You own two C corporations. The operating company is sitting on $300,000 of retained earnings, and you would like some of that cash in your own pocket. Your plan feels airtight: you sell your stock in the second company to the first company for $180,000, report a capital gain with full basis recovery, and pay tax at favorable rates. The paperwork says "stock purchase agreement." The wire transfer says "consideration." Everything looks like a sale.
The IRS will call it a dividend anyway — and the reason is a provision most owner-operators have never heard of. Section 304 of the Internal Revenue Code recharacterizes sales of stock between corporations you control as redemptions, then runs the proceeds through the dividend rules. If you control both sides of the deal, the "sale" price comes back to you as ordinary dividend income to the extent either company has earnings and profits, with no basis recovery on the dividend portion. This guide explains which transactions Section 304 catches, how the control test works, the four narrow exits under Section 302, how the dividend amount is measured, and what happens to your stock basis when the recast hits.
The Problem Section 304 Solves
Start with what would happen without this rule. Dividends from a C corporation are taxed as ordinary income to the extent of the company's earnings and profits, with no recovery of your stock basis. Capital gains from selling stock get basis recovery first and preferential rates. That gap creates an obvious temptation: instead of having your corporation pay you a dividend, you sell it something — in this case, stock in your other corporation — and dress the cash extraction up as a sale.
Congress closed that door with Section 304, titled "redemption through use of related corporations." The logic is economic, not formal. Before the transaction, you controlled both corporations and their combined earnings. After the transaction, you still control both corporations and their combined earnings — one of them is just holding the other's stock now, and you are holding cash. Nothing about your economic stake changed in the way a genuine sale to an outsider changes it. So the Code treats the cash you received as a distribution in redemption of stock and tests it under the redemption rules of Sections 302 and 301, which are far stricter than the rules for ordinary sales.
The practical takeaway: any time cash moves from a corporation you control to you, in exchange for stock in another corporation you control, assume Section 304 is in the room until you prove otherwise.
The Two Transactions Section 304 Catches
The statute covers two structures. Figure out which one matches your deal, because the earnings-and-profits math differs between them.
Brother-Sister Acquisitions: Section 304(a)(1)
This is the common case for owner-operators. One or more persons control each of two corporations — call them the issuing corporation (whose stock is being sold) and the acquiring corporation (which buys it). In return for property, usually cash, the acquiring corporation buys issuing-corporation stock from the controlling shareholder. The Code treats the cash as a distribution in redemption of the acquiring corporation's stock.
A concrete example: you own 100 percent of OpCo and 100 percent of HoldCo. You sell your HoldCo shares to OpCo for $180,000. That is a brother-sister acquisition. The $180,000 is tested as though OpCo redeemed its own stock from you, even though no OpCo share changed hands.
Parent-Subsidiary Acquisitions: Section 304(a)(2)
Here a subsidiary — the acquiring corporation — buys stock of its parent, the issuing corporation, from a shareholder. The Code treats the cash as a distribution in redemption of the parent corporation's stock.
Example: you own 100 percent of ParentCo, which owns 100 percent of SubCo. SubCo buys your ParentCo shares from you for cash. The proceeds are tested as a ParentCo redemption. Note the ordering rule in the statute: if a transaction fits the parent-subsidiary pattern, that paragraph governs and the brother-sister paragraph does not apply, even if the attribution rules could arguably frame it both ways.
Control: The 50 Percent Test That Attribution Usually Decides
Section 304 only applies if the control test is met, and the threshold is lower than most people expect. One or more persons must control both the issuing and acquiring corporations. Control means owning stock possessing at least 50 percent of the total combined voting power or at least 50 percent of the total value of all classes of stock. Either prong standing alone is enough.
Direct ownership is only the starting point. Section 304(c) requires measuring control with the constructive-ownership rules of Section 318, with modifications that make them easier to trip. Those rules attribute stock to you from:
- Family members — your spouse, children, grandchildren, and parents. Stock your spouse owns counts as stock you own.
- Partnerships, estates, trusts, and corporations — ownership flows through entities to you in proportion to your interest, and in some cases corporate-to-shareholder attribution applies at lower thresholds than the standard Section 318 versions.
This is where transactions that look safe turn out not to be. Suppose you directly own 40 percent of each of two corporations and your spouse owns 15 percent of each. Your direct stake misses the threshold, but with spousal attribution you are treated as owning 55 percent of both — control is met, and Section 304 applies. Before concluding a related-party stock sale is "just a sale," run the attribution math across every family member and entity in the picture. If control genuinely fails after attribution, Section 304 does not apply and the transaction is tested as an ordinary stock sale. That exit is real but narrow, because the attribution net is cast wide.
The Hypothetical Redemption: Four Narrow Exits Under Section 302
Once Section 304 applies, your proceeds are tested as a redemption, and the redemption must pass one of four tests in Section 302(b) to earn sale-or-exchange treatment with basis recovery and capital gain. Fail all four, and the entire amount is a Section 301 distribution — dividend income to the extent of the relevant earnings and profits. The tests:
1. Not essentially equivalent to a dividend. This is the facts-and-circumstances test. You need a "meaningful reduction" in your proportionate interest in the corporation — affecting your voting rights, your participation in earnings, and your share of net assets on liquidation. A cash-out that leaves your percentage ownership essentially where it was fails. Because Section 304 transactions by definition involve a shareholder who keeps controlling both corporations, this test is the one most recast transactions flunk.
2. Substantially disproportionate redemption. This is the mathematical test, with two prongs that must both hold immediately after the redemption: you own less than 50 percent of the total combined voting power, and your percentage of voting stock after the redemption is less than 80 percent of what it was before. If you owned 100 percent and still effectively control the corporation afterward through attributed ownership, neither prong is satisfied.
3. Complete termination of interest. If the redemption ends your entire proprietary interest in the corporation — no stock, and no continuing role as officer, director, or employee — you get exchange treatment. Family attribution can be waived for this test, but only under strict conditions: you must retain no interest in the corporation whatsoever for at least ten years and file the required agreement. For an owner-operator selling stock between two companies they intend to keep running, this exit is usually unavailable by design.
4. Partial liquidation. Exchange treatment is available for distributions in partial liquidation, but this test applies only to non-corporate shareholders and covers a genuinely contracting business — a real shrinkage of corporate operations, not a paper reshuffle of stock between related entities.
Notice the trap the statute sets: the attribution rules that pulled you into Section 304 in the first place also follow you into the Section 302 tests, measuring your before-and-after ownership with the same attributed shares included. A shareholder who maintains indirect control almost always fails every test, which lands the proceeds in dividend treatment. That is not an accident in the drafting. It is the provision working as intended.
How Much Is Dividend: The Earnings-and-Profits Stacking Rules
Fail the Section 302 tests, and the proceeds become a Section 301 distribution: dividend first, to the extent of earnings and profits, then tax-free return of basis, then capital gain. Section 304(b)(2) supplies special rules for whose earnings and profits count, and the order depends on which structure you have.
Brother-Sister Stacking: Acquirer First, Then Issuer
In a Section 304(a)(1) transaction, the dividend is measured against the combined earnings and profits of both corporations in a fixed order: first the acquiring corporation's earnings and profits (current plus accumulated), then the issuing corporation's. The ordering maximizes the dividend portion before any basis recovery begins.
Work through the numbers. Your acquiring corporation has $100,000 of earnings and profits and the issuing corporation has $50,000. You receive $180,000 for the stock. The first $100,000 is a dividend sourced from the acquirer, the next $50,000 is a dividend sourced from the issuer, and only the remaining $30,000 escapes dividend treatment — applied against your basis in the transferred stock, with any excess over basis taxed as capital gain. When both companies are profitable, the dividend swallows most or all of the proceeds.
Parent-Subsidiary: The Acquiring Subsidiary's Earnings Only
In a Section 304(a)(2) transaction, the rule is simpler: the dividend is measured solely by reference to the acquiring subsidiary's earnings and profits, as though the subsidiary itself made the distribution. The parent's earnings do not enter the computation. Any proceeds above the subsidiary's earnings and profits go against your basis in the parent stock you notionally surrendered.
The asymmetry matters for planning. In a brother-sister deal, earnings stacked in either company feed the dividend. In a parent-subsidiary deal, only the subsidiary's earnings count — which cuts both ways, since a cash-rich subsidiary produces the same dividend-heavy result with a shorter computation.
What Happens to Your Stock Basis
Here is the part that stings after the dividend portion is determined. Because the transaction is a distribution and not a sale, you do not recover the basis of the stock you "sold" against the dividend amount. That unrecovered basis is not lost, but it moves: it is added to the basis of your remaining stock in the acquiring corporation. If you hold no remaining acquiring-corporation stock, it attaches to the stock you retain in the issuing corporation instead.
Suppose your basis in the transferred issuing-corporation shares was $40,000 and $150,000 of your $180,000 in proceeds was dividend. The $30,000 non-dividend tail absorbs $30,000 of basis, and the leftover $10,000 of basis shifts onto your acquiring-corporation shares, raising their basis for the day you eventually sell or redeem those. The mechanics live in the regulations under Section 304, and the transfer must be documented — reconstructing a basis shift years later, during an audit or a sale, from deal papers that describe a "stock purchase" is exactly how basis gets permanently lost. Write down the Section 304 analysis, the earnings-and-profits computations with the stacking order, and the resulting basis adjustments, and keep them with the transaction file.
Booking It: The Cash Is Easy, the Split Is the Work
This is where bookkeeping meets tax law, and where most owner-operators go wrong in their own ledgers. The acquiring corporation's books are straightforward — cash out, investment in the sister company's stock recorded as an asset. The hard entry is on your side as the shareholder, because the books must reflect the tax reality: part dividend income, part return of investment, not a clean sale of an asset.
Say your personal books track the investment in the acquiring corporation, and the $180,000 receipt breaks into $150,000 of dividend and $30,000 of basis recovery. The entry looks like this:
option "operating_currency" "USD"
option "title" "Section 304 deemed redemption proceeds"
2026-01-01 open Assets:Personal:Checking USD
2026-01-01 open Assets:Investments:AcquiringCorp:Stock USD
2026-01-01 open Income:Dividends:AcquiringCorp USD
2026-06-30 * "Acquiring Corp" "Section 304 proceeds: dividend plus basis recovery"
Assets:Personal:Checking 180000.00 USD
Income:Dividends:AcquiringCorp -150000.00 USD
Assets:Investments:AcquiringCorp:Stock -30000.00 USDTwo details deserve attention. First, the dividend leg posts to dividend income, not to a gain account — booking the whole receipt against the investment account overstates your gain position and understates ordinary income. Second, the $10,000 of unrecovered basis from the earlier example does not appear as its own line; it stays embedded in the investment account's remaining basis, which is why a memo in your ledger or transaction file recording the basis shift is not optional decoration. When you eventually dispose of the acquiring-corporation shares, that shifted basis is what keeps you from paying tax twice on the same dollars.
If you track corporate books in plain text too, keep each corporation's ledger separate and record the intercompany investment at the acquiring corporation's cost. For background on structuring multi-entity books, see the documentation on organizing business finances and the Fava dashboards for visualizing each entity's position side by side.
Six Mistakes That Turn a Planned Sale Into a Surprise Dividend
1. Believing a real negotiated price makes it a real sale. Section 304 does not ask whether the price was fair, documented, or blessed by a valuation. It asks whether control existed. A fairly priced, arm's-length-looking deal between your own two companies is recast exactly the same as a sweetheart price.
2. Forgetting attribution. The 50 percent test is measured with family and entity attribution. Spouses, children, parents, partnerships, trusts, and related corporations all feed the computation. Every Section 304 analysis that skips the attribution workup is incomplete.
3. Booking the receipt as sale proceeds. Recording the full cash amount as a disposition of the investment account — with the difference over basis flowing to capital gain — bakes the wrong answer into your books from day one and makes the eventual correction painful.
4. Losing the shifted basis. The basis that moves to your remaining shares only helps you if you can prove it. A one-page memo with the pre-transaction basis, the earnings-and-profits stacking, and the post-transaction basis of each holding is the cheapest insurance in this entire area.
5. Missing the foreign-corporation reporting. When the acquiring or issuing corporation is foreign, the transaction creates deemed contributions and distributions that a U.S. shareholder must report on Form 5471, with significant penalties for failure to file. Cross-border related-party stock sales need specialist review before they close, not after.
6. Assuming S corporations dodge the rule. An S corporation with no earnings and profits — the normal case for a company that has always been an S corporation — often produces little or no dividend under the stacking rules simply because there is no earnings pool to source one from. But the provision can still apply mechanically, accumulated adjustments account and previously taxed income ordering still need analysis, and any C-corporation history means earnings and profits may be lurking. "We are S corporations" is the start of the analysis, not the end of it.
What to Document Before the Cash Moves
A Section 304 transaction should close with a paper trail that answers every question an examiner would ask: the control analysis for both corporations with the full Section 318 attribution workup, the application of each Section 302 test to the hypothetical redemption, the current and accumulated earnings-and-profits computations for each corporation with the stacking order shown, and the resulting basis adjustments to every affected holding. The selling shareholder typically reports the transaction on Form 1040 with an attached statement walking through that analysis; if the transaction qualifies for exchange treatment after all, the gain goes on Form 8949 and Schedule D like any stock sale.
The deeper lesson is about sequencing. Owners usually discover Section 304 after the wire has moved, when the return preparer asks an uncomfortable question in March. Run the analysis before the stock purchase agreement is signed instead: map the attribution, test the hypothetical redemption, stack the earnings and profits, and price the dividend outcome into the decision while you can still restructure — through a direct dividend, a genuine redemption that terminates an interest, or simply a different funding path. A dividend you planned for is a tax cost. A dividend you discover is a surprise, and surprises are always priced worse.
