Husband (H) buys all of the stock of Corporation X for $100,000 cash, giving him a single $100,000 basis in 100% of the company. In 1950 H makes a gift of one-half of the stock to his wife (W); the transferred stock has a value in excess of $50,000, and under the gift basis rules W takes a carryover basis of $50,000 in her half while H retains $50,000 of basis in his remaining half.
In 1955 all of H’s stock is redeemed by Corporation X for $150,000. Because H and W are treated as owning each other’s stock under the § 318 attribution rules, the redemption fails the sale-or-exchange tests of § 302(b), so the $150,000 distribution to H is taxed as a dividend under § 302(d) rather than as a sale of stock.
When a redemption is treated as a dividend, the redeemed shareholder does not recover his stock basis against the distribution. Treas. Reg. § 1.302-2(c) provides that the basis of the redeemed shares is added to the basis of the stock the related person continues to hold. H’s $50,000 of basis therefore shifts to W’s shares, so immediately after the transaction W holds the remaining stock of Corporation X (now 100%) with a basis of $100,000.
Because § 318 attribution makes H constructively own W’s stock, the redemption of all of H’s shares is not a meaningful reduction in his interest and is taxed as a dividend under § 302(d).
A shareholder whose redemption is a dividend does not recover his stock basis against the distribution; that basis survives instead of being written off.
Treas. Reg. § 1.302-2(c) reallocates the redeemed shareholder’s basis to the stock still held by the related person — here H’s $50,000 basis moves onto W’s shares.
After the redemption W owns 100% of Corporation X with a $100,000 basis, the sum of her original $50,000 carryover basis and H’s transferred $50,000.
