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Nonqualified Preferred Stock as Boot (§ 351(g))

This checklist identifies when preferred stock received in a § 351 exchange is nonqualified preferred stock (NQPS) under § 351(g), computes the resulting boot gain, and applies the family-owned-corporation, substantially identical, and other exceptions. Use it whenever preferred stock is issued in a corporate formation, recapitalization, or other § 351 transaction.

Step 1. Overview and Scope

This checklist analyzes whether preferred stock received in a § 351 exchange constitutes nonqualified preferred stock under § 351(g), and if so, the tax consequences to the transferor and the issuing corporation. Use this checklist whenever a client contributes property to a corporation in exchange for preferred stock, or when structuring a recapitalization involving preferred stock instruments that may trigger boot treatment.

• Primary statutory framework. § 351(g) was added by the Taxpayer Relief Act of 1997 (TRA 1997), Pub. L. 105-34, § 1014(a), enacted August 5, 1997.
  • Congress enacted the provision because "certain preferred stocks have been widely used in corporate transactions to afford taxpayers non-recognition treatment, even though the taxpayers may receive relatively secure instruments in exchange for relatively risky investments." H.R. Rep. No. 105-220, 105th Cong., 1st Sess. 543 (1997).
  • The NQPS rules address the policy concern that debt-like preferred stock was being used to obtain nonrecognition treatment in transactions that functionally represented sales or secured investments.
• Core policy. Congress determined that preferred stock instruments functioning like debt should be viewed as taxable consideration.
  • The House Report states that "the investor has often obtained a more secure form of investment" when receiving preferred stock in exchange for risky property. H.R. Rep. No. 105-220 at 544.
  • The NQPS provision ensures that nonrecognition treatment under § 351 is limited to equity-like instruments that expose the holder to genuine corporate risk and growth potential.
• Two-step analysis. The analysis proceeds in two sequential steps.
  • First determine whether the stock is "preferred stock" under § 351(g)(3)(A). If yes, determine whether it falls within one of the four disqualifying clauses of § 351(g)(2)(A).
  • Stock that is not preferred stock cannot be NQPS regardless of redemption features. The preferred stock threshold must be satisfied before any NQPS trigger is relevant.
• Dual treatment. NQPS receives congressionally intended dual treatment.
  • NQPS is treated as "other property" (boot) to the transferor who receives it. This means the transferor must recognize gain on the value of the NQPS received.
  • NQPS remains stock for purposes of the § 368(c) control test and other Code provisions. The NYSBA Tax Section Report No. 925 described this dual treatment as "somewizophrenic" treatment.
• Parallel provisions. NQPS treatment extends beyond § 351 to related Code sections.
  • NQPS treatment also applies under § 354(a)(2)(C) (reorganizations), § 355(a)(3)(D) (distributions), § 356(e) (boot in reorganizations), and § 1036(b) (stock-for-stock exchanges).
  • The same definition of NQPS and the same exceptions apply across all of these parallel provisions. Treas. Reg. § 1.356-7 applies the substantially identical exchange exception to reorganizations.

Step 2. The Preferred Stock Threshold Test Under § 351(g)(3)(A)

§ 351(g)(3)(A) provides that the term "preferred stock" means stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent. Stock shall not be treated as participating in corporate growth to any significant extent unless there is a real and meaningful likelihood of the shareholder actually participating in the earnings and growth of the corporation. If there is not a real and meaningful likelihood that dividends beyond any limitation or preference will actually be paid, the possibility of such payments will be disregarded in determining whether stock is limited and preferred as to dividends.

• The two-prong statutory test. § 351(g)(3)(A) imposes two requirements for preferred stock status.
  • Stock must be "limited and preferred as to dividends" and must "not participate in corporate growth to any significant extent." If stock fails either prong, it is not preferred stock and cannot be NQPS. § 351(g)(3)(A).
  • Neither the statute, the regulations, nor the legislative history defines "participate in corporate growth to any significant extent." The phrase requires a facts-and-circumstances analysis. (Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67, 163 (2012))
• Regulatory guidance by analogy. Courts look to Treas. Reg. § 1.305-5(a) for guidance in applying the preferred stock definition.
  • The regulation provides that "the distinguishing feature of 'preferred stock'... is not its privileged position as such, but that such privileged position is limited, and that such stock does not participate in corporate growth to any significant extent." Treas. Reg. § 1.305-5(a).
  • Gerdau Macsteel, 139 T.C. at 163 (relying on Treas. Reg. § 1.305-5(a) to interpret § 351(g)(3)(A)). The Tax Court established that the § 305 regulations provide the analytical framework for evaluating preferred stock status under § 351(g)(3)(A).
• Illusory participation rights are disregarded. A right to participate that lacks substance will not prevent a class of stock from being treated as preferred stock.
  • Treas. Reg. § 1.305-5(a) provides that stock with a theoretical participation right may still be preferred if "there is little or no likelihood" of actual participation.
  • Practitioners must evaluate whether participation rights are genuine or merely nominal features designed to avoid NQPS classification. The economic substance of the right controls over its formal description.
• Facts and circumstances factors. The determination requires examining multiple objective factors.
  • The regulation directs examiners to consider "prior and anticipated earnings per share, the cash dividends per share, the book value per share, the extent of preference and of participation of each class, both absolutely and relative to each other, and any other facts which indicate whether or not the stock has a real and meaningful probability of actually participating in the earnings and growth of the corporation." Treas. Reg. § 1.305-5(a).
  • No single factor is dispositive. The analysis requires a holistic assessment of all relevant economic indicators at the time of issuance.
• The AJCA 2004 "real and meaningful likelihood" amendment. The American Jobs Creation Act of 2004 added key language to the statutory test.
  • Pub. L. 108-357, § 899(a), added the sentence requiring "a real and meaningful likelihood of the shareholder actually participating in the earnings and growth of the corporation."
  • The Gulf Opportunity Zone Act of 2005, Pub. L. 109-135, § 403(kk), added the second sentence about dividends beyond any limitation or preference. Both amendments apply to transactions after May 14, 2003.
• Conversion rights are disregarded. The § 305 regulations exclude conversion privileges from the preferred stock determination.
  • Treas. Reg. § 1.305-5(a) provides that determination of whether stock is preferred "shall be made without regard to any right to convert such stock into another class of stock."
  • The House Bill had included "(including through a conversion privilege)" in the § 351(g)(3)(A) definition, but the Conference Committee removed this parenthetical as unnecessary. Conf. Rep. No. 105-220 (1997).
• TRAP. Formal participation rights alone are insufficient. Stock may have contractual participation rights and still be preferred stock if those rights lack economic substance.
  • Congress added the 2004 and 2005 amendments precisely to address taxpayers creating nominal participation features to avoid NQPS treatment.
  • Practitioners should not rely solely on the formal terms of the stock instrument. The economic reality of the participation rights determines whether the stock is preferred.

Step 2A. Prong One -- "Limited and Preferred as to Dividends"

• Definition and application. A stock is "limited and preferred as to dividends" if it enjoys a priority as to dividends but is limited to that priority.
  • Preferred stock of the conventional type is "limited and preferred as to dividends" by being entitled to a specific dividend in priority to any dividend on common stock but to nothing more. United States v. Liberty Banking Corp., 25 F. Supp. 203, 204 (S.D.N.Y. 1938).
  • The holder of limited and preferred stock enjoys a dividend preference but does not share equally in further dividend distributions beyond that preference.
• Participating preferred stock is NOT limited and preferred. Preferred stock that participates on parity with common stock in dividends beyond its stated preference fails this prong.
  • Rev. Rul. 79-21, 1979-1 C.B. 290 (participating nonvoting preferred stock is not "limited and preferred as to dividends" and must be taken into account in determining affiliation under § 1504(a)).
  • See also Pioneer Parachute Co., Inc. v. Commissioner, 162 F.2d 249 (2d Cir. 1947) (participating nonvoting preferred stock is not "limited and preferred as to dividends").
• The "mere possibility" standard. A formal right to participate in further dividends does not defeat "limited and preferred" status if there is no reasonable expectation of actual participation.
  • "The mere possibility that the stock in some particular taxable period might be entitled to dividends in excess of 7 percent no more makes it unlimited as to dividends than the possibility that in some particular tax period it might be entitled to voting rights makes it voting stock." Erie Lighting Co. v. Commissioner, 93 F.2d 883, 885 (1st Cir. 1937).
  • The First Circuit held that preferred stock was "limited and preferred as to dividends" where no further dividends beyond the preference were ever paid, focusing on actual facts rather than formal terms.
• The 2005 amendment on dividends beyond preference. The second sentence of § 351(g)(3)(A) codifies the illusory-rights rule for the dividend-limitation prong.
  • The 2005 Technical Corrections Act added that "If there is not a real and meaningful likelihood that dividends beyond any limitation or preference will actually be paid, the possibility of such payments will be disregarded in determining whether stock is limited and preferred as to dividends."
  • This amendment confirms that the inquiry is functional and economic rather than formal and contractual.

Step 2B. Prong Two -- "Does Not Participate in Corporate Growth to Any Significant Extent"

• The "real and meaningful likelihood" test. Congress codified a facts-and-circumstances standard for the participation prong.
  • § 351(g)(3)(A) provides that "Stock shall not be treated as participating in corporate growth to any significant extent unless there is a real and meaningful likelihood of the shareholder actually participating in the earnings and growth of the corporation."
  • This requires an objective, facts-and-circumstances analysis at the time of issuance. H.R. Rep. No. 108-755, at 771 (2004) (the inquiry is whether, "based on all the facts and circumstances, [stock] is limited and preferred as to dividends and does not participate in corporate growth to any significant extent").
• Gerdau Macsteel holding. The leading case on the participation prong provides the analytical framework.
  • In Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67 (2012), the Tax Court held that Class C stock received in a § 351 exchange was preferred stock because it did not participate in corporate growth to any significant extent. The stock provided a cumulative dividend of $9.50 per share and a redemption payout of the greater of $125 per share or a "formula value" tied to 45% of cumulative cost savings.
  • The subsidiary had no accumulated earnings, was expected to have little to no earnings before redemption, and the court held that "a deficit is not corporate growth." 139 T.C. at 163. The participation rights in the redemption formula were "unlikely to occur" and "illusory."
• ILM 201716045 application. The IRS applied the Gerdau framework in an advisory context.
  • ILM 201716045 (April 21, 2017) concluded that Class A stock with a "participating dividend" and "participating redemption premium" was NQPS because "there was no real and meaningful likelihood the Class A stock would participate in the corporate growth of Sub 1 to any significant extent."
  • The corporation had reported losses, paid no dividends, and had negative retained earnings. An "illusory right to share in any appreciation in the value of [the corporation] does not evidence 'a real and meaningful likelihood'" of participation.
• Key factors from Treas. Reg. § 1.305-5(a). In evaluating the participation prong, consider the regulatory factors by analogy.
  • Consider prior and anticipated earnings per share, cash dividends per share, book value per share, the extent of preference and participation of each class (absolute and relative), and any other facts indicating whether the stock has "a real and meaningful probability of actually participating in the earnings and growth of the corporation." Treas. Reg. § 1.305-5(a) (applied by analogy through Gerdau).
  • Post-Gerdau, courts conduct a forward-looking analysis at the time of issuance. The nominal terms of the stock are not dispositive. Substance controls over form.
• CAUTION. No single factor is dispositive. The determination is heavily fact-dependent.
  • The nominal terms of the stock instrument do not control the analysis. The economic reality at the time of issuance determines whether participation is meaningfully possible.
  • Computer Sciences Corp. v. Commissioner, Docket No. 4823-21 (2023) (denying summary judgment on NQPS issue because genuine issues of material fact existed about likely participation).
• EXAMPLE. Meaningful participation defeats preferred stock status. Treas. Reg. § 1.305-5(a), Example 10, illustrates when participation is real and meaningful.
  • Both Class A and Class B stock were found NOT to be preferred stock because the corporation had a history of earnings growth, had actually paid participating dividends, and it was "reasonable to anticipate that both the class B stock and the class A stock would participate in the current and anticipated earnings and growth of the corporation beyond their preferred interests."
  • Contrast this with Gerdau, where the corporation had no earnings and no likelihood of growth.

Step 3. The Four NQPS Triggers of § 351(g)(2)(A)

§ 351(g)(2)(A) provides that the term "nonqualified preferred stock" means preferred stock if-- (i) the holder of such stock has the right to require the issuer or a related person to redeem or purchase the stock, (ii) the issuer or a related person is required to redeem or purchase such stock, (iii) the issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or (iv) the dividend rate on such stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices.

• Sequential analysis. Only preferred stock can be NQPS.
  • Only if stock is "preferred stock" under § 351(g)(3)(A) (Step 2) does one proceed to analyze the four triggers. If stock is not preferred stock, none of these triggers matter.
  • The four triggers apply only after the preferred stock threshold has been satisfied.
• Any single trigger suffices. Each clause operates independently.
  • If preferred stock meets any one of the four clauses (i) through (iv), it is NQPS (subject to the 20-year and remote contingency filters of § 351(g)(2)(B) for clauses i-iii, and subject to the exceptions of § 351(g)(2)(C)).
  • A single disqualifying feature is sufficient to convert preferred stock into NQPS. Multiple disqualifying features do not change the outcome beyond the initial finding of NQPS status.

Step 3A. Clause (i) -- Holder Put Right

• Holder put right defined. The holder of the preferred stock has the right to require the issuer or a related person to redeem or purchase the stock.
  • This is a put option held by the shareholder, making the instrument economically equivalent to a demand obligation. § 351(g)(2)(A)(i).
  • The holder controls the timing of redemption, which makes this feature particularly debt-like and therefore subject to NQPS treatment.
• Related person inclusion. The put right triggers NQPS treatment whether exercisable against the issuer or any "related person."
  • "Related person" is defined in § 351(g)(3)(B) (incorporating §§ 267(b) and 707(b) at the 50% threshold).
  • A put exercisable against a parent, subsidiary, or brother-sister corporation can trigger NQPS status.
• CAUTION. Put rights are the strongest trigger. A holder put is the most unambiguous NQPS trigger.
  • Unlike issuer call rights, no "more likely than not" analysis is required.
  • Because the holder controls the timing of redemption, the instrument functions as a demand obligation and should be treated as boot.

Step 3B. Clause (ii) -- Mandatory Redemption

• Mandatory redemption defined. The issuer or a related person is required to redeem or purchase the stock.
  • This is the most straightforward case. The instrument has a mandatory redemption feature making it economically equivalent to a debt instrument with a maturity date. § 351(g)(2)(A)(ii).
  • Congress specifically targeted preferred stock with "an enhanced likelihood of recovery of principal" as inappropriate for nonrecognition treatment. H.R. Rep. No. 105-220 at 543.
• Economic substance of mandatory redemption. Mandatory redemption is the clearest debt-like feature.
  • The holder is guaranteed return of principal at a fixed date, which is the hallmark of a debt instrument rather than equity.
  • The mandatory redemption feature triggers NQPS status without any likelihood inquiry.
• Comparison to § 305(c). The mandatory redemption premium analysis under § 305(c) parallels NQPS treatment.
  • Under Treas. Reg. § 1.305-5(b)(2), a mandatory redemption premium is treated as a constructive distribution under § 305(c) regardless of the likelihood of redemption.
  • The mandatory redemption feature similarly triggers NQPS status without any likelihood inquiry.

Step 3C. Clause (iii) -- Issuer Call Right (More Likely Than Not)

• The "more likely than not" standard. The issuer or a related person has the right to redeem or purchase the stock, and as of the issue date, it is "more likely than not" that such right will be exercised.
  • § 351(g)(2)(A)(iii). This requires a facts-and-circumstances determination at the issue date. The standard means a greater than 50% probability.
  • Unlike mandatory redemption or holder put rights, this clause requires an assessment of probability at the time of issuance.
• Treas. Reg. § 1.305-5(b)(3) safe harbor (by analogy). Redemption pursuant to an issuer's right to redeem is not treated as "more likely than not" to occur if all three conditions are met.
  • Condition (A) requires that the issuer and holder are not related (using a 20% threshold rather than 50%). Condition (B) requires that there are no plans, arrangements, or agreements that effectively require or are intended to compel redemption. Condition (C) requires that exercise would not reduce the yield of the stock under OID principles. Treas. Reg. § 1.305-5(b)(3)(ii).
  • Failure to satisfy the safe harbor is not determinative. The issuer may still argue redemption is not more likely than not. Treas. Reg. § 1.305-5(b)(3)(iii).
• Example 5 from Treas. Reg. § 1.305-5. This example illustrates when the safe harbor does not apply.
  • Preferred stock callable at $105, mandatorily redeemable at $100, with a change-of-control provision allowing the holder to appoint a majority of the board if the issuer fails to call. The safe harbor did not apply because the board-appointment provision was "a plan, arrangement, or agreement that effectively requires or is intended to compel" redemption.
  • The constructive distribution was treated as occurring over the period ending on the call date.
• Example 8 from Treas. Reg. § 1.305-5. This example illustrates when the safe harbor does not apply but redemption is still not "more likely than not."
  • Stock with two call options, but based on expected lack of funds, it was unlikely the issuer would exercise either call. The safe harbor did not apply (because calls would reduce yield), but the call options were NOT "more likely than not" to be exercised due to the issuer's expected lack of funds.
  • This example demonstrates that failing the safe harbor does not automatically mean redemption is more likely than not. The facts-and-circumstances analysis controls the ultimate determination.
• NYSBA Report No. 925 recommendation. The Report urged regulatory alignment between § 305(c) and § 351(g).
  • The Report recommended that NQPS regulations incorporate the § 1.305-5(b)(3) safe harbor by direct reference to ensure consistent treatment between the § 305(c) and § 351(g) contexts.
  • The Report noted that inconsistent treatment between the § 305(c) constructive distribution context and the § 351(g) NQPS context creates unnecessary complexity for practitioners and taxpayers.

Step 3D. Clause (iv) -- Variable Dividend Rate

• Variable dividend rate defined. The dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices.
  • § 351(g)(2)(A)(iv). This makes the instrument economically similar to a floating-rate debt instrument.
  • The rate variation must be tied to an external benchmark rather than corporate performance metrics.
• TRAP. Clause (iv) is NOT subject to the 20-year limitation. § 351(g)(2)(B) applies only to clauses (i), (ii), and (iii).
  • Preferred stock with a variable dividend rate is NQPS regardless of when the rate variation occurs.
  • There is no temporal safe harbor for variable dividend rates. This is a critical distinction that practitioners frequently overlook.
• Indexed dividend examples. Common triggering indices include floating-rate benchmarks and commodity indices.
  • LIBOR (or its successors such as SOFR), the prime rate, federal funds rate, Treasury yields, commodity prices, inflation indices, or any similar external benchmark can trigger clause (iv). § 351(g)(2)(A)(iv).
  • Any dividend tied to an external market indicator rather than corporate performance falls within this clause.
• Partial variation triggers. The rate need only vary "in whole or in part" with reference to the index.
  • A dividend that is partially fixed and partially floating is still caught by clause (iv).
  • Even a small variable component is sufficient to trigger NQPS treatment under this clause.

Step 4. The 20-Year Limitation and Remote Contingency Filter

§ 351(g)(2)(B) provides that "Clauses (i), (ii), and (iii) of subparagraph (A) shall apply only if the right or obligation referred to therein may be exercised within the 20-year period beginning on the issue date of such stock and such right or obligation is not subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase."

• Two-part temporal filter. Clauses (i), (ii), and (iii) of § 351(g)(2)(A) apply only if BOTH parts are satisfied.
  • The right or obligation may be exercised within the 20-year period beginning on the issue date.
  • The right or obligation is not subject to a contingency which, as of the issue date, makes remote the likelihood of redemption or purchase. § 351(g)(2)(B). Clause (iv) (variable dividend rate) is not subject to either filter.

Step 4A. The 20-Year Rule

• 20-year safe harbor for redemption features. Even if a preferred stock has a put, mandatory redemption, or call feature, it will NOT be NQPS on that basis if the earliest possible exercise date is more than 20 years from issuance.
  • § 351(g)(2)(B). Preferred stock with mandatory redemption in 25 years is NOT NQPS by reason of clause (ii).
  • The 20-year period runs from the issue date of the original stock, not from any subsequent exchange date.
• Tacking in subsequent exchanges. QPS status can be preserved through subsequent exchanges under the substantially identical rule.
  • If QPS was QPS solely because the redemption right fell outside the 20-year period, and in a later reorganization the holder receives new preferred stock that is "substantially identical" to the original, the received stock retains QPS status. Treas. Reg. § 1.356-7(b).
  • See Step 11 below for the substantially identical analysis.
• CAUTION. The 20-year protection expires. For stock that avoids NQPS solely because redemption is after 20 years, practitioners must track the protection period.
  • Once the redemption date falls within 20 years of the original issue date, the stock may become NQPS in a subsequent transaction.
  • Practitioners should calendar the 20-year anniversary from the original issue date to assess when NQPS treatment may become applicable.
• EXAMPLE. 20-year safe harbor. T issues preferred stock on January 1, 2000 that is not NQPS solely because the holder cannot require redemption until January 1, 2022 (22 years).
  • In 2007, T merges into P and the holder receives P preferred stock with identical terms. Because the stock received is substantially identical and redemption did not become more likely than not within the 20-year period beginning January 1, 2000, the P stock is treated as QPS.
  • Treas. Reg. § 1.356-7(e), Example 2.

Step 4B. The Remote Contingency Rule

• Remote contingency as filter. A right or obligation exercisable within 20 years does NOT trigger NQPS status if it is subject to a remote contingency.
  • § 351(g)(2)(B). The right or obligation is not disqualifying if subject to a contingency which, as of the issue date, makes "remote" the likelihood of redemption or purchase.
  • The "remote" standard is a high bar. Remote is more stringent than merely unlikely.
• Change in contingency status. The test is applied at the issue date only.
  • If a remote contingency later becomes non-remote, the original stock characterization does not change (the test is applied at the issue date).
  • However, if the stock is later exchanged in a reorganization and the contingency has changed, the "substantially identical" test must be applied. Treas. Reg. § 1.356-7(b)(2)(ii).
• EXAMPLE. Contingency becomes more likely than not. T issues preferred stock on January 1, 2000 permitting holder-required redemption on January 1, 2018.
  • The stock is not NQPS solely because a contingency makes remote the likelihood of redemption before January 1, 2020. In 2007, T merges into P and the holder receives P preferred with identical terms. Before the exchange, the contingency makes remote redemption before 2020 for the T stock. But for the P stock, the same contingency makes redemption more likely than not before 2020.
  • Because the exchange caused exercise to become "more likely than not" within the 20-year period beginning on T's issue date, the P stock is NOT substantially identical and IS treated as boot. Treas. Reg. § 1.356-7(e), Example 4.

Step 5. The Death, Disability, and Services Exceptions

§ 351(g)(2)(C)(i)(I) provides that a right or obligation shall not be treated as described in clause (i), (ii), or (iii) of subparagraph (A) if "it may be exercised only upon the death, disability, or mental incompetency of the holder."

§ 351(g)(2)(C)(i)(II) provides that a right or obligation shall not be treated as described in clause (i), (ii), or (iii) if "in the case of a right or obligation to redeem or purchase stock transferred in connection with the performance of services for the issuer or a related person (and which represents reasonable compensation), it may be exercised only upon the holder's separation from service from the issuer or a related person."

§ 351(g)(2)(C)(ii) provides that clause (i)(I) "shall not apply if the stock relinquished in the exchange, or the stock acquired in the exchange is in-- (I) a corporation if any class of stock in such corporation or a related party is readily tradable on an established securities market or otherwise, or (II) any other corporation if such exchange is part of a transaction or series of transactions in which such corporation is to become a corporation described in subclause (I)."

• Death, disability, or mental incompetency exception. A redemption or purchase right exercisable ONLY upon the death, disability, or mental incompetency of the holder is not treated as a disqualifying feature.
  • § 351(g)(2)(C)(i)(I). This exception accommodates estate planning and family business succession arrangements.
  • The redemption right must be exercisable ONLY upon the specified event. If the right is also exercisable on other terms, the exception does not apply.
• Public company exception kills the death/disability exception. The death/disability exception does NOT apply to publicly traded corporations.
  • § 351(g)(2)(C)(ii)(I). The exception does not apply if the stock involved (either relinquished or acquired) is in a corporation with stock that is "readily tradable on an established securities market or otherwise."
  • § 351(g)(2)(C)(ii)(II). Nor does it apply if the exchange is part of a transaction in which the corporation is to become publicly traded.
• Services/separation from service exception. A redemption right tied to employment is excepted under certain conditions.
  • § 351(g)(2)(C)(i)(II). A right or obligation to redeem or purchase stock transferred in connection with the performance of services (where the stock represents reasonable compensation) is excepted if exercisable ONLY upon the holder's separation from service.
  • This accommodates typical employee stock redemption arrangements.
• Both exceptions require exclusivity. The redemption right must be exercisable ONLY upon the specified event.
  • If the right is also exercisable on other terms (death, disability, mental incompetency, or separation from service), the exception does not apply.
  • The exclusivity requirement is strictly construed. Any additional redemption trigger voids the exception.
• Treas. Reg. § 1.356-7(c) compensation stock tacking. Under Treas. Reg. § 1.356-7(c), preferred stock received in a reorganization is treated as "transferred in connection with the performance of services" (and as "reasonable compensation") if three conditions are met.
  • The received stock contains a separation-from-service redemption right. It is received in exchange for existing stock with a similar feature. And the existing stock was originally transferred for services and represented reasonable compensation.
  • The received stock retains this protected status in subsequent transactions.
• TRAP. The exceptions do NOT apply to clause (iv). The death/disability and services exceptions apply only to clauses (i), (ii), and (iii).
  • A variable dividend rate cannot be saved by these exceptions.
  • Preferred stock with a variable dividend rate tied to an index is NQPS regardless of whether it is compensatory stock or tied to a death/disability redemption feature.

Step 6. The Related Person Definition

§ 351(g)(3)(B) provides that "A person shall be treated as related to another person if they bear a relationship to such other person described in section 267(b) or 707(b)."

• Incorporation by reference. The definition of "related person" for NQPS purposes incorporates § 267(b) and § 707(b) in their entirety.
  • § 351(g)(3)(B). This means redemption or purchase rights exercisable by related persons are treated the same as rights exercisable by the issuer itself.
  • The incorporation by reference ensures that related-party redemption features are subject to the same NQPS treatment as issuer-level features.
• § 267(b) relationships. These include specified family and entity relationships.
  • Family members (§ 267(b)(1)), controlled corporations (§ 267(b)(2)), partnerships and partners (§ 267(b)(3)), trusts and beneficiaries (§ 267(b)(4)), grantors and fiduciaries (§ 267(b)(5)), and corporations under common control (§ 267(b)(3) through partnership attribution).
  • Each of these relationships can cause a redemption or purchase right exercisable by the related person to trigger NQPS status.
• 50% threshold (not 80%). For controlled corporations under § 267(b)(2), the threshold is "more than 50 percent" ownership of stock by value.
  • This is not the 80% control threshold of § 368(c). The related person test is substantially more inclusive than the control test.
  • A corporation owning 51% of another corporation's stock is a "related person" for NQPS purposes but would not constitute control for § 351(a) purposes.
• § 707(b) relationships. These include partnership-level relationships.
  • Relationships between a partnership and a partner owning more than 50% of capital or profits interests (§ 707(b)(1)), and between two partnerships with common ownership (§ 707(b)(2)).
  • These relationship rules ensure that redemption rights exercisable by partnership-related persons trigger NQPS treatment.
• TRAP. The 20% safe harbor threshold in Treas. Reg. § 1.305-5(b)(3)(ii). For the "more likely than not" safe harbor under § 305(c), the regulation substitutes "20 percent" for "50 percent" in applying §§ 267(b) and 707(b).
  • This safe harbor threshold is different from (and lower than) the 50% threshold in § 351(g)(3)(B) itself.
  • The § 305 safe harbor applies only for § 305(c) constructive distribution purposes, not for NQPS classification. For NQPS, the 50% threshold of § 351(g)(3)(B) controls.

Step 7. Gain Recognition When NQPS Is Received

§ 351(g)(1) provides that "In the case of a person who transfers property to a corporation and receives nonqualified preferred stock-- (A) subsection (a) shall not apply to such transferor, and (B) if (and only if) the transferor receives stock other than nonqualified preferred stock-- (i) subsection (b) shall apply to such transferor; and (ii) such nonqualified preferred stock shall be treated as other property for purposes of applying subsection (b)."

• Scenario A -- Only NQPS received. If a transferor receives ONLY NQPS in exchange for property, § 351(a) does not apply at all.
  • § 351(g)(1)(A). § 351(b) does not apply either because there is no qualifying stock received. The transferor must recognize the FULL amount of realized gain (or loss) on the transaction as if the property were sold. The transaction is fully taxable.
  • This was clarified by the IRRA 1998 technical correction.
• Scenario B -- NQPS plus qualifying stock received. If the transferor receives BOTH NQPS AND qualifying stock (stock that is not NQPS), then § 351(b) applies.
  • § 351(g)(1)(B)(i). The NQPS is treated as "other property" (boot). § 351(g)(1)(B)(ii).
  • Gain is recognized to the lesser of realized gain or the FMV of the NQPS received. § 351(b)(1). No loss is recognized. § 351(b)(2).
• The IRRA 1998 technical correction. The original TRA 1997 text had separate subparagraphs (B) and (C).
  • The Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105-206, § 6010(e)(1), restructured § 351(g)(1) to its current form, adding "and" at the end of subparagraph (A) and replacing former subparagraphs (B) and (C) with the current subparagraph (B) containing clauses (i) and (ii).
  • This change applied "as if included in the amendments made by the Taxpayer Relief Act of 1997." IRRA 1998 § 6010(e)(1).
• EXAMPLE. Scenario A -- Fully taxable. Transferor contributes property with FMV of $500,000 and adjusted basis of $200,000 (realized gain of $300,000) to a corporation. In exchange, the transferor receives ONLY NQPS worth $500,000.
  • § 351(a) does not apply. The transferor recognizes the full $300,000 realized gain.
  • Basis in the NQPS is $500,000 (FMV under § 358(a)(2)).
• EXAMPLE. Scenario B -- Boot treatment. Transferor contributes property with FMV of $1,000,000 and adjusted basis of $400,000 (realized gain of $600,000) to a corporation. In exchange, the transferor receives common stock worth $700,000 and NQPS worth $300,000.
  • Under § 351(g)(1)(B), the NQPS is treated as boot. Gain recognized is the lesser of realized gain ($600,000) or FMV of boot ($300,000). Gain recognized is $300,000.
  • The transferor takes a $300,000 basis in the NQPS (FMV) and the remaining basis is allocated to the common stock under § 358. See Step 8 for the full basis computation.

Step 8. Basis in Qualified Stock and NQPS Boot Under § 358

§ 358(a)(1) provides that "In the case of an exchange to which section 351... applies-- (1) Nonrecognition property. The basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged-- (A) decreased by-- (i) the fair market value of any other property (except money) received by the taxpayer, (ii) the amount of any money received by the taxpayer, and (iii) the amount of loss to the taxpayer which was recognized on such exchange, and (B) increased by-- (i) the amount which was treated as a dividend, and (ii) the amount of gain to the taxpayer which was recognized on such exchange."

§ 358(a)(2) provides that "The basis of any other property (except money) received by the taxpayer shall be its fair market value."

§ 358(b) provides that "(1) Allocation. In any case in which an exchange with respect to which this section applies results in the receipt of two or more properties to which paragraph (1) of subsection (a) is applicable, the amount allocated to each such property shall be its fair market value. (2) Special rule for allocation of basis among properties to which paragraph (1) of subsection (a) is applicable. If, in an exchange to which this section applies, as part of the consideration the taxpayer receives... two or more properties to which paragraph (1) of subsection (a) is applicable, the basis determined under subsection (a)(1) shall be allocated... in proportion to the fair market value of such properties."

• NQPS boot takes FMV basis. Under § 358(a)(2), the basis of boot received (including NQPS treated as boot) is its fair market value at the time of receipt.
  • Because the transferor already recognized gain equal to the FMV of the NQPS boot, taking a basis equal to FMV ensures no further gain or loss is recognized upon subsequent disposition (unless the value changes).
  • This is consistent with the general boot basis rule that boot takes a cost basis equal to its FMV.
• Qualified stock basis formula. Under § 358(a)(1), the basis in qualified stock received equals the transferor's adjusted basis in the property transferred, adjusted for boot and gain.
  • The basis equals the transferor's adjusted basis in the property transferred, decreased by the FMV of boot received, and increased by gain recognized on the exchange. § 358(a)(1)(A)(i), (B)(ii).
  • This formula ensures that unrecognized gain remains deferred in the qualified stock.
• Allocation among multiple classes of qualified stock. If the transferor receives more than one class of qualified stock, the aggregate basis must be allocated.
  • The aggregate basis computed under § 358(a)(1) is allocated among the classes in proportion to their relative fair market values. § 358(b)(2).
  • Each class of qualified stock receives its proportionate share of the aggregate basis.
• EXAMPLE. Full basis computation. Transferor A contributes equipment with FMV of $1,000,000 and adjusted basis of $400,000 to Newco. A receives in exchange common stock (FMV $700,000) and NQPS (FMV $300,000).
  • Realized gain is $600,000. Gain recognized is lesser of realized gain ($600,000) or boot FMV ($300,000) = $300,000. Basis in NQPS = $300,000 (FMV under § 358(a)(2)). Aggregate basis in common stock = $400,000 (property basis) minus $300,000 (boot FMV) plus $300,000 (gain recognized) = $400,000.
  • Because A received only one class of qualified stock, the entire $400,000 is allocated to the common stock. A's basis in the common stock is $400,000, which equals the original basis in the contributed equipment. The $200,000 of unrecognized gain ($600,000 realized minus $300,000 recognized) remains built into the common stock.
• EXAMPLE. Allocation among multiple qualified stock classes. Same facts, but A receives Class A common stock (FMV $400,000), Class B common stock (FMV $300,000), and NQPS (FMV $300,000).
  • Aggregate basis in qualified stock after § 358(a)(1) computation is still $400,000. This is allocated between Class A and Class B in proportion to FMV.
  • Class A gets ($400,000 / $700,000) times $400,000 = $228,571. Class B gets ($300,000 / $700,000) times $400,000 = $171,429. NQPS basis = $300,000. Total basis in all stock = $228,571 + $171,429 + $300,000 = $700,000. The $200,000 of unrecognized gain remains deferred in the qualified stock.

Step 9. NQPS and the 80% Control Test

NQPS is treated as stock for purposes of the § 368(c) control test even though it is treated as boot to the transferor who receives it. § 351(g)(1) (treating NQPS as boot to the transferor). § 368(c) (defining control without excluding NQPS).

• The "schizophrenic" treatment. NQPS receives dual treatment that is congressionally intended.
  • To the transferor who receives it, NQPS is "other property" (boot) under § 351(g)(1).
  • But for purposes of the § 368(c) control test, NQPS is treated as stock. This means NQPS helps satisfy the 80% control requirement even though it triggers gain recognition to the recipient. The NYSBA Tax Section Report No. 925 described this approach as "somewhat schizophrenic."
• NQPS counts toward control. NQPS received in exchange for property is counted as stock for purposes of determining whether the transferors are in "control."
  • NQPS is counted as stock for purposes of determining whether the transferors, in the aggregate, are in "control" of the corporation immediately after the exchange. § 368(c) defines control as ownership of stock possessing at least 80% of the total combined voting power and at least 80% of the total number of shares of all other classes of stock.
  • This statutory framework ensures that the receipt of NQPS by one transferor does not destroy the control test for other transferors who receive qualifying stock.
• Practical example. C contributes appreciated property to newly formed corporation X in exchange for all of X's common stock (90% of value and all voting power). B contributes cash in exchange for NQPS representing 10% of X's value.
  • Even though B receives boot, the NQPS is still treated as stock for purposes of §§ 351(a) and 368(c). C's transfer qualifies for nonrecognition treatment because B and C together control X immediately after the transfers.
  • C alone does not control X because C owns none of the nonvoting class held by B. If B had received other stock in addition to NQPS, B would recognize gain only to the extent of the FMV of the NQPS received.
• Attribution rules do not apply. For purposes of § 351 and § 368(c), direct ownership is required.
  • The stock attribution rules of § 318 do not apply to the § 368(c) control test.
  • Brams v. Commissioner, 734 F.2d 290 (6th Cir. 1984) (§ 318 attribution does not apply to § 368(c) control test).
• TRAP. Accommodation transferors are disregarded. A person who transfers property of "relatively small value" for the sole purpose of enabling other transferors to meet the control requirement is not counted toward control.
  • Under Treas. Reg. § 1.351-1(a)(1)(ii), an accommodation transferor who contributes a nominal amount of cash and receives NQPS solely to help the principal transferor satisfy the 80% control test will be disregarded.
  • Do not use an accommodation transferor to artificially satisfy the control requirement.
• Post-IRRA 1998 clarification. If a transferor receives ONLY NQPS (no qualifying stock), that transferor does not qualify for § 351(a) nonrecognition at all.
  • The transaction is treated as a fully taxable disposition under § 1001.
  • IRRA 1998, Pub. L. 105-206, § 6010(e)(1) (technical correction clarifying that § 351(b) boot treatment applies to NQPS only if the transferor also receives qualifying stock).

Step 10. Corporate-Level Consequences

• § 362(a) carryover basis increased by gain. Under § 362(a), the transferee corporation takes a carryover basis in property received in a § 351 exchange, increased by any gain recognized by the transferor.
  • When a transferor receives NQPS boot and recognizes gain, the corporation's basis in the contributed property is increased by the amount of that gain. § 362(a). The corporation does not take a basis in the NQPS issued (it is the corporation's own stock).
  • If the transferor recognizes $300,000 of gain due to NQPS boot, and the contributed property had a basis of $400,000, the corporation's basis in the property is $400,000 plus $300,000 equals $700,000.
• § 1032 no gain on stock issuance. Under § 1032(a), a corporation does not recognize gain or loss on the receipt of money or other property in exchange for its stock (including NQPS).
  • The corporate-level issuance of NQPS is a non-event for tax purposes, even though the NQPS is treated as boot to the transferor shareholder.
  • The corporation's issuance of NQPS triggers no corporate-level tax.
• § 311 on subsequent distributions. If the corporation later distributes appreciated property to the NQPS holder, § 311(b) may require gain recognition.
  • § 311(b)(1) may require the corporation to recognize gain as if the property were sold to the distributee at FMV. This is not NQPS-specific but is relevant to post-transaction planning.
  • § 311(a) provides that no gain or loss is recognized on distributions of property to shareholders, but § 311(b)(1) creates an exception for appreciated property where FMV exceeds adjusted basis. Loss is not recognized on distributions of built-in loss property.
• Coordination with § 305(c). If the NQPS contains redemption premium features, Treas. Reg. § 1.305-5(b) may apply.
  • The regulation may treat the premium as a constructive distribution under § 305(c), taken into account under principles similar to OID accrual under § 1272(a).
  • A de minimis exception applies if the redemption premium does not exceed the amount determined under § 1273(a)(3) principles. Treas. Reg. § 1.305-5(b)(4).

Step 11. The Substantially Identical Exchange Exception

Treas. Reg. § 1.356-7(b)(1) provides that preferred stock is QPS, even though described in § 351(g)(2), if it is received in exchange for (or in a distribution with respect to) preferred stock that is QPS, provided (i) the original preferred stock is QPS solely because, on its issue date, either a right or obligation was not exercisable until after a 20-year period, or was exercisable within 20 years but subject to a remote contingency, or the issuer's right was not more likely than not to be exercised within 20 years; and (ii) the stock received is substantially identical to the original preferred stock.

• Purpose of the exception. The substantially identical exchange exception prevents NQPS rules from imposing gain recognition on certain exchanges.
  • Without this exception, a holder of QPS (QPS solely because redemption was beyond 20 years) who exchanged it in a reorganization for new preferred stock could recognize gain if the new stock's terms placed redemption within 20 years of the original issue date. Treas. Reg. § 1.356-7(b) addresses this problem.
  • The exception ensures that reorganizations and recapitalizations do not inadvertently trigger NQPS treatment for stock that was originally qualified preferred stock.

Step 11A. General Rule Under Treas. Reg. § 1.356-7(b)(1)

• Two conditions for the exception. Both conditions must be satisfied.
  • The original preferred stock must have been QPS SOLELY because of the 20-year rule, the remote contingency rule, or the "not more likely than not" rule (or any combination). Treas. Reg. § 1.356-7(b)(1)(i). If the original stock was QPS for unrelated reasons (e.g., it simply lacked any redemption/purchase features), the exception does not apply.
  • The stock received must be "substantially identical" to the original preferred stock. Treas. Reg. § 1.356-7(b)(1)(ii).
• Example 2 from Treas. Reg. § 1.356-7(e). This example illustrates a successful substantially identical exchange.
  • T issues QPS to A on January 1, 2000 that is not NQPS solely because the holder cannot require redemption until January 1, 2022.
  • In 2007, pursuant to a reorganization in which T merges into P, A receives P preferred stock with identical terms. Because the P stock and T stock have identical terms, and redemption did not become more likely than not within the 20-year period beginning January 1, 2000, the P stock is treated as QPS under Treas. Reg. § 1.356-7(b).

Step 11B. The Substantially Identical Test Under Treas. Reg. § 1.356-7(b)(2)

• Two-prong test. The stock received is substantially identical to the original preferred stock only if both prongs are met. Treas. Reg. § 1.356-7(b)(2).
  • Both prongs must be satisfied for the exception to apply. Satisfaction of one prong alone is insufficient.
  • The test compares the received stock to the original stock as of the exchange date.
• Prong one -- No acceleration or increased likelihood. The received stock must not contain any term that worsens the holder's position.
  • The received stock must not contain any term that, relative to the original stock, either decreases the period in which a redemption/purchase right can be exercised, increases the likelihood that such a right will be exercised, or accelerates the timing of returns (including actual or deemed dividends or other distributions). Treas. Reg. § 1.356-7(b)(2)(i).
  • Any acceleration of redemption rights or increase in redemption likelihood voids the substantially identical status.
• Prong two -- No new "more likely than not" trigger. The exchange must not cause a change in redemption probability.
  • As a result of the exchange or distribution, exercise of the right or obligation must not become "more likely than not" to occur within a 20-year period beginning on the issue date of the original preferred stock. Treas. Reg. § 1.356-7(b)(2)(ii).
  • The critical measurement date is the original issue date, not the new stock's issue date.
• Example 4 from Treas. Reg. § 1.356-7(e). This example illustrates a failed substantially identical exchange.
  • T issues preferred stock on January 1, 2000 permitting holder-required redemption on January 1, 2018, not NQPS solely because a contingency makes remote the likelihood of redemption before January 1, 2020. In 2007, T merges into P and A receives P preferred with identical terms. Before the exchange, the contingency makes remote redemption before 2020 for the T stock. But for the P stock, the same contingency makes redemption more likely than not before 2020.
  • Because exercise became more likely than not within the 20-year period beginning on T's issue date, the P stock is NOT substantially identical and IS treated as boot.
• Example 5 from Treas. Reg. § 1.356-7(e). This example illustrates a successful exchange despite changed circumstances.
  • Same facts as Example 4, except immediately before the merger, the contingency already makes it more likely than not that T stock will be redeemed before January 1, 2020.
  • Because the redemption right was already "more likely than not" before the exchange, and the exchange did not cause this status, the P stock IS substantially identical and is treated as QPS. The key is whether the exchange CAUSED the change in likelihood.

Step 11C. Continuation in Subsequent Transactions Under Treas. Reg. § 1.356-7(b)(3)

• The tacking principle. Once stock is treated as QPS under the substantially identical exception, it retains QPS status in subsequent transactions.
  • "The stock received will continue to be treated as QPS in subsequent transactions involving such stock, and the principles of this paragraph (b) apply to such transactions as though the stock received is the original preferred stock issued on the same date as the original preferred stock." Treas. Reg. § 1.356-7(b)(3).
  • This prevents the exception from being lost through a series of reorganizations.
• Example 3 from Treas. Reg. § 1.356-7(e). This example illustrates when tacking fails due to changed terms.
  • Same facts as Example 2, except in 2010 A exchanges the P preferred stock in a recapitalization for P NQPS that permits holder-required redemption in 2020.
  • The P preferred stock surrendered by A is treated as QPS. But the P preferred stock received in the recapitalization is NOT substantially identical to the surrendered stock (because the redemption period was shortened from 2022 to 2020). Therefore, the newly received P preferred stock is NOT treated as QPS and is "other property" under § 356(a)(1)(B).

Step 12. Effective Date and Transition Rules

• General effective date -- June 8, 1997. The NQPS provisions apply to transactions after June 8, 1997.
  • TRA 1997 § 1014(f). The effective date is tied to June 8, 1997 (not the August 5, 1997 enactment date).
  • The AJCA 2004 amendment to § 351(g)(3)(A) (adding "real and meaningful likelihood") applies to transactions after May 14, 2003. The 2005 Technical Corrections Act applies as if included in the AJCA 2004 amendment.
• Binding contract exception. The NQPS provisions do not apply to transfers under pre-existing binding contracts.
  • The provisions do not apply to any transfer pursuant to a written binding contract in effect on June 8, 1997, and at all times thereafter before the transfer, if the contract provides for the transfer of a fixed amount of property. TRA 1997 § 1014(f)(2)(A).
  • The contract must have been binding on June 8, 1997 and must specify a fixed amount of property to be transferred.
• Ruling request transition rule. The NQPS provisions do not apply to certain pre-filed ruling requests.
  • The provisions do not apply to any transaction described in a ruling request submitted to the IRS on or before June 8, 1997. TRA 1997 § 1014(f)(2)(B).
  • The ruling request must have been submitted on or before the effective date.
• Public announcement or SEC filing transition rule. The NQPS provisions do not apply to publicly disclosed transactions.
  • The provisions do not apply to any transaction described on or before June 8, 1997 in a public announcement or in a filing with the SEC required solely by reason of the transaction. TRA 1997 § 1014(f)(2)(C).
  • The disclosure must have been made on or before the effective date.
• Pre-effective date stock characterization rule. Under Treas. Reg. § 1.356-7(a), pre-effective date stock can have NQPS character.
  • "Stock described in section 351(g)(2) is nonqualified preferred stock (NQPS) regardless of the date on which the stock is issued. However, sections 351(g), 354(a)(2)(C), 355(a)(3)(D), 356(e), and 1036(b) do not apply to any transaction occurring prior to June 9, 1997."
  • This means pre-June 9, 1997 stock can be NQPS in character, but the NQPS provisions do not apply to transactions before June 9, 1997. If such stock is later exchanged in a transaction after June 8, 1997, the NQPS rules apply to that later transaction.
• Example 1 from Treas. Reg. § 1.356-7(e). This example illustrates the pre-effective date rule.
  • In 1995, A transfers property to T and receives T preferred stock that is described in § 351(g)(2) in a § 351 transaction. In 2002, pursuant to a reorganization, A surrenders the T preferred stock in exchange for P NQPS.
  • Under Treas. Reg. § 1.356-7(a), the T preferred stock issued in 1995 is NQPS. However, because § 351(g) does not apply to pre-June 9, 1997 transactions, the T NQPS was not "other property" when issued in 1995. Under §§ 354(a)(2)(C) and 356(e)(2), the P NQPS received in 2002 is not "other property" because it is received in exchange for NQPS (NQPS-for-NQPS exchanges are tax-free).

Step 13. Economic Substance and Anti-Abuse Doctrines

• Codified economic substance doctrine under § 7701(o). A transaction is treated as having economic substance only if both prongs are satisfied.
  • The transaction must change in a meaningful way (apart from federal income tax effects) the taxpayer's economic position (objective prong). AND the taxpayer must have a substantial purpose (apart from federal income tax effects) for entering into the transaction (subjective prong). § 7701(o).
  • This applies to transactions entered into after March 30, 2010.
• Gerdau Macsteel dual holding on economic substance. In Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67 (2012), the Tax Court held on dual grounds.
  • The Class C stock was NQPS because it did not participate in corporate growth to any significant extent.
  • The transactions underlying the claimed capital loss "lacked economic substance." The court found that the $352,251 in fees incurred to effect the transactions was not deductible as an ordinary and necessary business expense under § 162. 139 T.C. at 163-164. The court found the stock gave holders "a guaranteed fixed annual income preference in the form of a set, cumulative dividend and, upon the stock's redemption, a fixed payout that was not related to corporate growth."
• Gerdau Macsteel penalty holding. The taxpayers in Gerdau faced accuracy-related penalties.
  • The taxpayers were not liable for the 40% gross valuation misstatement penalty under § 6662(h), following Fifth Circuit precedent in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), and Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988).
  • However, the taxpayers were liable for the 20% accuracy-related penalty under § 6662(a) to the extent of underpayment attributable to the disallowed capital loss. Gerdau Macsteel, 139 T.C. at 164.
• § 6662 penalties for transactions lacking economic substance. Under § 6662(b)(6), a 20% penalty applies to the portion of any underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance under § 7701(o).
  • If the relevant facts are not adequately disclosed, the penalty increases to 40% under § 6662(i).
  • Adequate disclosure on the tax return can reduce the penalty from 40% to 20% if economic substance is challenged.
• CAUTION. Document business purpose. Every NQPS transaction should have a documented non-tax business purpose.
  • The transaction must meaningfully change the taxpayer's economic position beyond tax savings.
  • Pre-§ 7701(o) cases like Gerdau applied the common law economic substance doctrine, but the principles remain directly applicable post-codification.
• The assignment-of-income doctrine context. While not directly an NQPS case, Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), aff'g 354 F. Supp. 1172 (M.D. Pa. 1973), establishes the relationship between § 351 and the assignment-of-income doctrine.
  • The Third Circuit held that § 351 nonrecognition takes precedence over the assignment-of-income doctrine when a cash-method transferor incorporates an ongoing business.
  • "If the cash basis transferor were taxed on the transfer of the accounts receivable, the specific congressional intent reflected in section 351(a) that the incorporation of an ongoing business should be facilitated by making the incorporation tax free would be frustrated." 490 F.2d at 1177. This principle establishes the baseline that § 351 nonrecognition is the rule, from which § 351(g) carves a specific exception for debt-like preferred stock.

Step 14. Reporting and Documentation

• Treas. Reg. § 1.351-3 statements for significant transferors. Every significant transferor in a § 351 exchange must include a statement on or with its income tax return.
  • The statement must contain (1) the name and EIN of the transferee corporation, (2) the date(s) of transfer, (3) the FMV and basis of property transferred aggregated by category (importation property, loss duplication property, property with respect to which gain or loss was recognized, and other property), and (4) the date and control number of any private letter rulings. Treas. Reg. § 1.351-3(a).
  • A "significant transferor" is defined as a person that owns at least 5% (by vote or value) immediately after the exchange if stock is publicly traded, or at least 1% if stock is not publicly traded. Treas. Reg. § 1.351-3(d)(1).
• Transferee corporation statement. The transferee corporation must include a statement on or with its return.
  • The statement must contain (1) the name and TIN of every significant transferor, (2) the date(s) of transfer, (3) the FMV and basis of property received aggregated by category, and (4) the date and control number of any private letter rulings. Treas. Reg. § 1.351-3(b).
  • The transferee is not required to file if all information is included in the transferor's statement(s) attached to the same return.
• Form 8886 for reportable transactions. Form 8886 is required if the NQPS transaction falls within the definition of a reportable transaction.
  • Reportable transaction categories include listed transactions, confidential transactions, transactions with contractual protection, loss transactions (exceeding $10 million for corporations, $2 million for others, $50,000 for individuals), transactions with significant book-tax differences, and transactions involving brief asset holding periods. Treas. Reg. § 1.6011-4(b).
  • Form 8886 must be attached to the tax return for each taxable year in which the taxpayer participates, and a copy must be sent to the Office of Tax Shelter Analysis when first filed.
• § 305(c) constructive distribution disclosure. The issuer's determination about constructive distributions is binding on holders.
  • Under Treas. Reg. § 1.305-5(b)(5), the issuer's determination as to whether there is a constructive distribution under the redemption premium rules is binding on all holders unless a holder explicitly discloses a different determination.
  • A holder that disagrees must disclose this on a statement attached to its timely filed return for the taxable year that includes the date the holder acquired the stock. Treas. Reg. § 1.305-5(b)(5).
• Record-keeping requirements. Practitioners should ensure clients maintain complete documentation.
  • Clients should maintain copies of stock certificates and articles of incorporation, documentation of corporate earnings and projections at the time of issuance, independent appraisals supporting the FMV of NQPS received, written explanations of non-tax business purpose, documentation showing satisfaction of the 80% control test, and detailed basis worksheets for all property transferred and stock received.
  • Complete contemporaneous documentation is essential if the NQPS characterization is later challenged by the IRS.
• TRAP. The § 1.305-5(b)(5) issuer binding rule. If the issuer determines that a constructive distribution exists under the redemption premium rules, all holders are bound by that determination.
  • Passive acceptance of the issuer's determination may preclude a holder from taking a different tax position in the event of an audit.
  • Holders who disagree with the issuer's determination must affirmatively disclose a contrary position on a timely filed statement.