310 / If an S corporation redeems a shareholder’s stock, how are redemption payments taxed?

If an S corporation has no accumulated earnings and profits from when it was a C corporation or as a result of a corporate acquisition, then a redemption of stock will be treated as a capital transaction. That is, it will be tax-free to the extent of the shareholder’s basis and any excess will be treated as capital gain.¹

If an S corporation has accumulated earnings and profits, however, then part of the payment by the corporation could be treated as a dividend.² The exceptions to dividend treatment under IRC Sections 302(a) and 303(a) are available to S corporations ( Q 300 to Q 303).

1.     IRC § 1368(b).