Section 303 Stock Redemptions

What Is a Section 303 Stock Redemption?

Congress has recognized the unique estate liquidity problem faced by the estates of deceased shareholders of family corporations. Often, such shareholders want to retain the business within the family. But the sudden liquidity needs arising at death—death taxes, probate costs, funeral expenses, etc.—could require these estates to sell off part of the business to generate cash. This would create a new problem: outsiders coming into the business. Or, if the corporation redeemed part of its stock to get cash into the estate, the corporation's distribution could be treated as a dividend.

For this reason, Congress passed a special provision, Section 303 of the Internal Revenue Code. In brief, Section 303 allows a shareholder's estate or heir to sell to the closely held corporation enough stock to pay federal and state death taxes, costs of estate administration, and funeral expenses without treating the transaction as a dividend to the redeeming shareholder.

Background on Taxation of Stock Redemptions

Generally when a corporation redeems (buys back) its stock, the corporate distribution is treated as a dividend to the shareholder unless:

1. the redemption is "not essentially equivalent to a dividend," a subjective test that cannot really be counted on,
2. the redemption is "substantially disproportionate," with strict mathematical tests that must be met, or
3. the redemption is a complete termination of the shareholder's interest in the corporation.

When a shareholder redeems only part of his or her stock, tests (1) and (2) were the only hope for favorable taxation before Section 303 was enacted. In practice, they were rarely met.

That means a partial redemption was usually taxable as a dividend to the redeeming shareholder instead of capital gain on the sale of an asset. So what? Aren't capital gains now taxed at the same rate as dividends anyway?

The shareholder's basis in the stock can offset a capital gain, but not dividend income. Remember, the basis of a decedent's stock steps up to its fair market value at death (through 2009). So, if the redemption occurs shortly following death, the redemption price will likely be the same as this fair market value. The result: no capital gain.

So, we are talking about getting cash out of the corporation for liquidity needs without tax consequences as opposed to having the corporation's distribution taxed as a dividend at the 15% special rate. That's the appeal of Section 303.

Section 303 Qualification Requirements

Life Insurance to Fund a 303 Redemption

Advantages and Disadvantages of Section 303