Corporate Tax | Just Tax

Stock Distribution Analysis (§§ 305, 307)

This checklist analyzes whether a stock distribution is tax-free under § 305(a) or falls into a § 305(b) exception, allocates basis between old and new shares under § 307, and applies the § 305(c) deemed-distribution rules. Use it whenever a corporation distributes its own stock, stock rights, or convertible securities.

Step 1. The § 305(a) General Rule and Constitutional Foundation

"Except as otherwise provided in this section, gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock." (§ 305(a))

"For purposes of this section, the term 'stock' includes rights to acquire such stock." (§ 305(d)(1))

"For purposes of subsections (b) and (c), the term 'shareholder' includes a holder of rights or of convertible securities." (§ 305(d)(2))

• The general rule of nonrecognition.
  • A distribution of a corporation's own stock or rights to its shareholders with respect to its stock is not includible in gross income unless one of the five exceptions in § 305(b) applies. (§ 305(a)) (Reg. § 1.305-1(a))
  • Treasury stock distributions are treated identically to newly issued stock. (Reg. § 1.305-1(a))
  • Nonrecognition is mandatory when the conditions of § 305(a) are satisfied. It is not an elective regime.
• The constitutional foundation in Eisner v. Macomber.
  • The Supreme Court held that a pro rata stock dividend of common stock on common stock does not constitute "income" within the meaning of the Sixteenth Amendment because the shareholder's proportional interest in the corporation's net assets remains unchanged and no severance of corporate assets occurs for the shareholder's separate use. (Eisner v. Macomber, 252 U.S. 189 (1920))
  • The Court reasoned that the stock dividend merely capitalizes accumulated profits into capital stock and proportionally reduces the intrinsic value of each share.
  • This case is the bedrock upon which the current statutory nonrecognition rule is built.
• The counterpoint in Koshland v. Helvering.
  • The Supreme Court held that a stock dividend of common stock on preferred stock was taxable because it conferred an interest "essentially different in character" from the shareholder's original holdings and altered the shareholder's proportional interest. (Koshland v. Helvering, 298 U.S. 441 (1936))
  • The Court distinguished Eisner v. Macomber on the ground that the distribution altered the shareholder's relationship to the corporation.
  • Koshland is the constitutional precursor to the modern statutory exceptions in § 305(b).
• The proportionate-interest refinement in Helvering v. Sprouse and Strassburger v. Commissioner.
  • The Supreme Court held that a stock dividend is not taxable if the shareholder's underlying economic interest in the corporation remains unchanged, even if a new class of stock is created or the form of the stock certificate changes. (Helvering v. Sprouse, 318 U.S. 604 (1943)) (Strassburger v. Commissioner, 318 U.S. 604 (1943))
  • In Strassburger, preferred stock distributed on common stock to the sole shareholder was not taxable because his proportional interest in the corporation was unaltered (he owned 100% before and after).
  • In Sprouse, preferred distributed to the sole shareholder was not taxable because the petitioner remained the sole owner both before and after the distribution.
• The class-by-class safe harbor in Tourtelot v. Commissioner.
  • The Seventh Circuit held that a pro rata stock dividend distributed within each class of stock (Class A on Class A, Class B on Class B) was not taxable because the shareholders' proportionate interest in each class and in the overall corporation remained unchanged. (Tourtelot v. Commissioner, 189 F.2d 167 (7th Cir. 1951))
  • The court applied the Macomber proportional-interest test on a class-by-class basis.
  • This case provides authority for the non-taxability of pro rata stock dividends even in complex multi-class capital structures.
• CAUTION. § 305 nonrecognition is not elective.
  • If the statutory requirements for § 305(a) are met, nonrecognition is mandatory.
  • A taxpayer cannot elect to treat a nontaxable stock dividend as taxable to obtain a stepped-up basis. If a § 305(b) exception applies, taxation is also mandatory.

Step 2. § 305(b)(1) Distributions in Lieu of Money

"Subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies... If the distribution is, at the election of any of the shareholders (whether exercised before or after the declaration thereof), payable either (A) in its stock, or (B) in property." (§ 305(b)(1))

• The "any shareholder" rule.
  • If any shareholder has an election or option to receive cash or other property instead of stock, the distribution of stock is treated as a distribution of property to which § 301 applies with respect to ALL shareholders, whether or not the election is actually exercised. (§ 305(b)(1)) (Reg. § 1.305-2(a))
  • The election can arise from the corporate charter, the declaration of the distribution, or the circumstances of the distribution.
  • It is irrelevant whether the election is exercisable before or after the declaration.
  • It is irrelevant whether all or only some shareholders have the election.
  • It is irrelevant whether the distribution is actually made in whole or in part in stock.
• The five irrelevance factors in the regulations.
  • Reg. § 1.305-2(a) enumerates five factors that do not affect the § 305(b)(1) determination. The only question is whether any shareholder has the right to an election or option to receive cash or property instead of stock. (Reg. § 1.305-2(a))
  • (1) Whether the distribution is actually made in whole or in part in stock or in stock rights.
  • (2) Whether the election or option is exercised or exercisable before or after the declaration.
  • (3) Whether the declaration provides that the distribution will be made in one medium unless the shareholder specifically requests payment in the other.
  • (4) Whether the election is provided in the declaration, the corporate charter, or arises from the circumstances.
  • (5) Whether all or part of the shareholders have the election.
• Discretionary redemption is not an election.
  • A shareholder does not have a taxable "election" under § 305(b)(1) if the distributing corporation retains absolute discretion over whether to redeem the shareholder's stock. (Colonial Savings Ass'n v. Commissioner, 854 F.2d 1001 (7th Cir. 1988)) (Western Federal Savings & Loan Ass'n v. Commissioner, 880 F.2d 1005 (8th Cir. 1989))
  • In Colonial Savings, the Seventh Circuit held that the FHLB's retention of discretion to refuse redemption requests meant member banks did not have an unconditional right to choose cash. The Supreme Court denied certiorari and the IRS acquiesced in the decision. (Acq., 1990-1 C.B. 1)
  • In Western Federal, the Eighth Circuit reached the same conclusion, emphasizing that the statutory phrase "in its discretion" precluded a finding of a shareholder election.
• Mixed dividends.
  • Where a dividend declaration provides that some portion is payable in stock without any election and another portion is subject to a cash/stock election, only the portion subject to the election is treated as a § 301 distribution. (Reg. § 1.305-2(b), Example 1).
  • EXAMPLE. Corporation X declares a dividend of 2 additional shares per share held, but any shareholder may elect to receive 1 additional share plus $12 principal amount of securities of Corporation Y. The first share (with respect to which no election applies) is NOT taxable under § 301. The second share to shareholders who do not elect is taxable under § 301. The securities of Corporation Y received by electing shareholders are also taxable under § 301. (Reg. § 1.305-2(b), Example 1)
• Regulated investment company exception.
  • Where a RIC declares a dividend pursuant to which shareholders may elect to receive either money or stock of equivalent value, the amount of the stock distribution is considered to equal the amount of the money which could have been received instead. (Reg. § 1.305-1(b)(2)).
  • This special rule avoids the need to value publicly traded RIC stock on the distribution date.

Step 3. § 305(b)(2) Disproportionate Distributions

"Subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies... If the distribution (or a series of distributions of which such distribution is one) has the result of (A) the receipt of property by some shareholders, and (B) an increase in the proportionate interests of other shareholders in the assets or earnings and profits of the corporation." (§ 305(b)(2))

• The two-result requirement.
  • A stock distribution is taxable under § 305(b)(2) only if both of the following results occur. (1) Some shareholders receive money or other property. (2) Other shareholders increase their proportionate interests in the assets or earnings and profits of the corporation. (§ 305(b)(2)) (Reg. § 1.305-3(a))
  • If one class of stock receives cash dividends and another class receives stock dividends, the stock dividends are treated as distributions to which § 301 applies.
  • The cash or property received by some shareholders need not be in the form of a distribution. It is sufficient that it is received in their capacity as shareholders and is a distribution to which § 301, § 356(a)(2), § 871(a)(1)(A), § 881(a)(1), § 852(b), or § 857(b) applies. (Reg. § 1.305-3(b)(3))
• No plan or prearrangement is required.
  • It is not necessary that the distributions be pursuant to a plan. It is sufficient if there is an actual or deemed distribution of stock and, as a result, some shareholders receive cash or property and other shareholders increase their proportionate interests. (Reg. § 1.305-3(b)(2)).
  • Quarterly stock dividends to one class plus annual cash dividends to another class constitute a "series of distributions" under § 305(b)(2), whether or not pursuant to a plan. (Reg. § 1.305-3(b)(2))
• The 36-month presumption.
  • Where the receipt of cash or property occurs more than 36 months following a distribution of stock (or vice versa), the distribution will be presumed NOT to result in the receipt of cash or property plus an increase in proportionate interests, unless the distributions were pursuant to a plan. (Reg. § 1.305-3(b)(4))
  • The presumption is rebuttable if the distributions were pursuant to a plan.
  • The 36-month window is a safe harbor, not a rigid cutoff. Distributions within 36 months require careful analysis.
• The isolated redemption exception.
  • A distribution of property incident to an isolated redemption of stock (for example, pursuant to a tender offer) will not cause § 305(b)(2) to apply even though the redemption distribution is treated as a distribution of property to which § 301 applies. (Reg. § 1.305-3(b)(3))
  • This exception applies only to isolated redemptions, not to periodic redemption plans.
  • A single redemption motivated by interest rate fluctuations or other independent business factors will generally qualify for the exception. (Colonial Savings Ass'n v. Commissioner, 854 F.2d 1001 (7th Cir. 1988))
• Class-by-class analysis.
  • Each class of stock is to be considered separately. The individual shareholders of a class will be deemed to have an increased interest if the class as a whole has an increased interest. (Reg. § 1.305-3(b)(6)).
  • If a corporation has Class A common and Class B nonconvertible preferred, and Class A receives a stock dividend while Class B receives a cash dividend, the Class A stock dividend is NOT taxable because it does not increase the proportionate interests of Class A shareholders as a class. (Reg. § 1.305-3(e), Example 2)
• Convertible securities treated as outstanding stock.
  • In determining whether a distribution has the result of a disproportionate distribution, there shall be treated as outstanding stock any right to acquire such stock and any security convertible into stock, whether or not exercisable or convertible during the taxable year. (Reg. § 1.305-3(b)(5)).
  • This rule prevents shareholders from avoiding the disproportionate distribution test by holding convertible securities instead of common stock.
• Cash in lieu of fractional shares.
  • § 305(b)(2) will not apply if a corporation declares a dividend payable in stock and distributes cash in lieu of fractional shares. The transaction is treated as though the fractional shares were distributed and then redeemed by the corporation. (Reg. § 1.305-3(c)).
  • The treatment of the cash received is determined under § 302, not § 305(b)(2).
• CAUTION. § 318 does NOT apply to § 305(b)(2) analysis.
  • The constructive ownership rules of § 318 do not apply in determining the increase in proportionate interest required by § 305(b)(2)(B) because they are not expressly made applicable by a provision of § 305.
  • Analyze proportionality based on actual stock ownership, not constructive ownership. (12 Ariz. L. Rev. 555, 565 (1970)).
• Hagan v. Commissioner.
  • The Tax Court held that a stock dividend was taxable under § 305(b)(2) because the corporation had a history of paying cash dividends, making the stock dividend part of a series of distributions that resulted in some shareholders receiving cash while others increased their proportionate interests. (Hagan v. Commissioner, 57 T.C.M. 1489 (1989), aff'd in part, rev'd in part on other grounds, 92-1 U.S.T.C. ¶ 50,030 (10th Cir. 1992))
  • The case illustrates that a corporation cannot avoid tax consequences by paying stock to some shareholders and cash to others.
  • The history of distributions and the overall effect on shareholders' interests are paramount.

Step 4. § 305(b)(3) Common and Preferred Stock Distributions

"Subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies... If the distribution (or a series of distributions of which such distribution is one) has the result of (A) the receipt of preferred stock by some common shareholders, and (B) the receipt of common stock by other common shareholders." (§ 305(b)(3))

• The mechanical rule.
  • A distribution (or series of distributions) that results in the receipt of preferred stock by some common shareholders and the receipt of common stock by other common shareholders is treated as a distribution of property to which § 301 applies. (§ 305(b)(3)) (Reg. § 1.305-4(a))
  • Unlike § 305(b)(2), this exception does not require an increase in proportionate interest. It is a purely mechanical rule based on the type of stock received by different common shareholders.
  • The "series of distributions" concept from § 1.305-3(b) applies to § 305(b)(3) as well. (Reg. § 1.305-4(a))
• The legislative purpose.
  • The exception was designed to prevent the "two-classes-of-common-stock" plan where taxpayers sought to avoid § 305(b)(2) by distributing preferred stock to some common shareholders and common stock to other common shareholders. (Reg. § 1.305-4(a)).
  • If a corporation has Class A and Class B common stock and distributes Class A on Class A while distributing new preferred on Class B, § 305(b)(3) applies mechanically.
• Convertible preferred and likelihood of conversion.
  • If the preferred stock distributed is convertible into common stock and it is reasonable to anticipate that some shareholders will convert while others will not, the distribution is taxable under § 305(b)(3). (Reg. § 1.305-4(b), Example 2)
  • The factors to consider include the conversion period length, the dividend rate, the redemption provisions, the marketability of the convertible stock, and the conversion price.
  • If conversion is expected to occur relatively quickly and some shareholders will convert while others will not, § 305(b)(3) likely applies.
• Regulatory examples.
  • Reg. § 1.305-4(b), Example 1 illustrates that where a corporation distributes preferred stock to some common shareholders and common stock to other common shareholders, both the preferred stock and the common stock are treated as distributions to which § 301 applies under § 305(b)(3). (Reg. § 1.305-4(b), Example 1)
  • The regulation confirms that the mechanical language of § 305(b)(3) captures any distribution that has the stated result, regardless of the corporation's motive or the shareholders' proportionate interests.
• CAUTION. Estate planning recapitalizations often create § 305(b)(3) issues.
  • When a corporation recapitalizes and distributes different classes of stock to different common shareholders, § 305(b)(3) may apply mechanically even if no shareholder's economic position is enhanced.
  • Consider whether all shareholders can receive the same type of stock or whether the recapitalization can be structured as a non-distribution exchange. (Reg. § 1.305-3(e), Example 12).

Step 5. § 305(b)(4) Distributions on Preferred Stock

"Subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies... If the distribution is with respect to preferred stock, other than an increase in the conversion ratio of convertible preferred stock made solely to take account of a stock dividend or stock split with respect to the stock into which such convertible stock is convertible." (§ 305(b)(4))

• The broad rule.
  • A distribution by a corporation of its stock or rights made with respect to its preferred stock is treated as a distribution of property to which § 301 applies unless the distribution is an increase in the conversion ratio of convertible preferred stock made solely to take account of a stock dividend, stock split, or similar event. (§ 305(b)(4)) (Reg. § 1.305-5(a))
  • This is the broadest of the § 305(b) exceptions. Virtually any distribution on preferred stock is taxable.
  • The exception for conversion ratio adjustments applies only if the adjustment is made solely to take account of a stock dividend or stock split with respect to the stock into which the convertible preferred is convertible.
• Definition of "preferred stock."
  • The term "preferred stock" generally refers to stock which, in relation to other classes of stock outstanding, enjoys certain limited rights and privileges (generally associated with specified dividend and liquidation priorities) but does not participate in corporate growth to any significant extent. (Reg. § 1.305-5(a))
  • The distinguishing feature is that the privileged position is limited and the stock does not participate in corporate growth to any significant extent.
  • A right to participate that lacks substance will not prevent a class of stock from being treated as preferred stock.
  • Factors to consider include prior and anticipated earnings per share, cash dividends per share, book value per share, and the extent of preference and participation of each class. (Reg. § 1.305-5(a))
  • The determination is made without regard to any right to convert such stock into another class. Convertible debentures are not included in the term "preferred stock." (Reg. § 1.305-5(a))
• Anti-dilution exception for convertible preferred.
  • An adjustment in the conversion ratio of convertible preferred stock made solely to take account of a stock dividend, stock split, or any similar event (such as the sale of stock at less than fair market value pursuant to a rights offering) which would otherwise result in dilution of the conversion right is excepted from § 305(b)(4). (Reg. § 1.305-5(a)).
  • An adjustment to compensate for a capital gain dividend by a closed-end regulated investment company is NOT considered a "similar event" for this purpose. (Reg. § 1.305-5(a))
• CAUTION. The word "solely" is a narrow safe harbor.
  • If the conversion ratio adjustment has any purpose other than to take account of a stock dividend or stock split, the exception does not apply.
  • Any additional economic benefit conferred on the convertible preferred shareholders causes the adjustment to fall outside the safe harbor. (§ 305(b)(4)).
• TRAP. Preferred stock with participation rights that lack substance.
  • If a class of stock has a nominal participation right but it is not reasonable to anticipate that the stock will actually participate in corporate growth beyond its preferred interest, the stock is treated as preferred stock and distributions on it are taxable under § 305(b)(4). (Reg. § 1.305-5(d), Example 9).
  • Conversely, if it is reasonable to anticipate that both classes will participate beyond their preferred interests, neither class is preferred stock and stock dividends are not taxable under § 305(b)(4). (Reg. § 1.305-5(d), Example 10)

Step 6. § 305(b)(5) Distributions of Convertible Preferred Stock

"Subsection (a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies... If the distribution is of convertible preferred stock, unless it is established to the satisfaction of the Secretary that such distribution will not have the result described in paragraph (2)." (§ 305(b)(5))

• The presumption of taxability.
  • A distribution of convertible preferred stock is treated as a distribution of property to which § 301 applies unless the corporation establishes to the Secretary's satisfaction that the distribution will not result in a disproportionate distribution as described in § 305(b)(2). (§ 305(b)(5)) (Reg. § 1.305-6(a)(1))
  • The burden of proof is on the corporation, not the shareholder.
  • § 305(b)(5) applies only to distributions of convertible preferred with respect to common stock. Distributions with respect to preferred stock are covered by § 305(b)(4).
• Key factors for rebutting the presumption.
  • The regulations identify five factors that determine whether a disproportionate result is likely. (Reg. § 1.305-6(a)(2))
  • (1) The conversion period length. A short conversion period increases the likelihood of taxability.
  • (2) The dividend rate on the convertible preferred.
  • (3) The redemption provisions.
  • (4) The marketability of the convertible stock.
  • (5) The conversion price relative to market value.
• Long conversion period plus market rates equals likely nontaxable.
  • Where the conversion right may be exercised over a period of many years and the dividend rate is consistent with market conditions, there is no basis for predicting the extent of conversion and it is unlikely that a disproportionate distribution will result. (Reg. § 1.305-6(a)(2)).
  • EXAMPLE. Corporation Z has one class of common stock. It declares a dividend payable in preferred stock convertible into common for 20 years at normal dividend rates. There is no basis for predicting the extent of conversion. The distribution is NOT taxable under § 301. (Reg. § 1.305-6(b), Example 1)
• Short conversion period plus slight premium equals likely taxable.
  • The distribution of convertible preferred stock is likely to result in a disproportionate distribution when both of the following conditions exist. (1) The conversion right must be exercised within a relatively short period of time after the date of distribution. (2) Taking into account the factors listed above, it may be anticipated that some shareholders will exercise their conversion rights and some will not. (Reg. § 1.305-6(a)(2)).
  • A conversion period of only a few months at a price only slightly above market will likely result in taxable treatment.
• Rev. Rul. 76-258.
  • The IRS ruled that under § 305(b)(5), a distribution of convertible preferred stock is treated as a distribution of property to which § 301 applies unless it is established that the distribution will not result in a disproportionate distribution.
  • The rebuttable presumption can be overcome if the taxpayer demonstrates that the arrangement does not result in a disproportionate distribution, for example by showing that the preferred is fully convertible into common at the current market price and conversion is probable. (Rev. Rul. 76-258, 1976-2 C.B. 95).

Step 7. § 305(c) Deemed Distributions and Constructive Stock Dividends

"For purposes of this section and section 301, the Secretary shall prescribe regulations under which a change in conversion ratio, a change in redemption price, a difference between redemption price and issue price, a redemption which is treated as a distribution to which section 301 applies, or any transaction (including a recapitalization) having a similar effect on the interest of any shareholder shall be treated as a distribution with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change, difference, redemption, or similar transaction." (§ 305(c))

Step 7A. The § 305(c) Framework and Two-Prong Test

"In general, such change, difference, redemption, or similar transaction will be treated as a distribution to which sections 305(b) and 301 apply where (1) The proportionate interest of any shareholder in the earnings and profits or assets of the corporation deemed to have made such distribution is increased by such change, difference, redemption, or similar transaction; and (2) Such distribution has the result described in paragraph (2), (3), (4), or (5) of section 305(b)." (Reg. § 1.305-7(a))

• The two-prong test.
  • A change in conversion ratio, redemption price, or similar transaction is treated as a deemed distribution under § 305(c) only if both prongs are satisfied. (Reg. § 1.305-7(a))
  • Prong 1. The proportionate interest of any shareholder in the earnings and profits or assets of the corporation is increased by the change or transaction.
  • Prong 2. The distribution has the result described in § 305(b)(2), (3), (4), or (5).
• Covered transactions.
  • The regulations treat the following as potential deemed distributions. (Reg. § 1.305-7(a))
  • Changes in conversion ratio of convertible securities.
  • Changes in redemption price of stock.
  • Differences between redemption price and issue price (redemption premiums).
  • Redemptions treated as distributions to which § 301 applies.
  • Any recapitalization or other transaction having a similar effect on the interest of any shareholder.
• Deemed distribution mechanics.
  • Where a change or transaction is treated as a distribution under § 305(c), the distribution is deemed made with respect to any shareholder whose interest in the earnings and profits or assets of the distributing corporation is increased thereby.
  • The distribution is deemed to be a distribution of the stock of such corporation made by the corporation to such shareholder with respect to his stock. Depending on the facts, the deemed distribution may be in common or preferred stock. (Reg. § 1.305-7(a)).
• Anti-dilution safe harbor.
  • A change in the conversion ratio or conversion price of convertible preferred stock made pursuant to a bona fide, reasonable, adjustment formula (including "market price" or "conversion price" formulas) which has the effect of preventing dilution will NOT be considered to result in a deemed distribution. (Reg. § 1.305-7(b)(1))
  • Exception. An adjustment to compensate for cash or property distributions to other shareholders that are taxable under § 301, § 356(a)(2), § 871(a)(1)(A), § 881(a)(1), § 852(b), or § 857(b) is NOT considered as made pursuant to a bona fide adjustment formula. (Reg. § 1.305-7(b)(1))
  • EXAMPLE. Corporation U has class A and class B stock. Class B is convertible into class A. The conversion price is adjusted if the corporation transfers class A stock below the conversion price. Corporation U sells class A to the public below the conversion price. The conversion price is adjusted downward. Such change is NOT deemed to be a distribution under § 305(c). (Reg. § 1.305-7(b)(2))

Step 7B. Redemption Premium Constructive Distributions

• Mandatory redemption or holder put.
  • If a corporation issues preferred stock that may be redeemed under certain circumstances at a price higher than the issue price, the difference (the redemption premium) is treated under § 305(c) as a constructive distribution of additional stock on preferred stock. (Reg. § 1.305-5(b)(1))
  • This rule applies if the issuer is required to redeem at a specified time or the holder has an option to require redemption.
  • The rule does not apply if the obligation is subject to a contingency beyond the legal or practical control of the holder that renders remote the likelihood of redemption. A contingency does not include the possibility of default, insolvency, or similar circumstances. (Reg. § 1.305-5(b)(2))
• Issuer call.
  • The redemption premium rule also applies by reason of the issuer's right to redeem, but only if, based on all facts and circumstances as of the issue date, redemption pursuant to that right is more likely than not to occur. (Reg. § 1.305-5(b)(3)(i)).
  • Even if redemption is more likely than not, the rule does not apply if the redemption premium is solely in the nature of a penalty for premature redemption (a premium paid as a result of changes in economic or market conditions over which neither the issuer nor the holder has control). (Reg. § 1.305-5(b)(3)(i))
• The safe harbor for issuer calls.
  • Redemption pursuant to an issuer's call is not treated as more likely than not if ALL of the following are satisfied. (Reg. § 1.305-5(b)(3)(ii))
  • (A) The issuer and holder are not related within the meaning of § 267(b) or § 707(b) (with "20 percent" substituted for "50 percent").
  • (B) There are no plans, arrangements, or agreements that effectively require or are intended to compel the issuer to redeem (disregarding a separate mandatory redemption obligation).
  • (C) Exercise of the right to redeem would not reduce the yield of the stock, as determined under principles similar to § 1272(a).
  • The fact that a redemption right is not described in the safe harbor does not affect the determination of whether redemption is more likely than not to occur. (Reg. § 1.305-5(b)(3)(iii))
• De minimis exception.
  • Constructive distribution treatment does not result if the redemption premium does not exceed a de minimis amount, determined under the principles of § 1273(a)(3). (Reg. § 1.305-5(b)(1)).
  • The de minimis threshold under § 1273(a)(3) is one-fourth of 1 percent of the stated redemption price at maturity multiplied by the number of complete years to maturity.
• Consistency and issuer determination binding on holders.
  • The issuer's determination as to whether there is a constructive distribution is binding on all holders, except a holder that explicitly discloses that its determination differs.
  • The disclosure must be made on a statement attached to the holder's timely filed federal income tax return for the taxable year that includes the date the holder acquired the stock. (Reg. § 1.305-5(b)(5)).
• Coordination of multiple redemption provisions.
  • If stock may be redeemed at more than one time, the time and price at which redemption is most likely to occur must be determined.
  • Any constructive distribution results only with respect to that time and price. If redemption does not occur at the identified time, the additional premium payable on any later redemption date is treated as a constructive distribution over the period from the missed date to the later date. (Reg. § 1.305-5(b)(4)).
• EXAMPLE. Safe harbor application.
  • Corporation X issues 100 shares of 4% preferred (issue price $40) to unrelated shareholders.
  • Each share is convertible into 3 shares of common (worth $10 each, or $30 total). The stock is callable in 3 years for $100. No mandatory redemption exists and no plans compel redemption. Because calling the stock for $100 would not reduce the yield of the preferred stock, the safe harbor applies and the $60 per share call premium is NOT treated as a constructive distribution. (Reg. § 1.305-5(d), Example 4).
• EXAMPLE. Safe harbor fails due to control provision.
  • Corporation Y issues preferred stock callable at $105 (with $100 issue price), mandatorily redeemable at $100 in 2006.
  • If Y fails to call by 2001, the holder appoints a majority of directors. Because failure to call causes the holder to gain control, the safe harbor does not apply. Redemption is more likely than not by 2001. The $5 per share premium is treated as a constructive distribution over the 5-year period ending January 1, 2001, under principles similar to § 1272(a). The de minimis exception does not apply because $5 exceeds the § 1273(a)(3) amount ($1.31). (Reg. § 1.305-5(d), Example 5).

Step 7C. Recapitalizations and Conversion Ratio Adjustments

• Automatic deemed distributions in two scenarios.
  • A recapitalization (whether or not an isolated transaction) will be deemed to result in a distribution to which § 305(c) applies if either of the following conditions is met. (Reg. § 1.305-7(c)(1))
  • (i) It is pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits.
  • (ii) A shareholder owning preferred stock with dividends in arrears exchanges his stock for other stock and, as a result, increases his proportionate interest.
• Amount of deemed distribution in recapitalizations with dividend arrearages.
  • The amount of the deemed distribution is the lesser of. (Reg. § 1.305-7(c)(2))
  • (i) The amount by which the fair market value or liquidation preference (whichever is greater) of the stock received exceeds the issue price of the preferred surrendered.
  • (ii) The amount of dividends in arrears.
• Issue price for pre-1973 stock.
  • For stock issued before July 12, 1973, "issue price" means the greater of the issue price or the liquidation preference (not including dividends in arrears). (Reg. § 1.305-7(c)(3)).
  • This rule prevents issuers from manipulating the issue price metric for older securities to reduce the amount of any deemed distribution.
• Isolated recapitalizations without arrearages generally NOT deemed distributions.
  • A recapitalization that is an isolated transaction, does not involve dividend arrearages, and is not pursuant to a plan to periodically increase interests will generally not be treated as a deemed distribution under § 305(c). (Reg. § 1.305-7(c)) (Reg. § 1.305-5(d), Example 2).
  • EXAMPLE. Corporation A recapitalizes and each share of preferred (convertible into 0.75 shares of common, issue price $100) is exchanged for one share of common (FMV $110). No dividend arrearages exist and no plan exists to periodically increase interests. The recapitalization is NOT deemed a distribution under § 305(c). (Reg. § 1.305-5(d), Example 2)
• Rev. Rul. 75-513.
  • A REIT paid a cash dividend to common shareholders. As a result, the conversion ratio of outstanding convertible debentures was increased. The IRS ruled that the increase in the conversion ratio constituted a deemed distribution of shares to the debenture holders under §§ 305(b)(2) and 305(c). The anti-dilution exception did not apply because the adjustment compensated for a taxable cash distribution. (Rev. Rul. 75-513, 1975-2 C.B. 114)
  • The debenture holders were treated as shareholders under § 305(d)(2).
  • The amount of the deemed distribution was the fair market value of the additional shares made available by the adjustment.
• Proposed regulations on amount and timing.
  • The 2016 proposed regulations (REG-133673-15, 81 Fed. Reg. 21280 (April 13, 2016)) confirm that conversion ratio adjustments triggered by taxable cash dividends result in deemed distributions under §§ 305(b)(2) and 305(c).
  • The proposed regulations provide that the amount equals the excess of the option value immediately after the adjustment over the option value without the adjustment, and the timing is the earlier of the adjustment effective date or the ex-dividend date.
  • This guidance reinforces the holding of Rev. Rul. 75-513 with detailed computational rules. (REG-133673-15, 81 Fed. Reg. 21280 (2016)).
• Rev. Rul. 77-37.
  • A corporation made a distribution that qualified as tax-free under § 355 (spin-off). The convertible securities' conversion ratio was adjusted to reflect the spin-off. The IRS ruled that no deemed distribution arose under § 305(c) because the anti-dilution exception of Reg. § 1.305-7(b)(1) applied. The distribution to actual shareholders was tax-free under § 355, not taxable under § 301. (Rev. Rul. 77-37, 1977-1 C.B. 85).
  • This ruling illustrates that conversion ratio adjustments made to reflect tax-free transactions are generally protected by the anti-dilution safe harbor.
• Rev. Rul. 76-186.
  • Following Rev. Rul. 75-513, the IRS ruled that the basis of the convertible debentures is increased by the value of the deemed distribution. (Rev. Rul. 76-186, 1976-1 C.B. 86)
  • § 301(d) provides that the basis of property received in a § 301 distribution is its FMV. For a deemed distribution under § 305(c), the holder's basis in the convertible security is increased by the amount includible in income.
  • This basis increase is particularly important for domestic investors but provides no U.S. tax benefit to foreign holders who are generally not subject to U.S. capital gains tax.

Step 7D. Periodic Redemptions and Isolated Redemption Exception

• Periodic redemption plans trigger deemed distributions.
  • When a corporation implements a plan for periodic redemptions of stock and the redemptions are treated as § 301 distributions to the redeemed shareholders, the non-redeemed shareholders who experience an increase in their proportionate interests are deemed to have received stock distributions under § 305(b)(2) via § 305(c). (Reg. § 1.305-3(e), Examples 8-9) (Rev. Rul. 78-60)
  • The deemed distribution is measured by the FMV of the shares that would have been distributed to produce the same proportionate interest increase.
  • In computing additional shares deemed distributed, the redemption itself is disregarded. The value of each share deemed distributed is determined by dividing the deemed outstanding shares into the aggregate FMV of actual shares outstanding after redemption. (Reg. § 1.305-3(e), Example 8)
• EXAMPLE. Periodic redemption plan computation.
  • Corporation T has 1,000 shares outstanding.
  • C owns 100 shares. Nine other shareholders each own 100 shares. T redeems up to 5% of each shareholder's stock each year. During the year, each of the nine other shareholders has 5 shares redeemed for cash. C's proportionate interest increases from 10% to 10.47%. Assuming the cash received is taxable under § 301, C is deemed under § 305(c) to have received a distribution under § 305(b)(2) of 5.25 shares of T stock to which § 301 applies. The amount is measured by the FMV of the number of shares that would have been distributed to increase C's interest by 0.47 percentage points. (Reg. § 1.305-3(e), Example 8).
• EXAMPLE. Earnings-based redemption program.
  • Corporation O offers to distribute $10,000 in redemption.
  • E and F each own 150 shares. G and H each own 350 shares. O redeems 15 shares from E and 35 shares from G. F and H continue to hold all their stock. F and H have increased their proportionate interests. F is deemed to have received 16.66 shares of stock to which § 301 applies. H is deemed to have received 38.86 shares of stock to which § 301 applies. (Reg. § 1.305-3(e), Example 9).
• Isolated redemptions do NOT trigger § 305(c) deemed distributions.
  • An isolated redemption (for example, pursuant to a tender offer) will not cause § 305(b)(2) to apply even though the redemption distribution is treated as a distribution of property to which § 301 applies. (Reg. § 1.305-3(b)(3)) (Reg. § 1.305-3(e), Example 10).
  • EXAMPLE. Corporation P redeems 150 shares of T's stock in a single and isolated redemption. G (the other shareholder) is NOT treated as having received a deemed distribution under § 305(c), even though G has an increased proportionate interest, because this is an isolated redemption and not part of a periodic redemption plan. (Reg. § 1.305-3(e), Example 10)
• Rev. Rul. 78-60.
  • A closely held corporation had a plan for periodic small redemptions by shareholders. The IRS ruled that the redemptions were treated as § 301 dividend distributions to the redeeming shareholders because no § 302(b) exception applied. The remaining shareholders who experienced small percentage increases were deemed to have received stock distributions under § 305(b)(2) via § 305(c). (Rev. Rul. 78-60, 1978-1 C.B. 81)
  • This ruling is critical for closely held corporations with redemption plans. If redemptions are part of a periodic plan and do not qualify under § 302(b), both the redeemed and non-redeemed shareholders may have adverse tax consequences.
  • Consider structuring redemptions to qualify as isolated transactions or to satisfy § 302(b)(2) or (b)(3).
• TRAP. Non-redeemed shareholders in periodic plans have constructive dividend income without receiving cash.
  • The deemed distribution to non-redeemed shareholders is taxable as a dividend to the extent of E&P, but the shareholders receive no cash with which to pay the tax.
  • This creates a classic "phantom income" problem in closely held corporations. (Reg. § 1.305-3(e), Example 8).

Step 8. The § 301 Waterfall When § 305(b) Applies

"Except as otherwise provided in this chapter, a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c)." (§ 301(a))

"For purposes of this section, the amount of any distribution shall be the amount of money received, plus the fair market value of the other property received." (§ 301(b)(1))

"For purposes of this section, fair market value shall be determined as of the date of the distribution." (§ 301(b)(3))

"(1) That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income. (2) That portion of the distribution which is not a dividend shall be applied against and reduce the adjusted basis of the stock. (3) That portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis of the stock, shall be treated as gain from the sale or exchange of property." (§ 301(c)(1)-(3)(A))

• The default § 301 treatment.
  • When any § 305(b) exception applies, the stock distribution is treated as a distribution of property to which § 301 applies. (§ 305(b)) (§ 301(a))
  • The amount of the distribution is the fair market value of the stock or rights on the date of distribution. (Reg. § 1.305-1(b)(1)) (§ 301(b)(1)) (§ 301(b)(3))
  • For RICs, the amount equals the cash that could have been received instead. (Reg. § 1.305-1(b)(2))
• The § 301(c) waterfall applied to taxable stock dividends.
  • The distribution is taxed in three tiers. (§ 301(c))
  • Tier 1. Dividend income. That portion of the distribution which is a dividend as defined in § 316 is included in gross income. (§ 301(c)(1))
  • Tier 2. Return of capital. That portion which is not a dividend is applied against and reduces the adjusted basis of the shareholder's stock. (§ 301(c)(2))
  • Tier 3. Capital gain. Any excess over the adjusted basis of the stock is treated as gain from the sale or exchange of property. (§ 301(c)(3)(A))
• Basis in taxable stock dividends equals FMV.
  • When § 305(b) applies and the distribution is taxable, the shareholder's basis in the stock received is its fair market value at distribution under § 301(d). (§ 301(d))
  • § 307 does NOT apply when § 305(b) makes the distribution taxable. The shareholder does not allocate basis from old stock.
  • TRAP. Do not apply the § 307(a) allocation formula to a taxable stock dividend. The basis is FMV, not a ratable share of the old stock's basis.
• No holding period tacking.
  • § 1223(5) (tacking of holding period for nontaxable stock dividends) does NOT apply to taxable stock dividends under § 305(b). The holding period of stock received in a taxable distribution begins on the date of distribution. (§ 1223(5)).
  • This affects whether gain on a subsequent sale qualifies for long-term capital gains treatment and whether dividends qualify for the preferential rates under § 1(h)(11).
• RIC exception to FMV measurement.
  • Where a regulated investment company declares a dividend pursuant to which shareholders may elect to receive either money or stock of equivalent value, the amount of the stock distribution is considered to equal the amount of the money which could have been received instead. (Reg. § 1.305-1(b)(2)).
  • This special rule simplifies valuation for publicly traded RIC shares.

Step 9. § 316 Earnings and Profits Analysis

"For purposes of this subtitle, the term 'dividend' means any distribution of property made by a corporation to its shareholders (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." (§ 316(a))

"Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits." (§ 316(a))

• Current E&P computed at year-end without reduction for distributions.
  • Current earnings and profits are computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year. (§ 316(a)(2))
  • A corporation may have negative E&P at the time of a mid-year distribution but generate sufficient current E&P by year-end to characterize the distribution as a dividend.
  • This creates potential surprises for mid-year distributions. A corporation that appears to have no E&P at the distribution date may retroactively create dividend treatment.
• Ordering rule. Current E&P first, then accumulated E&P (LIFO).
  • Every distribution is deemed made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. (§ 316(a))
  • First, distributions are treated as dividends to the extent of current E&P for the taxable year.
  • Second, to the extent distributions exceed current E&P, they are treated as dividends to the extent of accumulated E&P (from the most recent years first).
  • Third, any remaining distribution is a return of capital (basis reduction) and then capital gain.
• Taxable stock dividends reduce E&P by FMV.
  • When a stock distribution is taxable under § 305(b), the corporation reduces earnings and profits by the fair market value of the stock or rights distributed. (Reg. § 1.312-1(d)) (§ 312(d)(1)(A)).
  • This E&P reduction applies even though the corporation distributed its own stock and not cash.
• Nontaxable stock dividends do NOT reduce E&P.
  • A distribution of the corporation's own stock or securities that is not subject to tax by reason of § 305(a) is NOT considered a distribution of earnings and profits. (§ 312(d)(1)(B)).
  • Rationale. Because the shareholder pays no tax, there is no reason to reduce the corporation's E&P account.
• § 306(c)(2) escape hatch.
  • The term "section 306 stock" does not include any stock no part of the distribution of which would have been a dividend at the time of the distribution if money had been distributed in lieu of the stock. (§ 306(c)(2))
  • If the corporation had no current or accumulated E&P at the time of the nontaxable stock dividend, the preferred stock distributed is NOT § 306 stock.
  • This is often the first question to ask when analyzing whether preferred stock received in a purportedly tax-free distribution carries the § 306 taint.
• EXAMPLE. Current E&P surprise.
  • Corporation X has an accumulated E&P deficit of $500,000 on January 1.
  • On June 30, X distributes taxable stock with an FMV of $200,000 to its shareholders. At June 30, X has negative E&P of $400,000. By December 31, however, X generates $300,000 of current E&P. Under § 316(a)(2), the $200,000 distribution is treated as a dividend to the extent of current E&P ($300,000). The entire $200,000 distribution is dividend income to the shareholders, even though X had negative E&P on the distribution date.

Step 10. § 307 Basis Allocation for Nontaxable Stock Distributions

"If a shareholder in a corporation receives its stock or rights to acquire its stock (referred to in this subsection as 'new stock') in a distribution to which section 305(a) applies, then the basis of such new stock and of the stock with respect to which it is distributed (referred to in this section as 'old stock'), respectively, shall, in the shareholder's hands, be determined by allocating between the old stock and the new stock the adjusted basis of the old stock. Such allocation shall be made under regulations prescribed by the Secretary." (§ 307(a))

Step 10A. § 307(a) General Allocation Rule

"If a shareholder receives stock or stock rights as a distribution on stock previously held and under section 305 such distribution is not includible in gross income then, except as provided in section 307(b) and § 1.307-2, the basis of the stock with respect to which the distribution was made shall be allocated between the old and new stocks or rights in proportion to the fair market values of each on the date of distribution." (Reg. § 1.307-1(a))

• Proportionate FMV allocation.
  • When a shareholder receives stock or stock rights in a distribution that is not includible in gross income under § 305(a), the adjusted basis of the old stock is allocated between the old stock and the new stock or rights in proportion to their fair market values on the date of distribution. (§ 307(a)) (Reg. § 1.307-1(a))
  • Basis of old stock equals (FMV of old stock divided by total FMV) multiplied by adjusted basis of old stock.
  • Basis of new stock equals (FMV of new stock divided by total FMV) multiplied by adjusted basis of old stock.
• Distribution date controls, not record date.
  • The date of distribution is the date the stock or rights are distributed to the stockholder, not the record date. (Reg. § 1.307-1(a)).
  • This distinction matters when the record date and distribution date fall in different taxable years or when market prices fluctuate between the two dates.
• Rights allocation applies only if rights are exercised or sold.
  • The general basis allocation rule applies with respect to stock rights only if such rights are exercised or sold. (Reg. § 1.307-1(a)).
  • If rights are allowed to expire unexercised and unsold, no basis allocation to the rights occurs and the basis remains with the old stock.
• Partially taxable distributions.
  • If pursuant to § 305 part of the distribution is not includible in gross income, the basis of the stock with respect to which the distribution is made is allocated between (1) the old stock and (2) that part of the new stock or rights which is not includible in gross income, in proportion to the fair market values of each on the date of distribution. (Reg. § 1.307-1(a)).
  • No basis is allocated to the taxable portion of the distribution. The taxable portion takes a basis equal to its FMV under § 301(d).
• EXAMPLE. Basis allocation formula.
  • A taxpayer purchased 100 shares of common stock at $100 per share ($10,000 total basis).
  • The taxpayer acquired 100 rights to subscribe to 100 additional shares at $90 per share. Immediately after issuance, the old stock (ex-rights) was worth $110 per share ($11,000 total FMV) and the rights were worth $19 each ($1,900 total FMV). Total FMV is $12,900. Basis allocated to old stock equals ($11,000 / $12,900) multiplied by $10,000, or $8,527.13. Basis allocated to rights equals ($1,900 / $12,900) multiplied by $10,000, or $1,472.87. If rights are exercised, basis of new stock equals subscription price ($90) plus basis of rights exercised ($14.73), or $104.73 per share. If rights are sold, basis for gain or loss equals $14.73 per right. (Reg. § 1.307-1(b)).

Step 10B. § 307(b) Stock Rights and the 15-Percent Election

"If (A) a corporation distributes rights to acquire its stock to a shareholder in a distribution to which section 305(a) applies, and (B) the fair market value of such rights at the time of the distribution is less than 15 percent of the fair market value of the old stock at such time, then subsection (a) shall not apply and the basis of such rights shall be zero, unless the taxpayer elects under paragraph (2) of this subsection to determine the basis of the old stock and of the stock rights under the method of allocation provided in subsection (a)." (§ 307(b)(1))

"The election referred to in paragraph (1) shall be made in the return filed within the time prescribed by law (including extensions thereof) for the taxable year in which such rights were received. Such election shall be made in such manner as the Secretary may by regulations prescribe, and shall be irrevocable when made." (§ 307(b)(2))

• The 15-percent de minimis default.
  • If the fair market value of stock rights distributed is less than 15% of the fair market value of the old stock on the date of distribution, the basis of the rights is zero unless the shareholder elects to allocate basis under § 307(a). (§ 307(b)(1)) (Reg. § 1.307-2)
  • If the rights are worthless or nearly worthless relative to the stock, the default zero-basis rule simplifies record-keeping.
  • If the rights are valuable but still under 15% of the stock value, electing to allocate basis may be advantageous.
• The election mechanics.
  • The election is made by attaching a statement to the shareholder's timely filed return (including extensions) for the taxable year in which the rights were received. (§ 307(b)(2)) (Reg. § 1.307-2)
  • The election must be made with respect to all the rights received in a particular distribution in respect of all the stock of the same class owned in the issuing corporation at the time of distribution. It is an all-or-nothing election. (Reg. § 1.307-2)
  • The election, once made, is irrevocable with respect to the rights for which the election was made. (§ 307(b)(2))
  • The shareholder must retain a copy of the election and the tax return to substantiate the allocated basis upon subsequent disposition of stock acquired by exercise. (Reg. § 1.307-2)
• No election needed when rights FMV is 15% or more.
  • If the fair market value of the rights is 15% or more of the fair market value of the old stock, § 307(a) applies automatically and basis must be allocated between the old stock and the rights.
  • No election is necessary. (Reg. § 1.307-2).
• TRAP. Failure to elect when rights are valuable.
  • If rights with an FMV of less than 15% of the stock are later sold at a gain or exercised and the resulting stock is sold, the shareholder who failed to elect basis allocation may have artificially high gain (because the rights had zero basis) or may have lost the opportunity to claim a loss if the rights expire. (Reg. § 1.307-2).
  • EXAMPLE. Corporation X distributes rights to its common shareholders. Each right entitles the holder to purchase one additional share at $50. The old stock trades at $55 ex-rights. The rights trade at $4 each. The rights FMV ($4) is less than 15% of the stock FMV ($55 multiplied by 0.15 equals $8.25). The default basis of the rights is zero. If the shareholder sells the rights for $4 each, the entire $4 is gain. If the shareholder had elected basis allocation, a portion of the old stock basis would shift to the rights, reducing the gain on sale.

Step 11. § 306 Preferred Stock Bailout Rules

"If such disposition is not a redemption (within the meaning of section 317(b)) (A) The amount realized shall be treated as ordinary income. This subparagraph shall not apply to the extent that (i) the amount realized, exceeds (ii) such stock's ratable share of the amount which would have been a dividend at the time of distribution if (in lieu of section 306 stock) the corporation had distributed money in an amount equal to the fair market value of the stock at the time of distribution. (B) Any excess of the amount realized over the sum of (i) the amount treated under subparagraph (A) as ordinary income, plus (ii) the adjusted basis of the stock, shall be treated as gain from the sale of such stock. (C) No loss shall be recognized. (D) Treatment as dividend. For purposes of section 1(h)(11) and such other provisions as the Secretary may specify, any amount treated as ordinary income under this paragraph shall be treated as a dividend received from the corporation." (§ 306(a)(1))

Step 11A. Definition of § 306 Stock

• Category A. Preferred stock distributed in a nontaxable § 305(a) distribution.
  • § 306 stock means stock (other than common stock issued with respect to common stock) which was distributed to the shareholder selling or otherwise disposing of such stock if, by reason of § 305(a), any part of such distribution was not includible in the gross income of the shareholder. (§ 306(c)(1)(A))
  • This is the classic preferred stock bailout scenario. Common stock issued with respect to common stock is expressly excluded from § 306 stock.
  • If any part of the distribution was nontaxable under § 305(a), the preferred stock received is § 306 stock.
• Category B. Non-common stock received in a reorganization with stock-dividend effect.
  • § 306 stock includes stock which is not common stock and which was received in pursuance of a plan of reorganization within the meaning of § 368(a), or in a distribution or exchange to which § 355 applied, but only to the extent that either the effect of the transaction was substantially the same as the receipt of a stock dividend, or the stock was received in exchange for § 306 stock. (§ 306(c)(1)(B)).
  • This prevents taxpayers from avoiding § 306 by routing the preferred stock through a tax-free reorganization.
• Category C. Transferred or substituted basis stock.
  • § 306 stock includes stock the basis of which in the hands of the shareholder disposing of such stock is determined by reference to the basis of § 306 stock held by such shareholder or any other person. (§ 306(c)(1)(C))
  • Under this rule, common stock can become § 306 stock if its basis derives from § 306 stock (for example, in a § 351 transfer or by gift).
  • The § 306 taint carries over to transferees by gift and in certain tax-free exchanges.
• The E&P escape hatch.
  • The term "section 306 stock" does not include any stock no part of the distribution of which would have been a dividend at the time of the distribution if money had been distributed in lieu of the stock. (§ 306(c)(2))
  • If the corporation had no current or accumulated E&P at the time of the nontaxable distribution, the stock is NOT § 306 stock.
  • This is often the first question to ask when a client presents preferred stock received in a purportedly tax-free distribution.
• § 351 exchanges.
  • The term "section 306 stock" also includes any stock which is not common stock acquired in an exchange to which § 351 applied if receipt of money in lieu of the stock would have been treated as a dividend to any extent. (§ 306(c)(3)).
  • This extends the § 306 taint to non-common stock received in a § 351 exchange.
• Stock rights treated as stock.
  • For purposes of § 306, stock rights are treated as stock, and stock acquired through the exercise of stock rights is treated as stock distributed at the time of the distribution of the stock rights, to the extent of the fair market value of such rights at the time of the distribution. (§ 306(d)).
  • The basis of stock acquired by exercising § 306 rights includes the fair market value of the rights at distribution plus any amount paid on exercise.
• § 306(e) conversion rule.
  • If § 306 stock was issued with respect to common stock and later such § 306 stock is exchanged for common stock in the same corporation (whether by conversion privilege or otherwise), the common stock so received shall not be treated as § 306 stock. (§ 306(e)(1)).
  • However, common stock with respect to which there is a privilege of converting into stock other than common (or into property) is not treated as common stock for § 306 purposes. (§ 306(e)(2))
• Substantial change in terms.
  • If a substantial change is made in the terms and conditions of any stock, the fair market value of such stock and its ratable share of the hypothetical dividend amount are determined as of the time of distribution or the time of such change, whichever value is higher. (§ 306(g)).
  • This prevents taxpayers from manipulating stock terms to reduce the § 306 ordinary income amount.

Step 11B. § 306(a) Ordinary Income on Disposition

• Ordinary income on sale.
  • If § 306 stock is sold or otherwise disposed of (not by redemption), the amount realized is treated as ordinary income, capped at the stock's ratable share of the amount which would have been a dividend if money equal to the stock's FMV at distribution had been distributed instead. (§ 306(a)(1)(A)).
  • The ordinary income cap is the stock's ratable share of the E&P that would have been distributed if cash equal to FMV had been distributed at the time of the original stock distribution.
• Gain treatment for excess.
  • Any excess of the amount realized over the sum of (1) the amount treated as ordinary income plus (2) the adjusted basis of the stock is treated as gain from the sale of such stock. (§ 306(a)(1)(B)).
  • This excess gain is capital gain, not ordinary income.
• No loss recognized.
  • No loss is recognized on the disposition of § 306 stock. (§ 306(a)(1)(C)).
  • If the amount realized is less than the stock's basis, the loss is not recognized.
• Qualified dividend income treatment.
  • Any amount treated as ordinary income under § 306(a)(1)(A) is treated as a dividend for purposes of § 1(h)(11). (§ 306(a)(1)(D))
  • This means the ordinary income amount may qualify for the 0%, 15%, or 20% qualified dividend rate rather than ordinary income rates.
  • This taxpayer-favorable provision was added by the Jobs and Growth Tax Relief Reconciliation Act of 2003.
• Redemption treated as § 301 distribution.
  • If the disposition is a redemption within the meaning of § 317(b), the amount realized is treated as a distribution of property to which § 301 applies. (§ 306(a)(2)).
  • The redemption is tested under the § 301(c) waterfall (dividend to extent of E&P, then return of capital, then capital gain).
• Fireoved v. United States.
  • The Third Circuit held that the stock dividend and redemption were part of a plan having as one of its principal purposes the avoidance of Federal income tax. The court rejected the argument that the business purpose of the merger insulated the transaction from § 306 treatment, holding that even if one purpose was business-related, another principal purpose could be tax avoidance. (Fireoved v. United States, 462 F.2d 1281 (3d Cir. 1972))
  • The court established a high burden of proof on the taxpayer to demonstrate that tax avoidance was not a principal purpose.
  • The court also rejected a strict FIFO approach for mixed holdings of § 306 and non-§ 306 stock in favor of a pro rata allocation.
• Bialo v. Commissioner.
  • The Tax Court held that the preferred stock was § 306 stock and that the distribution and redemption were part of a plan having as one of their principal purposes the avoidance of federal income tax. The court relied heavily on a memorandum prepared by the petitioner's accountant which explicitly outlined the tax-avoidance purpose, calling it "a smoking gun." (Bialo v. Commissioner, 88 T.C. 1132 (1987))
  • The charitable contribution deduction was limited to the stock's adjusted basis under § 170(e)(1)(A) rather than its fair market value.
  • This case is a stark reminder of the importance of careful documentation and the attorney-client privilege.

Step 11C. § 306(b) Exceptions

• Termination of entire interest (non-redemption sale).
  • § 306(a) does not apply if the disposition is not a redemption, is not directly or indirectly to a person the ownership of whose stock would be attributable to the shareholder under § 318(a), and terminates the entire stock interest of the shareholder in the corporation. (§ 306(b)(1)(A))
  • § 318(a) applies for this termination test. Family attribution includes spouse, children, grandchildren, and parents.
  • The shareholder must completely sever all equity ties to the corporation, taking attribution into account.
• Complete termination or partial liquidation redemption.
  • § 306(a) does not apply if the disposition is a redemption to which § 302(b)(3) (complete termination) or § 302(b)(4) (partial liquidation) applies. (§ 306(b)(1)(B)).
  • The redemption must independently satisfy the requirements of § 302(b)(3) or (b)(4), tested with § 318 attribution.
• Complete liquidation.
  • § 306(a) does not apply if the § 306 stock is redeemed in a distribution in complete liquidation to which Part II (§ 331 and following) applies. (§ 306(b)(2)).
  • This exception aligns with the general principle that § 306 should not interfere with the ordinary tax consequences of a complete liquidation under § 331.
• Nonrecognition transactions.
  • § 306(a) does not apply to the extent that under any provision of the subtitle gain or loss to the shareholder is not recognized with respect to the disposition of the § 306 stock. (§ 306(b)(3)).
  • The § 306 taint carries over to the stock received in the nonrecognition transaction under § 306(c)(1)(C).
• Not in avoidance of tax.
  • § 306(a) does not apply if it is established to the satisfaction of the Secretary that the distribution and the disposition or redemption (or the disposition of the § 306 stock alone) was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax. (§ 306(b)(4))
  • The burden of proof is on the taxpayer.
  • This exception is extremely difficult to satisfy when there is direct evidence of a tax-avoidance motive, such as a written memorandum from an advisor. (Bialo v. Commissioner, 88 T.C. 1132 (1987))
• CAUTION. § 306 taint can last indefinitely.
  • Once stock is classified as § 306 stock, it retains that classification through subsequent transfers by gift, in estate, and in certain tax-free exchanges.
  • The basis rules in § 306(c)(1)(C) ensure the taint propagates to substituted-basis transferees. A client who receives preferred stock in a "tax-free" stock dividend may face ordinary income treatment decades later upon sale.

Step 12. Anti-Abuse Doctrines and Step-Transaction Risk

• The step-transaction doctrine.
  • Courts treat a series of formally separate steps as a single integrated transaction if the steps are in substance integrated, interdependent, and focused toward a particular result. The doctrine applies when a taxpayer seeks to get from point A to point D by taking otherwise unnecessary steps at points B and C to achieve tax consequences different from those a direct path would have produced. (Commissioner v. Clark, 489 U.S. 726, 738 (1989)) (Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938))
  • Three tests exist and courts apply whichever is most appropriate. Only one needs to be satisfied.
  • Binding commitment test. At the time the first step was entered into, there was a binding commitment to complete all later steps. (Commissioner v. Gordon, 391 U.S. 83, 96 (1968))
  • Mutual interdependence test. The steps are so interdependent that the legal relations created by one step would have been fruitless without completion of the entire series. (Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir. 1980)) (Barnes Group Inc. v. Commissioner, T.C. Memo. 2013-109)
  • End result (intent) test. A series of formally separate steps are really component parts of a single transaction intended from the outset to reach the ultimate result. (King Enterprises, Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969))
• Barnes Group Inc. v. Commissioner.
  • Barnes Group implemented a "Reinvestment Plan" to move excess cash from a profitable Singapore subsidiary to the U.S. parent through multi-step § 351 exchanges involving two newly formed corporations. The Tax Court, applying the mutual interdependence test, collapsed the multi-step exchanges and recharacterized the transaction as taxable dividend payments from the subsidiary to the parent. The court found no valid and independent economic or business purpose for including the intermediate entities and imposed § 6662(a) accuracy-related penalties. (Barnes Group Inc. v. Commissioner, T.C. Memo. 2013-109)
  • The court rejected Barnes' reliance on Rev. Rul. 74-503 because the substance of the Reinvestment Plan was a dividend.
  • This case demonstrates that multi-step transactions designed to characterize what is economically a stock distribution or dividend as something else are prime targets for step-transaction recharacterization.
• Gregory v. Helvering.
  • Evelyn Gregory caused a new corporation to be organized, had her existing corporation transfer subsidiary shares to the new corporation in exchange for new corporation stock, and immediately dissolved the new corporation to distribute the subsidiary shares to herself. The entire transaction took three days and no other business was ever transacted. The Supreme Court held that the transaction, though technically meeting the literal language of the reorganization statute, was "without substance" and must be disregarded because it was a mere device to distribute earnings without dividend treatment. (Gregory v. Helvering, 293 U.S. 465 (1935))
  • The Court stated that "the transaction upon its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose."
  • This case is the foundational business purpose doctrine precedent.
• The economic substance doctrine (§ 7701(o)).
  • The doctrine requires a two-prong conjunctive test, both of which must be satisfied. (§ 7701(o)(1))
  • Prong 1. The transaction changes in a meaningful way (apart from Federal, State, and local income tax effects) the taxpayer's economic position. (§ 7701(o)(1)(A))
  • Prong 2. The taxpayer has a substantial purpose (apart from Federal, State, and local income tax effects) for entering into the transaction. (§ 7701(o)(1)(B))
  • The potential for profit is taken into account in determining whether both prongs are satisfied. (§ 7701(o)(2)(A))
  • Achieving a financial accounting benefit is not taken into account as a purpose if the origin of such benefit is a reduction of Federal income tax. (§ 7701(o)(4))
• Penalties for transactions lacking economic substance.
  • A transaction lacking economic substance triggers a 20% accuracy-related penalty under § 6662(b)(6). A nondisclosed non-economic-substance transaction triggers a 40% penalty under § 6662(i). (§ 6662(b)(6)) (§ 6662(i))
  • Critical point. A reasonable cause exception may not be asserted for a transaction lacking economic substance. (§ 6664(c)(2))
  • Reliance on professional advice or a tax opinion does not protect against the penalty.
• Substance over form in stock distributions.
  • Courts may recharacterize a transaction based on its economic reality rather than its formal structure.
  • Stock distributions that may trigger recharacterization include a distribution characterized as a stock dividend that is economically a cash dividend, a stock distribution that is a disguised sale of assets, and transactions using intermediary entities to convert a taxable dividend into a tax-favored form. (Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Tex. 2007)) (TIFD-III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006)).
• TRAP. Prearranged sale of stock dividend stock triggers step-transaction.
  • If a corporation declares a nontaxable stock dividend and the shareholders have a prearranged plan to sell the dividend stock to a third party, the IRS may collapse the steps and treat the transaction as a taxable distribution of property followed by a sale.
  • To avoid this, each step must have independent economic substance and a valid business purpose, and the steps must not be mutually interdependent. (Fireoved v. United States, 462 F.2d 1281 (3d Cir. 1972)) (Chamberlin v. Commissioner, 207 F.2d 462 (6th Cir. 1953)).

Step 13. Documentation, Reporting, and Compliance Obligations

• Form 1099-DIV filing requirements.
  • Any person (including corporations, partnerships, and brokers) who pays dividends or other distributions on stock of $10 or more in money or other property must file Form 1099-DIV. (Instructions for Form 1099-DIV (Rev. January 2024))
  • Taxable stock dividends under § 305(b) are reported as dividends in Box 1a of Form 1099-DIV at their fair market value on the distribution date.
  • Nontaxable § 305(a) stock dividends are generally NOT reported on Form 1099-DIV because they are not taxable income.
  • Qualified dividends eligible for reduced capital gains rates are reported in Box 1b, subject to the holding period requirements.
  • Nondividend distributions (return of capital) are reported in Box 3.
• Form 5452 corporate report of nondividend distributions.
  • All corporations that have made nondividend distributions to their shareholders must file Form 5452. (Form 5452 Instructions (Rev. October 2018))
  • The corporation must attach an E&P computation for the tax year, including a schedule of differences from Schedule M-1 or M-3.
  • The corporation must attach a year-by-year computation of accumulated E&P since February 28, 1913.
  • For calendar year corporations, Form 5452 is attached to the income tax return for the tax year in which the nondividend distributions were made.
• S corporation dividend reporting.
  • An S corporation reports dividends paid from accumulated earnings and profits on Form 1099-DIV, NOT on Schedule K-1. (Instructions for Form 1120-S, Line 17c)
  • "Enter total dividends paid to shareholders from accumulated earnings and profits. Report these dividends to shareholders on Form 1099-DIV. Don't report them on Schedule K-1." (Instructions for Form 1120-S)
  • Distributions from the accumulated adjustments account are reported on Schedule K-1 Box 16, Code D.
• ASC 260 EPS restatement for stock dividends and stock splits.
  • If the number of common shares outstanding increases as a result of a stock dividend or stock split, the computations of basic and diluted EPS shall be adjusted retroactively for all periods presented to reflect that change in capital structure. (ASC 260-10-55-12)
  • This retroactive adjustment is required even for stock dividends declared but not paid until after the balance sheet date.
  • The fact that per-share computations reflect changes in shares from a stock dividend must be disclosed, including the retroactive treatment and the effective date.
• § 307(b) election documentation.
  • The election to allocate basis to stock rights under § 307(b)(2) must be made by attaching a statement to the shareholder's timely filed return for the year in which the rights were received. (§ 307(b)(2)) (Reg. § 1.307-2)
  • The shareholder must retain a copy of the election and the tax return to substantiate the allocated basis upon subsequent disposition.
  • Failure to retain this documentation may result in the IRS disallowing the basis allocation and defaulting the rights basis to zero.
• Form 8937 for § 305(c) deemed distributions.
  • Under the 2016 proposed regulations (REG-133673-15, 81 Fed. Reg. 21280 (April 13, 2016)), issuers must file Form 8937 (Report of Organizational Actions Affecting Basis of Securities) for deemed distributions from conversion ratio adjustments and other § 305(c) transactions, even if all holders are exempt recipients.
  • The deemed distribution amount equals the excess of the FMV of the right to acquire stock immediately after the adjustment over the FMV of such right without the adjustment.
  • Withholding agents must withhold on deemed distributions to foreign holders. The obligation accrues on the earliest of (a) a cash payment on the security, (b) sale or disposition of the security, or (c) the Form 1042 due date for the calendar year.
• Withholding on § 305(c) deemed distributions to foreign holders.
  • Deemed distributions are FDAP income subject to 30% gross withholding under § 1441, reducible by treaty. (§ 1441) (2016 Proposed Reg. REG-133673-15)
  • No cash is received by the foreign holder, creating a "cashless withholding" problem.
  • The 2016 proposed regulations impose withholding obligations on custodians and brokers.
• TRAP. DRIPs with below-market discounts trigger § 305(b)(2).
  • Shareholders participating in a dividend reinvestment plan with optional cash purchases at below-market prices are treated as receiving a distribution under § 305(b)(2) to the extent the FMV of the shares exceeds the purchase price. (Rev. Rul. 78-375, 1978-2 C.B. 130)
  • The reinvestment of cash dividends in additional stock under a DRIP triggers § 305(b)(1) because shareholders have an election to receive stock instead of cash.
  • The 5% discount safe harbor of Rev. Rul. 83-117, 1983-2 C.B. 98 applies to certain REIT DRIPs. If the discount is minimal and approximates issuance costs, the distribution may still qualify for the dividends paid deduction.
• State tax conformity.
  • California updated its general IRC conformity date to January 1, 2025 via Senate Bill 711, effective for tax years beginning on or after January 1, 2025. (FTB Summary of Federal Income Tax Changes)
  • California generally conforms to federal Subchapter C provisions including §§ 301 through 318, so nontaxable stock dividends under § 305(a) are likewise nontaxable for California purposes.
  • New York does not provide a preferential tax rate for qualified dividends at the state level. While federal law taxes qualified dividends at 0%, 15%, or 20% under § 1(h)(11), New York taxes dividend income as ordinary income at the applicable state tax rate. (Russell Investments, New York State Taxes -- What You Need To Know (July 2022))
  • If a stock dividend is taxable under federal § 305(b), it is included in New York entire net income and taxed at ordinary state corporate rates.