Stephen J. Ehrenberg
Stephen J. Ehrenberg

Use of controlled corporations to avoid Sec. 304

Issuance of final regulations limits taxpayers.

January 31, 2013
by Stephen J. Ehrenberg, CPA

In December, the IRS and Treasury issued final regulations (T.D. 9606)  that address transactions that are subject to Sec. 304, but that are entered into (1) with a principal purpose of avoiding the application of Sec. 304 to a corporation that is controlled by the issuing corporation in the transaction or (2) with a principal purpose of avoiding the application of Sec. 304 to a corporation that controls the acquiring corporation in the transaction. Since the final regulations did not change the temporary regulations, the final regulations are effective for transactions entered into on or after Dec. 29, 2009.

Why the scrutiny?

Sec. 302 governs the treatment of distributions in redemption of corporate stock. Sec. 302 stipulates whether these types of transactions will be treated as a:

  • Sale or exchange; or
  • Dividend distribution.

If the redemption is treated as a sale or exchange, it will result in a capital gain or loss for the shareholder. However, if it is treated as a dividend, the shareholder will recognize ordinary income to the extent of the redeeming corporation’s current and accumulated earnings and profits (E&P).

Absent the passing of the American Taxpayer Relief Act, P.L. 112-240, earlier this month, tax rates on dividend income could have risen as high as 39.6%, thus increasing the potential impact of the sale or exchange vs. dividend treatment on affected taxpayers. However, while the top dividend and long-term capital gains rates remain the same (20%) under the act, the implications of having a redemption treated as a dividend are still far-reaching, as dividend treatment prevents a taxpayer from recovering stock basis in a tax-free manner until the corporation’s current and accumulated E&P have been exhausted. Additionally, the tax base against which the 3.8% net investment income tax under Sec. 1411 (effective Jan. 1, 2013) is calculated could be affected by sale or exchange vs. dividend treatment.

Common control and related-party implications

One of the overriding themes of the Code involves the tax implications when common control exists and/or related parties are involved in a transaction. Sec. 267 (related-party rules), Sec. 318 (attribution rules), and Sec. 482 (transfer-pricing rules), among others, enforce an arms-length standard and aim to prevent related parties from gaining tax advantages that would otherwise not be available to parties who did not share common ownership interests.

Similar related-party rules exist when the redemption of corporate stock occurs through the use of related corporations. In particular, the following provisions of Sec. 304 were enacted to provide guidance in this area:

  • Sec. 304(a)(1): Stock purchases between brother/sister corporations.
  • Sec. 304(a)(2): Stock purchases of parent stock by subsidiary corporations.

Notably, if control, as governed by Sec. 304(c), exists and, in return for property, either:

  • One of the corporations acquires stock in the other corporation from the person (or persons) in control (i.e., brother/sister) (see Sec. 304(a)(1)(B)); or
  • One corporation acquires from a shareholder of another corporation stock in the other corporation (i.e., parent/subsidiary) (see Sec. 304(a)(2)(A));

then the transaction is treated as a distribution in redemption of the stock.

In the case of a stock purchase by brother/sister corporations, the distribution is treated as redemption of the stock of the corporation acquiring the stock, whereas in the case of a stock purchase by a subsidiary of a parent corporation stock, the distribution is treated as a redemption of the stock of the issuing corporation. In other words, the IRS recharacterizes stock transactions in which common control exists, thus looking to nullify any potential tax arbitrages that are available to related parties that would not otherwise be available in arms-length scenarios.

This is where the provisions of Sec. 302 come into play—if Secs. 302(b)(1) through (5) do not otherwise qualify the transaction for sale or exchange treatment, then these transactions, to the extent of the current and accumulated earnings and profits, could result in dividend income to the seller.

Anti-avoidance provisions expanded

Under the regulation, the IRS and Treasury have enhanced the anti-avoidance provisions of Sec. 304 to prevent the tax-free repatriation of earnings from foreign corporations to their U.S. parent and/or brother/sister controlled corporation. Before Temp. Regs. Sec. 1.304-4T was issued in 2009, domestic taxpayers had used controlled foreign corporations to structure transactions to avoid potential dividend treatment.

The original version of these regulations (T.D. 8209, issued in 1988) targeted transactions that sought to circumvent the E&P of the acquiring corporation through the use of a newly formed intermediary. The temporary regulations issued in 2009, which have now been finalized, update the deemed acquirer rule and add a new deemed issuer rule that targets another variation of the cross-chain stock sale. The rule eliminates a perceived loophole in the original temporary regulations that existed because only the identity of the acquirer was considered under the original temporary regulations.


The final regulations under Sec. 304 limit taxpayers’ ability to avoid dividend treatment as part of stock purchase transactions among controlled corporations. Because of the significant effect of having a transaction treated as a dividend rather than a sale or exchange, taxpayers must be aware of the impact of these rules prior to structuring these types of transactions.

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Stephen J. Ehrenberg, CPA, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.