Section 302(b)(1) states that sale or exchange tax treatment shall
apply if the redemption is not essentially equivalent to a dividend.
This rule is a continuation of the dividend equivalency rule,
under prior law mentioned earlier.
Despite its lack of objectivity, it remains in the code for redemptions of
preferred stock which shareholders typically have no control over.
Although largely based on subjective facts and circumstances,
the courts have provided some guidance over time.
For instance, the US Supreme Court held that a stock redemption is not essentially
equivalent to a dividend, only when the shareholder's interest in the corporation
has been meaningfully reduced.
Other case laws suggest that a meaningful reduction is best defined
as a decrease in the shareholder's voting control.
But reductions in the right to share in corporate earnings or
to receive corporate assets upon liquidation might also be sufficient.
The second type of
qualifying stock redemption is a disproportionate redemption.
In particular, code section 302(b)(2) states that a sale or
exchange treatment shall apply if a redemption is substantially
disproportionate with respect to the shareholder which involves two conditions.
First, after the redemption, the shareholder owns
less than 80% of the interest owned in the corporation before the redemption.
Notice that this is not referring to total ownership interest, but
less than 80% of the original ownership in the corporation.
Second, after the redemption, the shareholder owns less than 50% of
the total combined voting power of all classes of stock entitled to vote.
Recall that the stock attribution rules in section 318 apply when evaluating
ownership interest before and after the redemption.