be increased to equal the maximum rate on ordinary income. For example, in 2017, the maximum ordinary income rate was 39.6%, plus another 3.8% for the NIIT.    

Ready, Set, Redeem

Stock redemptions take time to implement properly. If you're interested in taking advantage of this strategy, contact us to understand the full tax implications.