Shareholder Buyout Structures & the IRC §302 Tax Framework
A practical, attorney-written walkthrough of how closely-held corporations buy out exiting shareholders: redemption vs cross-purchase vs hybrid, the §302 sale-vs-dividend tests, family attribution waivers, valuation methods, and installment-note rules. Includes an interactive structure calculator.
Why structure matters
When one or more shareholders of a closely-held corporation exit, the deal can be structured several ways. The choice changes the balance sheet, the basis of the remaining shareholders, the cash flow, the tax treatment for the exiting shareholder, and the post-transaction governance. Getting the structure right at the outset is worth more than any subsequent drafting refinement.
This guide walks through the three core structures, the tax framework that decides whether the exiting shareholder pays capital gain or ordinary income rates, the valuation methods most commonly used, the rules for installment notes, and the full document set a typical buyout produces.
Who this guide is for. Owners or counsel of closely-held C-corporations and S-corporations facing a shareholder exit, family business succession, partner buyout, or restructure where the post-transaction cap table will look materially different from the current one. Not a substitute for advice on your specific facts.
Buyout Structure Calculator
Six inputs about the deal produce a recommended structure (redemption, cross-purchase, or hybrid), the specific documents needed, and the key tax filings to coordinate with a CPA. Directional, not predictive.
Educational tool. Not legal or tax advice. Real structure depends on facts the calculator cannot weigh.
The three structures compared
The first structural choice is who buys the exiting shareholder's stock. This choice changes the balance sheet, the basis of the remaining shareholders, the cash flow, and the tax treatment for everyone at the table.
| Factor | Redemption | Cross-purchase | Hybrid |
|---|---|---|---|
| Who buys | The corporation | The remaining shareholders, personally | Both, in defined portions |
| Source of funds | Corporate cash, corporate borrowing, or corporate note | Shareholders' personal cash, personal borrowing, or personal note | Combination |
| Basis impact on remaining shareholders | No basis increase | Basis increases by purchase price | Partial basis increase |
| Exiting shareholder tax | §302 sale-vs-dividend analysis | Capital gain or loss on personal sale | Mixed |
| Best for | Corporation has cash; simple structure | Remaining shareholders want stepped-up basis | Large deals; neither source alone covers price |
The basis trade-off. A pure redemption is administratively simpler, but the remaining shareholders inherit no basis increase. A pure cross-purchase gives stepped-up basis but requires the remaining shareholders to fund personally. For deals over $1 million, the basis difference can be tens of thousands of dollars in future tax savings, which often justifies the more complex structure.
IRC §302: sale vs dividend
For a redemption, the exiting shareholder's tax treatment depends on Internal Revenue Code §302. A redemption is treated either as a sale (capital gain or loss) or as a distribution (ordinary income to the extent of corporate earnings and profits). The exiting shareholder almost always prefers sale treatment.
The three §302(b) tests
A redemption qualifies for sale treatment if it satisfies any one of these three tests:
- §302(b)(1) Not essentially equivalent to a dividend. A subjective facts-and-circumstances test. Useful as a fallback but harder to plan around because it depends on the IRS's view of whether the redemption produced a meaningful reduction in the shareholder's proprietary interest.
- §302(b)(2) Substantially disproportionate redemption. The shareholder must own less than 50% of the voting stock immediately after, and the post-redemption percentage must be less than 80% of the pre-redemption percentage. Most useful for partial buyouts of a single shareholder, not full exits.
- §302(b)(3) Complete termination of interest. The cleanest path: the exiting shareholder must completely terminate the ownership interest. Combined with the §302(c)(2) family attribution waiver, this is the most common test used in family buyouts.
Family attribution and §302(c)(2)
§318 attributes stock owned by spouses, children, grandchildren, and parents to one another. Without a waiver, a parent who sells all her stock to her child's holding company has not "completely terminated" her interest because the child's stock is attributed back to her. The §302(c)(2) waiver lets the exiting shareholder break attribution if:
- She retains no continuing interest in the corporation other than as a creditor on an installment note,
- She has not acquired any interest other than by bequest or inheritance during the 10 years preceding the redemption, and
- She files the waiver agreement with her tax return for the year of redemption, agreeing not to acquire any prohibited interest for 10 years after the redemption.
The §302(c)(2) trap. The waiver requires that the exiting shareholder not acquire any interest other than as a creditor for ten years. Common violations: staying on as a paid consultant, retaining a board seat, accepting a part-time employee role. Any of those defeats the waiver and recharacterizes the entire redemption as a dividend (ordinary income, with no offset for basis). Plan the exit cleanly; do not retrofit a consulting arrangement that defeats the waiver.
Special rules for S-corporations
For S-corps, the redemption affects the Accumulated Adjustments Account (AAA) and may produce a deemed distribution to the remaining shareholders if structured incorrectly. S-corp redemptions are often hybrid (partial corporate, partial personal) to manage the AAA and E&P balance and preserve S-eligibility (the corporation must keep within the 100-shareholder limit and must not have any ineligible shareholder).
A redemption of S-corp stock is treated as either a §1368 distribution (which reduces AAA pro rata) or a §302 sale (which does not reduce AAA but instead reduces stock basis of the exiting shareholder). The mechanical rule under §1368 is that the redemption first reduces AAA, then accumulated E&P (if any), then is treated as gain. CPA coordination on AAA and E&P balances is mandatory; a buyout that wipes out AAA can produce unexpected ordinary income on subsequent distributions to remaining shareholders.
Valuation methods
Five common methods for valuing the exiting shareholder's stake. Most deals use a combination.
- Book value. Stockholders' equity from the most recent balance sheet, divided by shares. Easy and predictable, but often understates value for established businesses with goodwill or going-concern value.
- Multiple of EBITDA. Trailing 12-month EBITDA multiplied by a negotiated multiple (typically 3x-6x for closely-held businesses, higher for SaaS or recurring-revenue models). Requires clean financials.
- Formula method. Pre-negotiated formula in the bylaws or shareholder agreement (e.g., 1.5x trailing revenue, or 4x trailing net income, or book value plus 1x trailing earnings). Reduces post-event negotiation friction.
- Independent appraisal. A qualified business appraiser produces a written valuation report. Most defensible for IRS purposes, especially for §302 and §1014 questions. Required for some types of ESOP transactions and for deals above $5-10 million.
- Negotiated price. The parties agree on a number. Works when both sides are well-informed; risky when one party lacks information.
Installment notes and AFR
Most closely-held buyouts include some installment component, because the corporation rarely has all the cash at closing and installments give the exiting shareholder a reliable income stream.
Imputed interest under §1274 and §7872
For installment notes between related parties or where one side of the transaction is a corporation, IRS rules under §1274 (original issue discount) and §7872 (below-market loans) require interest at no less than the applicable federal rate (AFR) for the term of the note. A 0% or below-AFR note triggers imputed interest, creating phantom income and expense on both sides.
Installment-method reporting under §453
The exiting shareholder may elect installment-method reporting under §453, deferring gain recognition over the payment period rather than recognizing the full gain in the year of closing. Important caveats: installment-method reporting is unavailable for sales of publicly-traded securities and for certain related-party transactions, and an interest charge applies to installment obligations exceeding $5 million.
Security for installment payments
Ways to secure the exiting shareholder's installment note:
- Pledge of remaining shareholders' stock (cross-default with operating covenants),
- Personal guarantees from remaining shareholders,
- Escrow of a portion of the price,
- UCC-1 lien on corporate assets,
- Life insurance on remaining shareholders.
Documents in a typical buyout package
A clean buyout produces a defined set of documents. The exact list depends on structure, but most deals include:
- Stock redemption or stock purchase agreement. The core deal document.
- Promissory note if installment, at or above AFR with defined amortization and default provisions.
- Security agreement / UCC-1 for secured installment notes.
- Personal guaranty from remaining shareholders backstopping the corporation's payment obligations.
- Board resolutions authorizing the redemption (corporate-side authority).
- Shareholder consents if required by bylaws or state law.
- Mutual release between exiting and remaining parties.
- §302(c)(2) family attribution waiver where applicable, filed with the exiting shareholder's tax return.
- Updated stock ledger and certificate cancellation.
- Updated bylaws for new board composition, voting thresholds, and transfer restrictions.
- Amended shareholder agreement for the post-transaction cap table.
- State filings: amended articles or statement of information if officers, directors, or registered agent changed.
You can see template versions of several of these documents on Terms.Law: the Stock Purchase Agreement Generator, the Shareholder Agreement Generator, the Corporate Bylaws Generator, and the Stock Certificate Generator.
Common pitfalls
- ✗Ignoring existing buy-sell terms. If the bylaws or shareholder agreement already has a buy-sell triggered by exit, the new buyout must comply or expressly amend the existing terms. Drafting a fresh stock purchase agreement that conflicts with an existing buy-sell creates a contract dispute risk.
- ✗Skipping the §302 analysis. Treating a buyout as automatic sale treatment without confirming a §302 test is met. If the IRS recharacterizes the redemption as a dividend, the exiting shareholder pays ordinary income tax on the full distribution.
- ✗Installment note below AFR. A 0% or low-interest installment note triggers imputed interest under §1274 and §7872, creating phantom tax positions on both sides.
- ✗Letting the exiting shareholder stay on as a paid consultant. After a §302(c)(2) redemption, this violates the waiver and recharacterizes the redemption as a dividend.
- ✗Forgetting to update bylaws. Post-buyout governance falls back to either stale bylaws or default state law, neither of which is what the parties intended.
- ✗Skipping the mutual release. Without a release, the exiting shareholder can sue for pre-closing claims months or years after the deal closes.
- ✗No security for the installment note. If the corporation defaults, an unsecured installment-note holder is a general creditor, behind every secured creditor and trade payable.