Corporate Tax | Just Tax

Tainted Preferred Stock (§ 306)

This checklist analyzes whether stock is § 306 stock and computes the ordinary-income consequences on disposition, covering the § 305(a) stock-dividend origin, the recapitalization origin, the § 306(c)(1)(C) carryover rule, and the four statutory exceptions that remove the taint. Use it whenever a shareholder receives non-common stock in a distribution or reorganization and is considering a later sale, redemption, or reorganization exchange.

Step 1. The Policy Purpose and Anti-Bailout Function of § 306

The preferred stock bailout is the classic tax avoidance device that § 306 was designed to prevent. A shareholder who wants to withdraw corporate earnings at capital gains rates receives a nontaxable preferred stock dividend under § 305(a), then sells or redeems the preferred while retaining the common stock and its appreciation potential. Congress enacted § 306 in 1954 to recharacterize the proceeds from such transactions as ordinary income.

• Chamberlin v. Commissioner, 207 F.2d 462 (6th Cir. 1953), cert. denied, 347 U.S. 918 (1954). The seminal pre-§ 306 case. The taxpayer, sole shareholder of Chamberlin Electric Manufacturing Corp., received a dividend of preferred stock. He then sold the preferred stock to an insurance company and retained the common stock. The Sixth Circuit held that the sale of the preferred stock produced capital gain, notwithstanding that the economic substance of the transaction was the extraction of corporate earnings at favorable tax rates. The court reasoned that each step was independently valid. The stock dividend was nontaxable under predecessor law, and the sale of the preferred was a capital asset transaction. This decision prompted Congress to enact § 306.
• S. Rep. No. 1622, 83d Cong., 2d Sess. 245 (1954). The Senate Finance Committee Report stated that § 306 was intended to prevent shareholders from bailing out corporate earnings at capital gains rates through the issuance of preferred stock dividends followed by sale or redemption. The Report described the two-step transaction. First, a nontaxable stock dividend of preferred stock. Second, the sale or redemption of the preferred stock while the shareholder retained the common stock with its future appreciation potential.
• The two-step bailout mechanics. Step one. Corporation with accumulated earnings and profits distributes preferred stock pro rata to common shareholders. Under § 305(a), the distribution is not includible in gross income if the § 305(b) exceptions do not apply. Step two. Shareholder sells the preferred stock to a third party or the corporation redeems it. Absent § 306, the shareholder would report capital gain on the sale (taxed at favorable rates under § 1(h)) or capital gain on the redemption (if the redemption qualified as a sale under § 302(b)). The shareholder would retain the common stock with all future appreciation potential. § 306 prevents this result by treating the proceeds as ordinary income in whole or in part.
• CAUTION. § 306 applies only to stock dividends and reorganizations where the shareholder retains a common equity interest. If the shareholder disposes of the entire interest in the corporation (including the underlying common stock), § 306 may not apply because the shareholder has extracted the full economic stake in the corporation. See § 306(b)(1)(A) (termination of interest exception).
• Bazley v. Commissioner, 331 U.S. 737 (1947). A recapitalization must have a genuine business purpose. The Supreme Court held that a transfer of all corporate assets to a new corporation followed by the issuance of preferred stock and cash to the original shareholders, with the shareholders retaining common stock in the new corporation, was the substantial equivalent of a dividend and therefore taxable as ordinary income. This case established the "dividend equivalence" concept that pervades § 306 analysis.
• Davant v. Commissioner, 366 F.2d 874 (5th Cir. 1966). The Fifth Circuit applied the step-transaction doctrine to integrate a recapitalization and subsequent redemption. The court held that when a recapitalization and redemption are steps in a single plan, the transaction must be treated as a dividend to the extent of earnings and profits. This reinforces that § 306 operates independently of the step-transaction doctrine because § 306 explicitly creates its own tax consequences without requiring recharacterization of the transaction.

Step 2. Definition of § 306 Stock. § 306(c)(1)(A) (The Stock Dividend Category)

§ 306(c)(1)(A) defines § 306 stock as "stock (other than common stock issued with respect to common stock) which was distributed to the shareholder by the corporation if, by reason of section 305(a), any part of such distribution was not includible in the gross income of the shareholder."

• The statutory definition. § 306(c)(1)(A) provides that stock is § 306 stock if it is (i) not common stock issued with respect to common stock, and (ii) was distributed to the shareholder in a distribution to which § 305(a) applied (meaning any part of the distribution was not includible in gross income). This captures preferred stock dividends and other non-common stock distributions.
• The common-on-common exception. Stock that is "common stock issued with respect to common stock" is explicitly excluded from the definition of § 306 stock under § 306(c)(1)(A). This means a pro rata distribution of common stock on common stock, even if nontaxable under § 305(a), does not produce § 306 stock. The rationale is that common stock carries the full appreciation potential of the corporation, so its distribution does not facilitate a bailout of corporate earnings at capital gains rates.
• Treas. Reg. § 1.306-3(c). The regulations provide that stock which is distributed by a corporation to a shareholder with respect to its stock, and which is not includible in gross income by reason of § 305(a), is § 306 stock unless the stock is common stock distributed with respect to common stock. The regulations further clarify that § 306 stock includes not only preferred stock but any stock other than common stock issued with respect to common stock.
• Rev. Rul. 72-969, 1972-2 C.B. 181. A recapitalization under § 368(a)(1)(E) in which each common shareholder surrenders common stock and receives in exchange new common stock plus cash in lieu of fractional shares does not produce § 306 stock with respect to the common stock received. However, if preferred stock is received in the recapitalization, that preferred stock is § 306 stock. The ruling confirms that the common-on-common exception applies in recapitalization contexts.
• Interaction with § 305(b) exceptions. § 305(b) provides six exceptions under which a stock distribution is treated as a distribution of property under § 301 (and therefore includible in gross income as a dividend to the extent of E&P). If a distribution falls within any § 305(b) exception, it is taxable as a § 301 distribution and does NOT produce § 306 stock. The § 305(b) exceptions are. (1) distributions at the election of any shareholder (§ 305(b)(1)). (2) distributions on preferred stock (§ 305(b)(2)). (3) distributions of convertible preferred (§ 305(b)(3)). (4) distributions with a reasonable redemption clause (§ 305(b)(4)). (5) distributions on some stock and not others in a § 306(c)(1)(B) manner (§ 305(b)(5)). (6) distributions of preferred to some common shareholders and property to others (§ 305(b)(6)).
• Rev. Rul. 75-505, 1975-2 C.B. 112. A recapitalization in which common shareholders receive preferred stock in exchange for their common stock, where the preferred stock has a dividend rate significantly above market and is callable at a premium, produces § 306 stock. The ruling emphasizes that the economic substance of the transaction is the withdrawal of corporate earnings through preferred stock characteristics.
• Rev. Rul. 76-386, 1976-2 C.B. 93. Shares of common stock that carry a right of first refusal and have voting rights are "common stock" for purposes of § 306(c)(1)(A), even though the right of first refusal restricts transferability. The ruling holds that the presence of a right of first refusal does not convert common stock into preferred or other non-common stock.
• Rev. Rul. 79-163, 1979-1 C.B. 81. Stock that does not have the right to participate, without limit, in corporate growth is not "common stock" for purposes of § 306(c)(1)(A). A corporation issued Class A stock with a stated dividend rate and a liquidation preference, but with no right to participate in dividends beyond the stated rate and no right to participate in liquidation proceeds beyond the preference amount. The IRS ruled that this Class A stock is not common stock and therefore is § 306 stock when distributed nontaxably under § 305(a).
• Rev. Rul. 81-81, 1981-1 C.B. 123. A corporation recapitalized by issuing new common stock to its shareholders in exchange for their old common stock and outstanding preferred stock. The preferred stock received in the recapitalization was not § 306 stock because the shareholders surrendered their old preferred stock in the recapitalization and did not retain a common equity interest after receiving the new preferred. The ruling illustrates a structure that avoids § 306 taint.
• Rev. Rul. 81-186, 1981-2 C.B. 84. A recapitalization in which a corporation issues nonvoting common stock to certain shareholders and voting common stock to other shareholders, where both classes participate equally in dividends and liquidation, does not produce § 306 stock because both classes qualify as common stock. The ruling confirms that the common-on-common exception applies even when different classes of common stock are issued.
• Roebling v. Commissioner, 77 T.C. 30 (1981). The Tax Court held that capitalized dividend arrearages on preferred stock, when satisfied through the issuance of new preferred stock in a recapitalization, constitute § 306 stock. The court reasoned that the new preferred stock was received in a distribution that was nontaxable under § 305(a), and the stock was not common stock issued with respect to common stock.

Step 3. Definition of § 306 Stock. § 306(c)(1)(B) (The Reorganization Category)

§ 306(c)(1)(B) defines § 306 stock as stock (other than common stock) received in pursuance of a plan of reorganization (within the meaning of § 368(a)) or in a distribution or exchange to which § 355 applies (or so much of § 356 as relates to § 355), "if the effect of the transaction was substantially the same as the receipt of a stock dividend, or the stock has been received in exchange for section 306 stock."

• The statutory definition. § 306(c)(1)(B) has two prongs. First, non-common stock received in a reorganization or § 355 distribution has the effect of a stock dividend (the "dividend equivalence" prong). Second, stock received in exchange for § 306 stock carries over the taint (the "substituted basis" prong, which overlaps with § 306(c)(1)(C)).
• The "substantially the same as the receipt of a stock dividend" test. This is a facts-and-circumstances test. The critical inquiry is whether the shareholder received non-common stock in a reorganization while retaining a continuing common equity interest in the corporation or its successor, such that the economic effect mirrors a nontaxable preferred stock dividend. If the shareholder receives only non-common stock and no common stock, the transaction is less likely to be treated as equivalent to a stock dividend because the shareholder has not retained the appreciation potential of the common.
• Treas. Reg. § 1.306-3(d), Example 1. A and B each own 50 shares of common stock of Corporation X. Corporation X recapitalizes under § 368(a)(1)(E). A and B each surrender their 50 shares of old common stock and receive in exchange 50 shares of new common stock plus 10 shares of 6-percent nonvoting preferred stock. The preferred stock is § 306 stock because A and B received non-common stock in a recapitalization while retaining their common equity interest, which has the effect of a stock dividend.
• Treas. Reg. § 1.306-3(d), Example 2. Same facts as Example 1, except that A and B each surrender their 50 shares of old common stock and receive only 10 shares of 6-percent preferred stock with no new common stock. The preferred stock is NOT § 306 stock because A and B did not retain a common equity interest. Without the retention of common stock, the transaction does not have the effect of a stock dividend.
• Rev. Rul. 58-614, 1958-2 C.B. 920. In a statutory merger under former law, preferred shareholders of the acquired corporation received preferred stock of the acquiring corporation. The acquiring corporation had outstanding common stock held by its original shareholders. The IRS ruled that the preferred stock received by the former shareholders of the acquired corporation was § 306 stock because the transaction had the effect of a stock dividend. The preferred shareholders did not receive common stock but the acquiring corporation had common stock outstanding, meaning the preferred shareholders obtained an interest in a corporation where others held the appreciation potential.
• Rev. Rul. 59-30, 1959-1 C.B. 84. In a reorganization, shareholders received preferred stock of the acquiring corporation but did not retain any common stock or participating interest in the acquiring corporation or its subsidiaries. The IRS ruled that the preferred stock was NOT § 306 stock because the transaction did not have the effect of a stock dividend. The absence of any retained common or participating interest eliminated the bailout potential that § 306 targets.
• Rev. Rul. 61-120, 1961-1 C.B. 386. In a recapitalization under § 368(a)(1)(E), shareholders exchanged old preferred stock for new preferred stock with substantially the same terms. The IRS ruled that the new preferred stock was NOT § 306 stock because the transaction was merely a continuation of the prior preferred interest and did not have the effect of a stock dividend. The new preferred stock was not substantially different from the old preferred stock.
• Rev. Rul. 75-236, 1975-1 C.B. 106. Corporation X had outstanding Class A stock and common stock. Both classes were held by the same shareholders in the same proportions. In a recapitalization, the Class A stock was exchanged for common stock, and the common stock was reclassified as new common stock. Because the shareholders received common stock for Class A stock (which was essentially preferred stock in character), and the shareholders already held the common stock, the new common stock received was NOT § 306 stock under the common-on-common exception. However, if the Class A stock had been exchanged for preferred stock, that preferred stock would have been § 306 stock.
• Commissioner v. Clark, 489 U.S. 726 (1989). The Supreme Court addressed the dividend equivalence test in the context of boot received in a reorganization. A taxpayer received boot (cash and notes) in a reorganization in addition to stock. The taxpayer argued that the boot should be treated under § 356(a)(1) as gain from the exchange, limited by the gain realized. The Court held that the boot should first be tested under § 356(a)(2) as a dividend to the extent of the ratable share of E&P, applying the "dividend equivalence" test. The Court reasoned that § 356(a)(2) requires examining the post-reorganization interest to determine whether the boot has the effect of a dividend. This approach informs the § 306(c)(1)(B) analysis. The post-reorganization interest of the shareholder determines whether non-common stock received has the effect of a stock dividend.
• The boot rule for § 356. Treas. Reg. § 1.306-3(d) provides that if boot is received in a reorganization in exchange for § 306 stock, the boot is treated as a distribution of property to which § 301 applies. This means boot received for § 306 stock is tested as a dividend immediately, without regard to whether the shareholder has gain on the exchange. § 356(f) also provides that boot received in exchange for § 306 stock is treated as a § 301 distribution.

Step 4. Definition of § 306 Stock. § 306(c)(1)(C) (The Substituted Basis Category)

§ 306(c)(1)(C) defines § 306 stock as "stock the basis of which (in the hands of the shareholder selling or otherwise disposing of such stock) is determined by reference to the basis of section 306 stock."

• The statutory definition. § 306(c)(1)(C) carries the § 306 taint forward to any stock the basis of which is determined by reference to the basis of § 306 stock. This applies to transfers in which the basis of the transferred stock carries over to the transferee.
• § 351 exchanges. If § 306 stock is contributed to a corporation in a § 351 exchange, and the shareholder receives stock in the transferee corporation, the stock received takes a substituted basis under § 358. Because the basis of the stock received is determined by reference to the basis of the § 306 stock contributed, the stock received in the transferee corporation is § 306 stock. This applies regardless of whether the transferee corporation is the same as or different from the distributing corporation.
• Gifts. If a shareholder makes a gift of § 306 stock to another person, the donee takes a carryover basis under § 1015. Because the donee's basis is determined by reference to the donor's basis in § 306 stock, the stock in the donee's hands remains § 306 stock. The taint follows the stock through gratuitous transfers.
• § 1036 exchanges. If § 306 stock is exchanged for stock of the same corporation in a transaction qualifying under § 1036 (exchange of stock for stock in the same corporation), the stock received takes a substituted basis under § 1031(d). Because the basis of the new stock is determined by reference to the basis of the § 306 stock surrendered, the new stock is § 306 stock. However, see § 306(e)(1) for the exception when § 306 stock is exchanged for common stock of the same corporation.
• Transfers to partnerships and trusts. If § 306 stock is contributed to a partnership, the partnership takes a substituted basis under § 723. The partnership's stock is therefore § 306 stock. Similarly, if § 306 stock is transferred to a trust and the trust's basis is determined by reference to the transferor's basis, the stock in the trust's hands is § 306 stock.
• Death step-up under § 1014 cleanses the taint. § 306(c)(1)(C) applies only to stock the basis of which is determined "by reference to the basis of section 306 stock." When a decedent dies owning § 306 stock, the estate or heir takes a stepped-up basis under § 1014 equal to the fair market value of the stock at the decedent's death (or alternate valuation date). Because the new basis is NOT determined by reference to the decedent's basis, the stock received by the estate or heir is NOT § 306 stock. The § 306 taint is cleansed at death.
• § 1022 basis retains the taint (added by T.D. 9811, 2017). For decedents dying in 2010 when the estate tax was repealed and § 1022 applied in lieu of § 1014, the basis of inherited property was determined under § 1022 rather than stepped up to fair market value. T.D. 9811 (2017) clarified that when basis is determined under § 1022, the basis may retain the taint of § 306 stock because § 1022 does not provide a complete step-up to fair market value in the same manner as § 1014. For decedents dying after 2010, § 1014 applies and the taint is cleansed.
• Treas. Reg. § 1.306-3(e). The regulations provide that if § 306 stock is transferred in a transaction in which the basis of the stock in the transferee's hands is determined by reference to the basis in the transferor's hands, the stock in the transferee's hands is § 306 stock. The regulations expressly state that this includes transfers by gift (§ 1015), transfers to a corporation in a § 351 exchange (§ 358), and transfers in exchange for stock of the same corporation (§ 1031(d)). The regulations also confirm that stock acquired from a decedent where the basis is determined under § 1014 is NOT § 306 stock because the basis is determined by reference to fair market value at death, not by reference to the decedent's basis.

Step 5. The "No E&P" Exception. § 306(c)(2)

§ 306(c)(2) provides: "Stock shall not be treated as section 306 stock if, at the time of the distribution of such stock, or at the time of any subsequent distribution by the corporation through the medium of such stock, no part of the distribution would have been a dividend if cash had been distributed in lieu of stock."

• The statutory exception. § 306(c)(2) provides a complete exception from § 306 treatment if the corporation has no earnings and profits at the time of the stock distribution. The test is hypothetical. If the corporation had distributed cash in lieu of the stock, and no part of that cash distribution would have been a dividend under § 301(c)(1), then the stock distributed is not § 306 stock. This exception applies even if the corporation later accumulates E&P.
• E&P measured at time of distribution. The critical determination is made at the time of the stock distribution. The corporation computes its current E&P for the taxable year of the distribution without diminution by reason of the distribution itself. § 316(a)(2) provides that for purposes of determining the dividend character of a distribution, the amount of current E&P is computed as of the close of the taxable year without reduction for distributions made during the year. If there is no current E&P and no accumulated E&P at the time of distribution, the exception applies.
• Subsequent stock distributions through the same stock. § 306(c)(2) also looks at "any subsequent distribution by the corporation through the medium of such stock." This means that if the corporation later declares a stock dividend on the previously issued preferred stock, the E&P test must be satisfied at the time of that subsequent distribution as well. If the corporation has E&P at the time of the subsequent distribution, the previously issued stock may become § 306 stock at that time.
• Treas. Reg. § 1.306-3(a). The regulations state that stock distributed to a shareholder is § 306 stock if, by reason of § 305(a), any part of the distribution was not includible in the gross income of the shareholder. However, stock is not § 306 stock if, at the time of the distribution (or at the time of any subsequent stock distribution through the same stock), the corporation had no earnings and profits, so that a cash distribution at that time would not have been a dividend. The regulations confirm that the determination is made without diminution of E&P by reason of the distribution.
• CAUTION. The no E&P exception requires a positive showing that no dividend would have resulted. The burden is on the taxpayer to demonstrate that the corporation had neither current nor accumulated E&P at the time of distribution. This requires a careful computation of E&P under § 312, which may differ significantly from taxable income. The corporation may have E&P even when it has taxable losses due to timing differences (e.g., depreciation, net operating losses, or tax-exempt income).
• Current E&P computation without diminution. Under § 316(a)(2), current E&P is determined as of the close of the taxable year without reduction for distributions made during the year. This means that even if a cash distribution would have exhausted the corporation's cash and created a deficit, the current E&P for the year is computed without regard to the distribution. For example, if a corporation has $100,000 of current E&P at year-end and distributes $120,000 in cash during the year, the entire $120,000 is a dividend because current E&P is not reduced by the distribution.

Step 6. The § 351 Exchange Rule. § 306(c)(3)

§ 306(c)(3) provides: "Stock which is not otherwise section 306 stock and which is acquired in an exchange to which section 351 applies shall be treated as section 306 stock to the extent that (A) the effect of the transaction was substantially the same as the receipt of a stock dividend, or (B) the stock was received in exchange for section 306 stock."

• The statutory definition. § 306(c)(3) addresses a gap in § 306(c)(1). Under § 306(c)(1), stock is § 306 stock if distributed as a nontaxable stock dividend or received in a reorganization. However, stock received in a § 351 exchange is neither a stock dividend nor a reorganization distribution. § 306(c)(3) extends § 306 treatment to non-common stock acquired in a § 351 exchange if the transaction had the effect of a stock dividend.
• The "substantially the same as the receipt of a stock dividend" test applied to § 351. § 306(c)(3)(A) applies the same dividend equivalence test from § 306(c)(1)(B) to § 351 exchanges. The inquiry is whether the shareholder received non-common stock in a § 351 exchange while retaining a common equity interest, such that the economic effect mirrors a nontaxable preferred stock dividend. If the shareholder contributes property to a controlled corporation and receives preferred stock while others hold the common stock, or while the shareholder retains a common interest, the preferred stock may be § 306 stock.
• § 304(b)(2) rules applied by reference. § 306(c)(3) incorporates by reference the rules of § 304(b)(2) for determining whether a transaction has the effect of a stock dividend. § 304(b)(2) provides that in determining whether a transfer of property to a corporation in exchange for stock has the effect of a dividend, the rules of § 302(d) and § 302(b) apply as if the stock were redeemed. This means the § 302(b)(1)-(4) tests are used to determine whether the shareholder's interest in the corporation has been meaningfully reduced.
• § 318(a) attribution rules apply with § 304(c)(3)(B) modification. For purposes of applying § 304(b)(2) to § 306(c)(3), the constructive ownership rules of § 318(a) apply with the modification of § 304(c)(3)(B). Under § 304(c)(3)(B), stock constructively owned by an individual under § 318(a)(2)(A) (family attribution) or § 318(a)(3)(A) (attribution from partnerships, estates, trusts, and corporations) is not considered outstanding for purposes of determining the percentage ownership interest of the shareholder. This modification prevents double counting of constructively owned stock.
• CAUTION. § 351 exchanges involving preferred stock require careful § 306(c)(3) analysis. When a shareholder contributes appreciated property to a controlled corporation and receives preferred stock, the practitioner must determine whether the transaction has the effect of a stock dividend. If the shareholder or related parties retain the common stock, and the preferred stock has the characteristics of a bail-out vehicle, the preferred stock is likely § 306 stock.

Step 7. Tax Consequences on Disposition. § 306(a)(1) Sales and Exchanges

§ 306(a)(1)(A): "If a shareholder sells or otherwise disposes of section 306 stock (other than by way of a redemption, or a disposition referred to in paragraph (1)(B), (2), (3), or (4) of subsection (b)), then the amount realized shall be treated as a distribution of property to which section 301 applies."

• § 306(a)(1)(A). Amount realized treated as ordinary income. If a shareholder sells or otherwise disposes of § 306 stock (other than by redemption or by a disposition qualifying for one of the § 306(b) exceptions), the entire amount realized is treated as a distribution of property to which § 301 applies. This means the amount realized is ordinary income to the extent of the shareholder's ratable share of the corporation's earnings and profits at the time of the original stock distribution.
• The dividend equivalency calculation. The amount treated as ordinary income under § 306(a)(1)(A) is limited to the shareholder's ratable share of the corporation's earnings and profits at the time of the original distribution of the § 306 stock. Treas. Reg. § 1.306-1(b)(1) provides that the amount treated as ordinary income is the amount that would have been a dividend if cash had been distributed in lieu of the stock at the time of the original distribution. This is computed as the shareholder's proportionate share of the E&P at distribution, based on the value of the § 306 stock received relative to the total value distributed.
• § 306(a)(1)(B). Excess over ordinary income plus basis equals gain from sale. If the amount realized on the disposition exceeds the sum of (i) the amount treated as ordinary income under § 306(a)(1)(A) and (ii) the adjusted basis of the § 306 stock, the excess is treated as gain from the sale or exchange of property. This gain may qualify for capital gain treatment under § 1(h). The basis of the § 306 stock is not used to reduce the ordinary income portion but is available to reduce any excess.
• § 306(a)(1)(C). No loss recognized. If the amount realized is less than the adjusted basis of the § 306 stock, no loss is recognized. § 306(a)(1)(C) explicitly prohibits loss recognition on the disposition of § 306 stock. This rule prevents shareholders from claiming artificial losses on § 306 stock while retaining the common stock.
• Basis add-back to common stock. If the amount realized exceeds the ordinary income amount but is less than the sum of the ordinary income amount plus the adjusted basis of the § 306 stock, the difference between the amount realized and the ordinary income amount is added back to the basis of the underlying common stock with respect to which the § 306 stock was distributed. This ensures that the shareholder recovers the basis of the § 306 stock through the common stock if the sale proceeds are insufficient to absorb both the ordinary income and the full basis.
• § 306(a)(1)(D). Qualified dividend income treatment (added by JGTRRA 2003). The amount treated as a dividend under § 306(a)(1)(A) is treated as dividend income for purposes of § 1(h)(11), meaning it may qualify for the reduced tax rate on qualified dividend income (20%, 15%, or 0% depending on the taxpayer's income level). This provision was added by the Jobs and Growth Tax Relief Reconciliation Act of 2003. Before JGTRRA, § 306 dividends were taxed at ordinary income rates. The practical effect of JGTRRA 2003 was to significantly reduce the "bite" of § 306 for many taxpayers, since qualified dividends are taxed at rates comparable to long-term capital gains.
• Treas. Reg. § 1.306-1(b)(1). The regulations provide that if § 306 stock is sold, the amount realized is treated as ordinary income to the extent it does not exceed the ratable share of E&P attributable to the stock at the time of the original distribution. The regulations clarify that the basis of the § 306 stock is applied after the ordinary income limitation is determined. Any excess of the amount realized over the ordinary income amount plus basis is capital gain. If the amount realized is less than the ordinary income amount plus basis but more than the ordinary income amount, the difference is added to the basis of the common stock.
• Treas. Reg. § 1.306-1(b)(2), Example 1. A owns 100 shares of common stock of Corporation X with a basis of $10,000. Corporation X distributes 100 shares of preferred stock pro rata to A. The preferred stock has a fair market value of $10,000. A allocates $5,000 of basis to the preferred stock under § 307 (leaving $5,000 basis in the common stock). At the time of distribution, Corporation X has $20,000 of E&P. A's ratable share of E&P attributable to the preferred is $10,000 (100% of the preferred distribution). A later sells the preferred stock for $12,000. Under § 306(a)(1), $10,000 is treated as ordinary income (dividend), $5,000 is recovered basis (with $3,000 added back to common stock basis), and the remaining $2,000 is capital gain.
• Treas. Reg. § 1.306-1(b)(2), Example 2. Same facts as Example 1, except A sells the preferred stock for $8,000. Under § 306(a)(1), $8,000 is treated as ordinary income (dividend) because the amount realized does not exceed the ratable share of E&P ($10,000). No basis is recovered and no loss is allowed. The $5,000 basis of the preferred stock is added back to the basis of the common stock, so A's common stock basis becomes $10,000 ($5,000 original remaining basis plus $5,000 from preferred).
• Treas. Reg. § 1.306-1(b)(2), Example 3. Same facts as Example 1, except A sells the preferred stock for $14,000. Under § 306(a)(1), $10,000 is treated as ordinary income (dividend), $5,000 is recovered basis, and the remaining $4,000 is capital gain.
• EXAMPLE. A and B each own 50 shares of Corporation X common stock. Corporation X distributes pro rata 100 shares of preferred stock as a dividend on common. Preferred FMV equals $10,000. Corporation X has $20,000 of E&P. A receives 50 shares with allocated basis of $500 ($10 per share). A's ratable share of E&P equals $5,000 (50% of the $10,000 preferred value relative to the total distribution). If A sells for $6,000, $5,000 is ordinary income and $500 is capital gain (amount realized of $6,000 minus ordinary income of $5,000 minus basis of $500 equals $500 capital gain). If A sells for $5,100, $5,000 is ordinary income, no loss is allowed, and $400 is added back to common stock basis ($5,100 amount realized minus $5,000 ordinary income equals $100 basis recovered. The remaining $400 of basis is added to common stock basis).

Step 8. Tax Consequences on Redemption. § 306(a)(2)

§ 306(a)(2) provides: "If section 306 stock is redeemed by the issuing corporation, the amount distributed in redemption thereof shall be treated as a distribution of property to which section 301 applies."

• The statutory rule. § 306(a)(2) provides that if § 306 stock is redeemed by the issuing corporation, the entire amount distributed in the redemption is treated as a distribution of property to which § 301 applies. Unlike a sale to a third party under § 306(a)(1), a redemption of § 306 stock does not produce any capital gain. The entire amount received is tested as a dividend under § 301, limited only by the corporation's current and accumulated E&P at the time of the redemption.
• Entire amount realized tested as dividend first. Under § 306(a)(2), the entire amount distributed in the redemption is treated as a § 301 distribution. This means the full amount is dividend income to the extent of the corporation's current and accumulated E&P at the time of the redemption (not limited to the E&P at the time of the original distribution). Unlike § 306(a)(1), there is no ratable share limitation based on E&P at the time of the original stock distribution. The E&P measured is the E&P at the time of the redemption.
• § 306 stock basis is disregarded. Under § 306(a)(2), the adjusted basis of the § 306 stock is completely disregarded. The shareholder does not recover basis on the redemption of § 306 stock. This is a harsher result than § 306(a)(1), where at least the basis is potentially recoverable as capital gain or added back to common stock basis. The basis of the redeemed § 306 stock effectively disappears for tax purposes.
• No loss recognized. Consistent with § 306(a)(1)(C), no loss is recognized on the redemption of § 306 stock. Even if the redemption proceeds are less than the basis of the § 306 stock, the shareholder cannot claim a loss.
• Treas. Reg. § 1.306-1(c). The regulations provide that if § 306 stock is redeemed by the issuing corporation, the amount received by the shareholder is treated as a distribution to which § 301 applies, regardless of whether the redemption would otherwise qualify as a sale or exchange under § 302(b). The regulations confirm that the basis of the § 306 stock is not taken into account in determining the tax consequences of the redemption. The entire amount distributed is dividend income to the extent of E&P.
• Interaction with § 317(b) definition of redemption. § 317(b) defines a redemption as an acquisition by a corporation of its own stock from a shareholder in exchange for property, whether or not the stock is cancelled, retired, or held as treasury stock. A redemption of § 306 stock triggers § 306(a)(2) regardless of whether the redemption is pro rata or non-pro rata, and regardless of whether the shareholder's interest in the corporation is reduced. Even a redemption that would otherwise qualify under § 302(b)(3) (complete termination of interest) is subject to § 306(a)(2) unless the § 306(b)(1)(B) exception applies.
• CAUTION. Redemption of § 306 stock produces a worse tax result than sale to a third party. Under § 306(a)(1), the ordinary income is capped at the ratable share of E&P at the time of the original distribution, and the shareholder may recover basis and recognize capital gain. Under § 306(a)(2), the entire redemption amount is a § 301 distribution (dividend to the extent of E&P at redemption), and no basis is recovered. Practitioners should advise clients to sell § 306 stock to third parties rather than redeem it whenever possible.
• § 301(c) ordering rule applies. The amount treated as a § 301 distribution under § 306(a)(2) is taxed under the § 301(c) ordering rules. First, as dividend income to the extent of current and accumulated E&P. Second, as a tax-free return of basis (though § 306(a)(2) disregards basis). Third, the excess is capital gain. Because § 306(a)(2) disregards basis, the entire distribution is dividend income to the extent of E&P, and any excess is capital gain.

Step 9. The Termination of Interest Exception. § 306(b)(1)

§ 306(b)(1)(A): "Subsection (a) shall not apply to the disposition of section 306 stock if the shareholder's entire interest in the corporation is terminated (whether or not his interest during the taxable year was the same as his interest during the taxable year of the distribution) by the sale or exchange of his section 306 stock, and subsection (a) would not have applied to such stock if it had not been section 306 stock."

§ 306(b)(1)(B): "Subsection (a) shall not apply to the disposition of section 306 stock if the section 306 stock is redeemed as part of a transaction in which the shareholder's entire interest in the corporation is terminated (whether or not his interest during the taxable year was the same as his interest during the taxable year of the distribution) and such termination would have qualified under the provisions of paragraph (3) or (4) of section 302(b) if section 306 stock had not been issued."

• § 306(b)(1)(A). Sale or exchange terminating entire interest. § 306(b)(1)(A) provides an exception to § 306(a) when the shareholder sells or exchanges all of his § 306 stock AND the sale or exchange terminates the shareholder's entire interest in the corporation. Two critical requirements must be satisfied. (i) The shareholder's entire interest in the corporation must be terminated, and (ii) the sale or exchange of the stock would have produced capital gain if the stock had not been § 306 stock. The sale must not be to a related party.
• § 306(b)(1)(B). Redemption terminating entire interest. § 306(b)(1)(B) provides a similar exception for redemptions. The § 306 stock must be redeemed as part of a transaction in which the shareholder's entire interest in the corporation is terminated, and the termination must satisfy either § 302(b)(3) (complete termination of interest) or § 302(b)(4) (partial liquidation of a noncorporate shareholder). This means the redemption must qualify as a sale or exchange under § 302(b)(3) or (4).
• § 302(c)(2) waiver of family attribution. For the § 302(b)(3) complete termination test to be satisfied, the shareholder must either actually terminate all stock ownership (including constructive ownership) or file the agreement required by § 302(c)(2) to waive family attribution under § 318(a)(1). Under § 302(c)(2), a shareholder may waive the family attribution rules if (i) the shareholder retains no interest in the corporation (including as an officer, director, or employee) immediately after the redemption, (ii) the shareholder does not acquire any such interest within 10 years after the redemption, and (iii) the shareholder files a formal agreement with the Secretary to notify the Secretary if such an interest is acquired within the 10-year period.
• Treas. Reg. § 1.306-2(a). The regulations provide that § 306 does not apply to a disposition of § 306 stock if the shareholder's entire interest in the corporation is terminated by a sale or exchange of the § 306 stock, provided the transaction would have produced capital gain if the stock had not been § 306 stock. For redemptions, the regulations require that the termination of interest qualify under § 302(b)(3) or (4). The regulations also confirm that the shareholder's interest is determined by reference to the constructive ownership rules of § 318(a), which means stock owned by related parties is attributed to the shareholder.
• TRAP. The termination of interest exception is rarely available in closely held corporations. Because the constructive ownership rules of § 318(a) apply, a shareholder in a closely held family corporation is generally treated as owning the stock of his spouse, children, grandchildren, and parents. To terminate the "entire interest," the shareholder and all related parties must dispose of their stock, which is almost never the case in a family business. Even if the shareholder sells his personal holdings to an unrelated party, the attribution rules prevent the exception from applying unless family members also dispose of their shares.
• No related party sales. § 306(b)(1)(A) implicitly requires that the sale be to an unrelated party. If the shareholder sells § 306 stock to a related party (as defined in § 267(b) or § 707(b)(1)), the sale does not terminate the shareholder's interest because the related party's ownership is attributed to the seller under § 318(a).
• CAUTION. The termination of interest exception requires advance planning. Because § 318(a) attribution rules are so broad, practitioners should map out the entire ownership structure (including family members, trusts, partnerships, and estates) before advising a client that the exception is available. A shareholder who sells his § 306 stock believing he has terminated his interest may be surprised to find that his spouse's or child's stock ownership is attributed to him, causing § 306(a) to apply.

Step 10. The Liquidation Exception. § 306(b)(2)

§ 306(b)(2) provides: "Subsection (a) shall not apply to the disposition of section 306 stock if such stock was redeemed as part of the complete liquidation of a corporation to which part II (sec. 331 and following) of this subchapter applies."

• The statutory exception. § 306(b)(2) provides that § 306(a) does not apply if the § 306 stock is redeemed as part of a complete liquidation to which § 331 applies. Under § 331, amounts distributed in complete liquidation of a corporation are treated as payment in exchange for stock, producing capital gain or loss to the shareholder. This exception reflects the policy that a complete liquidation represents the termination of the corporation and the shareholder's entire interest, so there is no bailout of earnings at capital gains rates.
• Only complete liquidations qualify. The exception applies only to "complete" liquidations. A partial liquidation or a liquidation that does not qualify under § 331 does not trigger the exception. The corporation must adopt a plan of complete liquidation and distribute all of its assets to its shareholders in cancellation of their stock.
• TEFRA 1982 amendment removed partial liquidation. Before the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), § 306(b)(2) also excepted redemptions in partial liquidations. TEFRA 1982 amended § 306(b)(2) to remove the partial liquidation exception, leaving only complete liquidations. This change was made because partial liquidations were being used to bail out earnings through preferred stock redemptions while the corporation continued in business.
• Pridemark, Inc. v. Commissioner, 345 F.2d 35 (4th Cir. 1965). The Fourth Circuit addressed the standard for a genuine complete liquidation. The court held that a complete liquidation requires a genuine cessation of the corporation's business activities and a distribution of its assets to the shareholders. A sham liquidation or a liquidation followed by a reincorporation of the same business does not qualify. The court emphasized that the transaction must represent a true termination of the corporate enterprise, not merely a rearrangement of corporate form.
• Treas. Reg. § 1.306-2(b)(1). The regulations confirm that § 306(a) does not apply to the redemption of § 306 stock in a complete liquidation to which § 331 applies. The regulations clarify that the shareholder's gain or loss on the liquidation is determined under § 331 without regard to § 306. The basis of the § 306 stock is taken into account in computing gain or loss under § 331, and the character of the gain or loss is determined by the character of the stock under § 1221 or § 1222.
• § 332 liquidations. The § 306(b)(2) exception does not apply to liquidations under § 332 (parent-subsidiary liquidations) because § 332 is not part of "part II (sec. 331 and following)" in the same sense. In a § 332 liquidation, the parent corporation generally recognizes no gain or loss, and the subsidiary's tax attributes carry over. The § 306(b)(2) exception is designed for shareholder-level liquidations under § 331.
• CAUTION. The liquidation exception requires a bona fide complete liquidation. The IRS examines purported liquidations carefully for signs of sham transactions. A liquidation followed by a reincorporation of the business assets, a sale of assets to related parties, or a continuation of the business by the shareholders individually may be challenged as lacking genuine cessation. Practitioners should ensure that all formalities of a complete liquidation are observed, including the adoption of a plan of liquidation, the filing of Form 966, and the actual distribution of all corporate assets.

Step 11. The Nonrecognition Transaction Exception. § 306(b)(3)

§ 306(b)(3) provides: "Subsection (a) shall not apply to a disposition of section 306 stock to the extent that, under the provisions of this subtitle, gain or loss is not recognized to the shareholder disposing of such stock."

• The statutory exception. § 306(b)(3) provides that § 306(a) does not apply to a disposition of § 306 stock to the extent that gain or loss is not recognized under other provisions of the Code. This exception applies to nonrecognition transactions such as reorganizations under § 354, § 351 exchanges, § 355 distributions, and § 1036 exchanges of stock for stock in the same corporation.
• Nonrecognition transactions covered. The exception applies to the extent gain or loss is not recognized. In a § 354 reorganization, the shareholder generally recognizes no gain or loss on the exchange of stock for stock. In a § 351 exchange, no gain or loss is recognized if the control requirement is satisfied. In a § 355 distribution, no gain or loss is recognized on the distribution of a controlled corporation's stock. In each case, § 306(a) does not apply to the extent of the nonrecognized gain or loss.
• Taint carries over to substituted basis stock received. Although § 306(a) does not apply to the nonrecognition transaction itself, the § 306 taint carries over to any stock received in the transaction if the stock received takes a substituted basis determined by reference to the § 306 stock surrendered. This is the application of § 306(c)(1)(C). Stock the basis of which is determined by reference to § 306 stock is itself § 306 stock. See also Treas. Reg. § 1.306-3(e).
• Boot triggers § 306(a) consequences. If the shareholder receives boot in addition to stock in the nonrecognition transaction, the boot is subject to § 306(a). Under Treas. Reg. § 1.306-2(b)(2), boot received in exchange for § 306 stock is treated as a distribution to which § 301 applies. This means boot received for § 306 stock in a reorganization is taxed as a dividend (to the extent of E&P) without regard to the nonrecognition provisions.
• Treas. Reg. § 1.306-2(b)(2). The regulations provide that § 306(a) does not apply to a disposition of § 306 stock to the extent that gain or loss is not recognized on the disposition. However, if boot is received, the fair market value of the boot is treated as a § 301 distribution. The regulations give the example of a shareholder who exchanges § 306 stock in a reorganization for stock and cash. The stock received is not taxed under § 306(a) (subject to taint carryover), but the cash is treated as a dividend to the extent of E&P.
• Treas. Reg. § 1.306-3(f). Common stock received in exchange for § 306 stock is NOT § 306 stock. The regulations provide an important exception to the substituted basis rule. If § 306 stock is exchanged for common stock in the same corporation (or a successor corporation in a reorganization), the common stock received is NOT § 306 stock. This is the regulation counterpart to § 306(e)(1). For example, if a shareholder exchanges § 306 preferred stock for common stock in a recapitalization under § 368(a)(1)(E), the common stock received is not § 306 stock even though its basis is determined by reference to the preferred stock.
• § 356(f). Boot received for § 306 stock treated as § 301 distribution. § 356(f) provides that if a shareholder exchanges § 306 stock in a reorganization and receives boot, the boot is treated as a distribution of property to which § 301 applies. This provision operates independently of § 356(a)(2) (the dividend equivalence rule for boot) and ensures that boot received for § 306 stock is always taxed as a dividend to the extent of E&P.
• CAUTION. The nonrecognition exception defers but does not eliminate § 306 consequences. Practitioners often mistakenly believe that a reorganization "cleanses" § 306 stock. This is incorrect. The taint carries over to any stock received with a substituted basis. Only common stock received in exchange for § 306 stock is exempt from taint under § 306(e)(1) and Treas. Reg. § 1.306-3(f). Any non-common stock received in exchange for § 306 stock remains § 306 stock.

Step 12. The Tax Avoidance Exception. § 306(b)(4)

§ 306(b)(4) provides: "Subsection (a) shall not apply to a disposition of section 306 stock to such extent as the taxpayer establishes to the satisfaction of the Secretary -- (A) that the distribution, and the disposition, or so much of either as occurs after the enactment of this title, was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax, and (B) that either section 306(c)(1)(B)(i) (relating to distributions in pursuance of plans of reorganization) or section 306(c)(1)(C) (relating to stock acquired in exchanges to which section 351 applies) applies, and the interest of the shareholder in the corporation was substantially reduced (by reason of the disposition of the section 306 stock or, if the underlying stock has been disposed of before the disposition of the section 306 stock, by reason of the disposition of such underlying stock) by comparison with his interest in the corporation immediately after the distribution described in section 306(c)(1)(B) or (C), or that the stock was acquired by the taxpayer in a transaction to which section 306(c)(1)(B) or (C) applied and the stock so acquired was disposed of before the disposition of the section 306 stock."

• The statutory exception. § 306(b)(4) provides a tax avoidance exception that applies in two situations. First, under § 306(b)(4)(A), the taxpayer must establish to the Secretary's satisfaction that neither the distribution nor the disposition was in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax. Second, under § 306(b)(4)(B), the taxpayer must show either (i) that § 306(c)(1)(B) (reorganization stock) or § 306(c)(1)(C) (§ 351 exchange stock) applies, and the shareholder's interest was substantially reduced by comparison with the interest held immediately after the distribution, or (ii) that the stock was acquired in a § 306(c)(1)(B) or (C) transaction and the underlying stock was disposed of before the § 306 stock.
• Burden on taxpayer to establish to Secretary's satisfaction. § 306(b)(4) expressly places the burden on the taxpayer to establish the exception "to the satisfaction of the Secretary." This is a heavy burden. Unlike most exceptions in the Code, which apply if the taxpayer can prove certain facts, § 306(b)(4) requires affirmative satisfaction of the IRS. The taxpayer cannot merely assert lack of tax avoidance purpose but must produce objective evidence.
• Fireoved v. United States, 462 F.2d 1281 (3d Cir. 1972). The leading case on § 306(b)(4). The taxpayers received preferred stock in a recapitalization and later sold it to a pension trust while retaining the common stock. The taxpayers argued that the sale was motivated by business purposes, not tax avoidance. The Third Circuit held that the taxpayers failed to carry their burden of proof under § 306(b)(4). The court inferred a tax avoidance purpose from the taxpayers' retention of control through the common stock, the pre-arranged nature of the sale, and the fact that the economic substance of the transaction was the withdrawal of corporate earnings at capital gains rates. The court emphasized that the taxpayers' subjective intent was less important than the objective facts and circumstances surrounding the transaction.
• Bialo v. Commissioner, 88 T.C. 1132 (1987). The taxpayer received preferred stock in a recapitalization and later donated it to charity. The taxpayer claimed a charitable deduction under § 170. The Tax Court held that the § 306 stock was subject to § 306(a) and that the charitable deduction must be reduced under § 170(e)(1)(A) by the amount that would have been ordinary income if the stock had been sold. The court also found that the taxpayer failed to qualify for the § 306(b)(4) exception. Significantly, the court noted that the taxpayer had obtained a pre-distribution tax memorandum analyzing § 306, which the court treated as strong evidence that tax avoidance was a principal purpose of the transaction. The presence of advance tax planning documentation undermined the taxpayer's claim of lack of tax avoidance purpose.
• Pescosolido v. Commissioner, 91 T.C. 52 (1988), aff'd, 883 F.2d 187 (1st Cir. 1989). The taxpayer was a controlling shareholder who received preferred stock in a recapitalization and later donated it to charity. The Tax Court held that the § 306(b)(4) exception did not apply. The court found that the taxpayer's genuine charitable intent did not negate the tax avoidance purpose of the overall plan. The court emphasized that objective facts control over taxpayer testimony about subjective intent. The First Circuit affirmed, noting that a controlling shareholder who structures a recapitalization to receive preferred stock and then disposes of it while retaining common stock cannot realistically claim that tax avoidance was not a principal purpose. The court stated that "the very structure of the transaction bespeaks tax avoidance."
• Treas. Reg. § 1.306-2(b)(3) safe harbors. The regulations provide that in determining whether the § 306(b)(4) exception applies, all the facts and circumstances are considered. The regulations identify several factors that may indicate the absence of a tax avoidance plan. (i) The distribution was made for a valid business purpose such as raising capital or facilitating estate planning. (ii) the disposition was required by circumstances beyond the shareholder's control, such as death, divorce, or insolvency. (iii) The shareholder did not participate in the formulation of the plan of distribution. (iv) The disposition was made at arm's length to an unrelated party. However, the regulations emphasize that these factors are merely illustrative and do not create automatic safe harbors.
• Rev. Rul. 77-455, 1977-2 C.B. 93. A shareholder who was retiring from a corporation received preferred stock in a recapitalization. Two years later, the shareholder sold the preferred stock to an unrelated third party at arm's length and completely retired from any involvement with the corporation. The IRS ruled that the § 306(b)(4) exception applied because (i) the shareholder's interest in the corporation had been substantially reduced by the sale, (ii) the sale was to an unrelated party at arm's length, (iii) the shareholder had a genuine retirement purpose, and (iv) the transaction was not in pursuance of a tax avoidance plan. This ruling illustrates the type of isolated, arm's length disposition by a minority shareholder that Congress intended the exception to cover.
• Legislative history. Intended for minority shareholders with isolated dispositions. The legislative history of § 306(b)(4) indicates that Congress intended the exception to protect minority shareholders who receive stock in reorganizations or § 351 exchanges and later make isolated dispositions for nontax business or personal reasons. The exception was not intended for controlling shareholders who engineer recapitalizations and then dispose of preferred stock as part of an earnings withdrawal plan.
• TRAP. The tax avoidance exception is nearly impossible for controlling shareholders to satisfy. Given the burden of proof, the objective nature of the inquiry, and the case law, controlling shareholders and majority shareholders in closely held corporations should assume that the § 306(b)(4) exception is unavailable. The very fact of control, combined with the retention of common stock after a preferred stock distribution, creates an almost insurmountable inference of tax avoidance purpose. Practitioners should advise clients that reliance on § 306(b)(4) is extremely risky.
• CAUTION. Advance tax planning documentation can undermine the exception. As demonstrated in Bialo, obtaining a tax memorandum analyzing § 306 before the distribution can be used against the taxpayer as evidence of tax avoidance purpose. While practitioners should always document advice, they should be aware that such documentation may be discoverable in litigation and used to show that the taxpayer was aware of § 306 and structured the transaction accordingly.

Step 13. Convertible Stock and the Cleansing Rule. § 306(e)

§ 306(e)(1) provides: "If section 306 stock is exchanged for common stock in the same corporation (whether or not such common stock is section 306 stock), such common stock shall not be treated as section 306 stock."

§ 306(e)(2) provides: "For purposes of this section, stock which is convertible into common stock shall be treated as common stock only if, when sold, the amount realized includes the fair market value of such common stock."

• § 306(e)(1). Exchange of § 306 stock for common stock cleanses the taint. § 306(e)(1) provides the primary mechanism for cleansing § 306 stock of its taint. If § 306 stock is exchanged for common stock in the same corporation, the common stock received is NOT § 306 stock, regardless of whether the common stock received would otherwise be § 306 stock under § 306(c)(1)(C). This provision applies even if the exchange is taxable. The rationale is that common stock carries the full appreciation potential of the corporation, so receiving common stock in exchange for preferred stock does not facilitate a bailout.
• § 306(e)(2). Convertible stock is NOT common stock unless converted. § 306(e)(2) provides that stock which is convertible into common stock is treated as common stock for § 306 purposes only if, at the time of sale, the amount realized includes the fair market value of the underlying common stock. In other words, convertible preferred stock is generally NOT treated as common stock unless it has actually been converted. This means convertible preferred stock distributed as a dividend is § 306 stock until it is converted into common stock. Once converted, the common stock received is not § 306 stock under § 306(e)(1).
• Treas. Reg. § 1.306-3(f). The regulations implement § 306(e)(1) by providing that common stock received in exchange for § 306 stock is not § 306 stock. The regulations also clarify that if § 306 stock is exchanged for stock and securities of another corporation in a reorganization, the non-common stock received is § 306 stock unless it is common stock of the issuing corporation. The regulations give the example of a shareholder who exchanges § 306 preferred stock for common stock in a recapitalization. The common stock received is not § 306 stock.
• Rev. Rul. 64-45, 1964-1 C.B. 132. A shareholder owned § 306 preferred stock and exchanged it for common stock of the same corporation in a recapitalization. The IRS ruled that under § 306(e)(1), the common stock received was NOT § 306 stock. The taint of the preferred stock was cleansed by the exchange for common stock. This ruling provides the basis for a common tax planning technique. Converting § 306 preferred stock into common stock to eliminate the § 306 taint before a sale or other disposition.
• Planning opportunity. Conversion to cleanse taint. The § 306(e)(1) cleansing rule creates a significant planning opportunity. A shareholder who owns § 306 preferred stock and wishes to sell can first convert the preferred into common stock (if the preferred is convertible) or exchange the preferred for common stock in a recapitalization under § 368(a)(1)(E). Once the shareholder holds common stock, the § 306 taint is removed, and a subsequent sale of the common stock produces capital gain or loss under normal rules. However, if the preferred stock is not convertible, a recapitalization may be required, which involves corporate-level transaction costs and SEC compliance considerations for public companies.
• CAUTION. The cleansing rule applies only to common stock in the same corporation. § 306(e)(1) applies only to exchanges for common stock "in the same corporation." If § 306 stock is exchanged for common stock of a different corporation in a reorganization, the common stock of the other corporation may be § 306 stock unless the nonrecognition exception of § 306(b)(3) applies. The cleansing effect of § 306(e)(1) is limited to the issuing corporation.
• Convertible preferred stock planning. Shareholders who receive convertible preferred stock in a nontaxable distribution should be aware that the convertible preferred is § 306 stock under § 306(c)(1)(A), but conversion into common stock cleanses the taint under § 306(e)(1). The timing of conversion should be planned carefully. If the shareholder converts and then sells the common stock, the sale is taxed under normal § 1001 rules. However, if the shareholder sells the convertible preferred without converting, § 306(a)(1) applies.

Step 14. Changes in Terms and Conditions. § 306(g)

§ 306(g) provides: "If a substantial change is made in the terms and conditions of any stock in a corporation, then, for purposes of this subchapter -- (1) the fair market value of such stock shall be the greater of -- (A) its fair market value determined on the basis of such change, or (B) its fair market value immediately before such change; (2) the earnings and profits of the corporation shall be the greater of -- (A) the earnings and profits at the time of the issuance of such stock (determined as of the time of such issuance), or (B) the earnings and profits immediately before such change; and (3) subsection (c)(2) shall not apply unless the stock would not have been section 306 stock if its fair market value and the earnings and profits of the corporation at the time of the issuance of such stock had been the same as the fair market value of such stock and the earnings and profits of the corporation immediately before such change."

• The statutory anti-manipulation rule. § 306(g) is an anti-manipulation provision designed to prevent taxpayers from avoiding § 306 by altering the terms of stock after issuance. If a corporation makes a "substantial change" in the terms and conditions of stock, § 306(g) requires measuring the stock's characteristics at the more favorable of two points in time for purposes of determining § 306 treatment.
• Substantial changes in stock terms. A substantial change includes modifications to dividend rights, liquidation preferences, redemption features, conversion rights, voting rights, or other material terms of the stock. Examples include increasing the dividend rate on preferred stock, adding a mandatory redemption feature, adding a conversion feature, changing the liquidation preference, or modifying voting rights. A change is "substantial" if it materially alters the economic rights of the stockholder.
• FMV measured at higher of distribution or change time. Under § 306(g)(1), the fair market value of the stock for § 306 purposes is the greater of (i) the fair market value determined on the basis of the changed terms, or (ii) the fair market value immediately before the change. This prevents taxpayers from arguing that a change reduced the stock's value below the threshold for § 306 treatment.
• E&P measured at higher of two times. Under § 306(g)(2), the corporation's earnings and profits for § 306 purposes are the greater of (i) the E&P at the time of the stock's issuance, or (ii) the E&P immediately before the change. This prevents taxpayers from arguing that the corporation's E&P have been reduced below the level that would create § 306 stock.
• § 306(c)(2) no E&P exception requires no E&P at BOTH times. Under § 306(g)(3), the no E&P exception of § 306(c)(2) does not apply unless the stock would not have been § 306 stock if the FMV and E&P at the time of issuance had been the same as the FMV and E&P immediately before the change. In other words, the no E&P exception applies only if the corporation had no E&P at BOTH the time of issuance AND the time of the change. If the corporation had E&P at either time, the exception does not apply after a substantial change.
• Treas. Reg. § 1.306-3(g). The regulations provide that if a substantial change is made in the terms and conditions of stock, § 306(g) applies to prevent taxpayers from manipulating the stock's characteristics to avoid § 306. The regulations define a "substantial change" as a change that materially affects the value of the stock or the rights of the stockholder. Changes in dividend rates, redemption prices, conversion ratios, liquidation preferences, and voting rights are examples of substantial changes. The regulations confirm that the FMV and E&P tests of § 306(g)(1) and (2) apply, and that the no E&P exception is available only if both the pre-change and post-change tests are satisfied.
• CAUTION. Changes to preferred stock terms after issuance should be reviewed for § 306(g) implications. A corporation that modifies the terms of outstanding preferred stock may inadvertently trigger § 306(g), causing stock that was not originally § 306 stock to become § 306 stock (or causing stock that qualified for the no E&P exception to lose that qualification). Any amendment to a certificate of incorporation that affects the rights of preferred shareholders should be analyzed under § 306(g).
• Planning consideration. Because § 306(g) can retroactively cause stock to become § 306 stock, practitioners should advise corporate clients to include anti-modification provisions in preferred stock instruments to prevent inadvertent substantial changes. If a change is contemplated, the practitioner should model the § 306(g) consequences before the change is implemented.

Step 15. Stock Rights. § 306(d)

§ 306(d) provides: "For purposes of this section -- (1) Stock rights shall be treated as stock, and the term 'stock' includes rights to acquire stock; and (2) Stock acquired through the exercise of rights to acquire stock shall be treated as stock distributed at the time of the distribution of such rights, to the extent of the fair market value of such rights at the time of the distribution."

• § 306(d)(1). Stock rights treated as stock. § 306(d)(1) provides that rights to acquire stock (such as warrants, options, and stock purchase rights) are treated as stock for purposes of § 306. This means that if a corporation distributes nontaxable stock rights to its shareholders, those rights may be § 306 stock if they are not rights to acquire common stock distributed with respect to common stock.
• § 306(d)(2). Stock acquired on exercise treated as stock distributed when rights were distributed. § 306(d)(2) provides that stock acquired through the exercise of stock rights is treated as stock distributed at the time the rights were distributed, to the extent of the fair market value of the rights at the time of distribution. This means the § 306 taint attaches to the stock acquired on exercise based on the characteristics of the rights at the time of the original distribution.
• FMV of rights at distribution controls dividend equivalency. For purposes of determining the amount treated as ordinary income under § 306(a)(1), the dividend equivalency is measured by the fair market value of the rights at the time of the original distribution, not the fair market value of the stock acquired on exercise. This prevents taxpayers from manipulating the timing of exercise to affect the § 306 consequences.
• Treas. Reg. § 1.306-3(b). The regulations provide that rights to acquire stock are treated as stock under § 306(d)(1). If stock rights are distributed in a transaction to which § 305(a) applies, the rights are § 306 stock unless they are rights to acquire common stock distributed with respect to common stock. When the rights are exercised, the stock acquired is § 306 stock to the extent of the fair market value of the rights at the time of distribution. Any amount paid to exercise the rights is added to the basis of the stock acquired.
• Example of rights treatment. Corporation X distributes to its common shareholders pro rata rights to acquire preferred stock. The rights have a fair market value of $5,000 at distribution. Corporation X has $10,000 of E&P. The rights are § 306 stock because they are rights to acquire non-common stock distributed with respect to common stock. A shareholder who exercises the rights and acquires preferred stock holds § 306 stock with a dividend equivalency of $5,000 (the FMV of the rights at distribution). If the shareholder later sells the preferred stock for $8,000, $5,000 is ordinary income and the remaining $3,000 is tested against basis under § 306(a)(1)(B).
• CAUTION. Stock rights distributed on common stock are often overlooked as § 306 stock. Because rights are intangible and may have little or no apparent value when distributed, practitioners sometimes fail to recognize that they constitute § 306 stock. Even "in the money" rights distributed nontaxably under § 305(a) can trigger § 306. The FMV of the rights at distribution must be determined (often requiring a valuation) to assess the potential § 306 exposure.
• Basis allocation under § 307. When stock rights are distributed, the shareholder must allocate basis between the underlying stock and the rights under § 307. If the FMV of the rights is less than 15% of the FMV of the underlying stock, the basis of the rights is zero unless the shareholder elects to allocate. If the FMV is 15% or more, basis must be allocated. This allocated basis becomes the basis of the rights for § 306(a)(1) purposes.

"No gain or loss shall be recognized if stock or securities are exchanged solely for stock or securities in a corporation which is a party to the reorganization." (IRC § 354(a)(1)) "If a shareholder sells or otherwise disposes of section 306 stock (other than by way of a redemption, or a disposition referred to in paragraph (1)(B), (2), (3), or (4) of subsection (b)), then the amount realized shall be treated as a distribution of property to which section 301 applies." (IRC § 306(a)(1)(A))

Step 16. Related Code Sections and Critical Interactions

• § 301 and § 306(a)(2) redemption treatment. § 306(a)(2) treats the entire amount distributed in redemption of § 306 stock as a § 301 distribution. This means the § 301(c) ordering rules apply. The distribution is a dividend to the extent of current and accumulated E&P, then a tax-free return of basis (though § 306(a)(2) disregards basis), then capital gain. The interaction between § 306(a)(2) and § 301 ensures that redemptions of § 306 stock always produce the worst possible tax result for the shareholder.
• § 302(b) tests and their relationship to § 306 exceptions. The § 302(b) tests determine whether a redemption is treated as a sale or exchange (capital gain/loss) or as a § 301 distribution (dividend income). § 306 overrides the § 302(b) tests for redemptions of § 306 stock under § 306(a)(2). However, the § 302(b) tests are incorporated by reference into the § 306(b)(1)(B) termination of interest exception and the § 306(b)(4) tax avoidance exception. For § 306(b)(1)(B), the redemption must satisfy § 302(b)(3) or (4). For § 306(b)(4), the § 302(b) tests inform the determination of whether the shareholder's interest has been substantially reduced.
• § 303 redemptions to pay death taxes. § 303 provides that a redemption of stock from a decedent's estate may be treated as a sale or exchange (up to the amount of death taxes and funeral and administrative expenses) regardless of the § 302(b) tests. § 303 does not override § 306(a)(2). If the stock redeemed is § 306 stock, § 306(a)(2) still applies, and the redemption proceeds are treated as a § 301 distribution. However, because § 1014 steps up the basis of inherited stock, and because the step-up cleanses the § 306 taint under § 306(c)(1)(C), stock inherited from a decedent is generally not § 306 stock. Therefore, § 303 and § 306 rarely intersect in practice.
• § 305 and § 306 overlap. § 305 determines whether a stock distribution is taxable. If a stock distribution falls within one of the § 305(b) exceptions, it is taxable as a § 301 distribution and does not produce § 306 stock. If a stock distribution is nontaxable under § 305(a), it may produce § 306 stock if the stock distributed is not common stock issued with respect to common stock. The interaction is sequential. First apply § 305 to determine taxability, then apply § 306 to determine if nontaxable non-common stock distributions produce § 306 stock.
• § 307 basis allocation for stock distributions. When a corporation distributes stock (other than common on common) to a shareholder with respect to its stock, § 307 requires the shareholder to allocate basis between the old stock and the new stock. The allocation is based on the relative fair market values of the old and new stock at the time of distribution. The basis allocated to the § 306 stock is used in the § 306(a)(1) calculation. It reduces the amount of capital gain but does not reduce the amount treated as ordinary income.
• § 316 E&P determination. § 316 governs the determination of whether a distribution is a dividend. § 316(a) provides that a distribution is a dividend if it is paid out of either current E&P or accumulated E&P. § 316(a)(2) provides that current E&P is determined as of the close of the taxable year without reduction for distributions made during the year. This rule is critical for the § 306(a)(1) dividend equivalency calculation and for the § 306(c)(2) no E&P exception.
• § 317(b) redemption definition. § 317(b) defines a redemption as an acquisition by a corporation of its own stock from a shareholder in exchange for property, whether or not the stock is cancelled, retired, or held as treasury stock. This definition controls whether a transaction is a "redemption" for purposes of § 306(a)(2). Any acquisition of § 306 stock by the issuing corporation in exchange for property is a redemption subject to § 306(a)(2), regardless of form.
• § 318 constructive ownership rules. § 318(a) provides comprehensive constructive ownership rules for determining stock ownership. Family attribution under § 318(a)(1) attributes stock owned by spouses, children, grandchildren, and parents. Entity attribution under § 318(a)(2) and (3) attributes stock between entities and their owners. § 318(a) applies for purposes of the § 306(b)(1) termination of interest exception and the § 306(c)(3) § 351 exchange rule. The § 304(c)(3)(B) modification applies for § 306(c)(3) purposes.
• § 356(f) boot received for § 306 stock treated as § 301 distribution. § 356(f) provides that if boot is received in exchange for § 306 stock in a reorganization, the boot is treated as a distribution of property to which § 301 applies. This operates independently of the general § 356(a)(2) dividend equivalence rule. Even if the boot would not be treated as a dividend under § 356(a)(2) (e.g., because the shareholder's interest is substantially reduced), boot received for § 306 stock is always taxed as a dividend to the extent of E&P.
• § 1059 extraordinary dividends (corporate shareholders). § 1059 requires corporate shareholders to reduce the basis of stock by the nontaxed portion of extraordinary dividends received on the stock. While § 1059 does not directly interact with § 306, both provisions target similar transactions. The extraction of corporate value through distributions while the shareholder retains the underlying equity interest. A corporate shareholder that receives a nontaxable stock dividend and later sells the distributed stock must consider both § 306 and § 1059.
• § 170 charitable deduction reduction. Under § 170(e)(1)(A), a charitable deduction for a contribution of property is reduced by the amount of ordinary income that would have been recognized if the property had been sold. When § 306 stock is contributed to charity, the charitable deduction is reduced by the amount that would have been ordinary income under § 306(a)(1). This was the holding in Bialo v. Commissioner, 88 T.C. 1132 (1987), and Pescosolido v. Commissioner, 91 T.C. 52 (1988).

"Every person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe." (IRC § 6001) "The amount of taxes imposed by any other law shall be assessed within 3 years after the return was filed." (IRC § 6501(a))

Step 17. Documentation, Reporting, and Penalties

• Form 8949 and Schedule D for dispositions. A shareholder who sells or exchanges § 306 stock must report the disposition on Form 8949 and Schedule D of Form 1040. However, the portion of the gain treated as ordinary income under § 306(a)(1)(A) is not reported on Schedule D as capital gain. Instead, the ordinary income portion is reported as dividend income. Only the excess of the amount realized over the ordinary income amount plus basis is reported as capital gain on Schedule D. The shareholder should use code "O" on Form 8949 to indicate an ordinary income adjustment.
• Form 1099-B and 1099-DIV reporting. A broker who executes a sale of § 306 stock on behalf of a customer reports the proceeds on Form 1099-B. The broker does not adjust the proceeds for the § 306 ordinary income characterization. The shareholder must make the proper adjustment on Form 8949. If the corporation redeems § 306 stock, the corporation reports the redemption proceeds on Form 1099-DIV if the proceeds are treated as a dividend under § 306(a)(2).
• Form 8937 for corporate organizational actions. A corporation that issues stock in a distribution or reorganization that produces § 306 stock may be required to file Form 8937 to report organizational actions affecting the basis of securities. Form 8937 provides information to shareholders and the IRS about the tax consequences of stock distributions, recapitalizations, mergers, and other corporate actions.
• Form 8886 reportable transaction disclosure. If a transaction involving § 306 stock is identified as a reportable transaction under § 6011, the taxpayer must file Form 8886. Reportable transactions include listed transactions, transactions of interest, and other categories defined by the IRS. While § 306 transactions are not automatically reportable, aggressive structures designed to avoid § 306 through the tax avoidance exception or through complex reorganizations may trigger disclosure requirements.
• § 6662 accuracy-related penalties (20%). § 6662(a) imposes an accuracy-related penalty of 20% on the portion of an underpayment attributable to negligence or disregard of rules or regulations, or to a substantial understatement of income tax. If a taxpayer fails to properly report § 306 income and the IRS asserts a deficiency, the § 6662 penalty may apply. The penalty may be avoided if the taxpayer has reasonable cause and acted in good faith under § 6664(c), which requires adequate disclosure or a reasonable basis for the tax position.
• § 6707A failure to disclose penalties. § 6707A imposes penalties for failure to disclose reportable transactions under § 6011. If a § 306 transaction is a reportable transaction and the taxpayer fails to file Form 8886, the penalty is 75% of the decrease in tax resulting from the transaction, with minimum and maximum dollar amounts. The penalty applies to both individuals and entities.
• 3-year statute of limitations. Under § 6501(a), the IRS generally has three years from the date a return is filed to assess tax. For § 306 transactions, the statute of limitations runs from the filing of the return for the year in which the § 306 stock was sold, redeemed, or otherwise disposed of. If the return is filed before the due date, the statute runs from the due date.
• 6-year statute for substantial omissions. § 6501(e)(1)(A) extends the statute of limitations to six years if the taxpayer omits from gross income an amount properly includible that is in excess of 25% of the gross income stated on the return. If a taxpayer fails to report a significant amount of § 306 ordinary income, the 6-year statute may apply. For example, if a taxpayer reports $100,000 of gross income and fails to report $50,000 of § 306 income, the 6-year statute applies because the omission exceeds 25% of reported gross income.
• Documentation of E&P at distribution time. Practitioners must maintain contemporaneous documentation of the corporation's earnings and profits at the time of the original stock distribution. This includes workpapers showing the computation of current E&P under § 312 and accumulated E&P. The E&P computation is critical for both the § 306(a)(1) dividend equivalency calculation and the § 306(c)(2) no E&P exception. E&P should be computed under both § 312 and the regulations, with particular attention to adjustments for tax-exempt income, nondeductible expenses, and timing differences.
• Basis allocation records under § 307. When a nontaxable stock distribution produces § 306 stock, the shareholder must allocate basis between the underlying common stock and the § 306 stock under § 307. The allocation must be based on the relative fair market values of the common and preferred stock at the time of distribution. Practitioners should maintain contemporaneous valuations or market data supporting the allocation. If the stock is not publicly traded, a qualified appraisal may be required to support the FMV determination.
• Contemporaneous documentation for § 306(b)(4) exception claims. A taxpayer who claims the tax avoidance exception of § 306(b)(4) must produce substantial contemporaneous documentation. This documentation should include. (i) corporate minutes and board resolutions showing the business purpose of the distribution. (ii) independent valuations or fairness opinions supporting the transaction. (iii) Evidence of arm's length negotiation. (iv) documentation of the shareholder's financial or personal circumstances motivating the disposition. (v) Evidence that the shareholder did not participate in planning the distribution. (vi) Any other objective evidence showing that tax avoidance was not a principal purpose. Advance tax planning memoranda should be drafted carefully, as they may be used against the taxpayer.
• TRAP. Inadequate documentation can shift the burden and result in penalties. Taxpayers who fail to maintain proper E&P computations, basis allocation records, and exception documentation may find themselves unable to defend against IRS adjustments. The burden of proof for the § 306(b)(4) exception is on the taxpayer, and failure to produce contemporaneous evidence is often fatal. Practitioners should advise clients to maintain a § 306 file from the date of the original distribution through the date of disposition.
• Practice tip. Create a § 306 compliance checklist file. For each client transaction that may produce § 306 stock, practitioners should create a master file containing. (i) The corporate resolution authorizing the distribution or reorganization. (ii) the E&P computation at the time of distribution. (iii) The § 307 basis allocation worksheet. (iv) valuation reports for the stock distributed and the underlying common stock. (v) Copies of all stock certificates issued. (vi) Documentation of any subsequent changes to stock terms (for § 306(g) analysis). (vii) Shareholder agreements and buy-sell agreements. (viii) Constructive ownership charts under § 318(a). (ix) contemporaneous memos regarding business purpose and tax planning considerations.