Corporation M has 400 shares of common stock outstanding, with individuals A, B, C and D each owning 100 shares (25 percent). No stock is constructively owned by any shareholder under section 318. Corporation M then redeems 55 shares from A, 25 shares from B, and 20 shares from C in exchange for cash.
A redemption is “substantially disproportionate” under section 302(b)(2) only if, immediately after the redemption, the shareholder owns less than 80 percent of the percentage of voting stock the shareholder owned immediately before, and owns less than 50 percent of total voting power. Because each shareholder began at 25 percent, the shareholder must end below 20 percent (80 percent of 25 percent) of the 300 shares then outstanding for the exchange to qualify.
After the redemptions, A owns 45 shares (15 percent), B owns 75 shares (25 percent), and C owns 80 shares (26 2/3 percent); D still owns 100 shares (33 1/3 percent). Only A falls below the 20-percent threshold, so the distribution is substantially disproportionate only with respect to A.
A’s redemption is treated as a sale or exchange under section 302(a), producing capital gain or loss. The amounts paid to B and C are not substantially disproportionate and are tested under the other paragraphs of section 302(b); if none apply, they are treated as section 301 distributions.
A redemption is substantially disproportionate only if the shareholder’s post-redemption voting-stock percentage is less than 80 percent of the pre-redemption percentage, plus below 50 percent of total voting power.
The ratios use the shares outstanding after the redemption. Here the denominator drops from 400 to 300, which is why D’s unchanged 100 shares rise from 25 percent to 33 1/3 percent.
Only A ends below 20 percent, so only A’s redemption qualifies under section 302(b)(2); B and C remain at or above their thresholds and fall back to distribution testing.
A qualifying redemption is a sale or exchange under section 302(a) yielding capital gain or loss, while a non-qualifying redemption is a section 301 distribution (dividend to the extent of earnings and profits).
