The IRS treats a stock redemption as either a dividend or a capital gain.  According to Internal Revenue Code § 302, if a stockholder’s equity interest remains relatively the same compared to other stockholders after a stock redemption, the stock redemption is treated and taxed as a dividend.  However, if the stock redemption significantly decreases the stockholder’s equity stake in the corporation or eliminates it entirely, it will be treated and taxed as a capital gain.

Generally, nonresident aliens are exempt from tax on capital gains from U.S. source income unless it falls within four specific categories or they satisfy the 183 day rule pursuant to Internal Revenue Code § 871.  Pursuant to Internal Revenue Code § 871, if a nonresident alien was in the United States for 183 days or more during the tax year, they are subject to a 30% tax (or lower if there is a treaty between the United States and their country of origin) on net capital gains from U.S. sources.  Internal Revenue Code § 871 also covers taxation of nonresident aliens on certain fixed or determinable U.S. source income.  Dividends, unlike capital gains, are normally subject to a 30% tax rate for nonresident aliens, regardless of time spent in the United States.  Tax treaties may apply and result in a reduced tax rate.

This means that while the distinction between whether a stock redemption is treated and taxed as a dividend or capital gain isn’t critical for U.S. residents, the distinction is extremely important for nonresident aliens who may find themselves taxed on a stock redemption which are treated as dividends which they wouldn’t be taxed on if they did not satisfy the 183 day rule and they were treated as a capital gain.  Stock redemptions are not subject to tax in many foreign countries therefore it may come as a surprise for nonresident aliens when they find themselves in a situation where they are being taxed on their stock redemptions.

The distinction between a stock redemption being a dividend or a capital gain becomes crucial for nonresident aliens looking to understand and comply with U.S. tax law.