Chapter Six – (1) Stock Dividends & (2) §306 Stock

A stock dividend is defined as:

A distribution by the issuer corporation of its own stock to its shareholders.

Alternative types of dividend distributions:

1)  cash;

2)  property (e.g., (a) land or (b) stock of another corporation);

3)  debt of distributing corporation; or, 

4)  stock of the distributing corporation.

Possible Types of  Distributions of Stock

1)  Same class of stock (e.g., common on common) – dividend made to retain the corporation’s cash.

2)  A different class (e.g., preferred stock  distributed on common stock) - to enable preferred ownership status for some shareholders.

3)  Rights or warrants to acquire stock of the  distributor - to facilitate obtaining additional cash infusions from some shareholders who can buy stock at an advantageous price based on the pricing of the stock right.

Stock Split vs. Stock Dividend                      p.290

What  (1) financial accounting and (2) Texas Business Organizations Code treatment?

Stock dividend - requires an allocation from earned surplus to stated or paid-in capital account for the distributing corp.

Stock split - no required allocation to paid-in capital; objective is to make the price of the stock more attractive for trading.

Stock Distributions Before Code §305                   p.292

Eisner v. Macomber - a distribution of a stock dividend is not "income" in the U.S. Constitutional sense (16th amendment), rejecting the Revenue Act of 1916 provision.

But, does (should) the power to tax income include the power to define “income”?

Subsequent litigation history (p.294):  Did an increase occur in a shareholder’s proportionate interest in the corporation.

Stock Distributions Before Code §305, cont.        P.292

Legislative sequel (1954 Code, Regs. & 1969 Act):
(1) Code §305(a) - gross income does not include any distribution of stock on stock, subject to various exceptions where the proportionate ownership interest is changed.   

(2) Code §306 - preferred stock bailouts produce postponed ordinary income to the recipient shareholder.

Code §305(b) Exceptions - Income Recognition

1)  §305(b)(1) - distributions in lieu of money - election available to the shareholder to take cash or stock – this results in a change in the proportional stock ownership for all.

2)  §305(b)(2) - disproportionate distributions occurring as a result of:  (i) the receipt of property by some shareholders; and,  (ii) an increase in the proportionate share interests in the corporation by others.

Code §305(b), continued

3) §305(b)(3) - distributions resulting in the receipt of (i) preferred stock by some common shareholders,  and (ii) common stock by other common shareholders.

4) §305(b)(4) - distributions of stock on preferred stock (except for capital adjustments).

5) §302(b)(5) distributions of convertible preferred - unless establishing that not resulting in a disproportionate distribution.

Rev. Rul. 78-60
P.299

Periodic small redemptions by shareholders of a closely held corporation.  Small changes in ownership resulting from these distributions.

Issue 1:  Redeeming shareholders not eligible for §302(a) exchange treatment.  No §302(b) exceptions apply.  Therefore, §301 distributions.

Issue 2:  Remaining shareholders had small percentage increases.  See §305(c) regs. re §301 dividend treatment for these shareholders.

Treatment to Recipient Shareholder - Other Effects

1) Dividend distribution amount is FMV of stock & then an E&P reduction.

2) Allocation of tax basis in proportion to the relative fair market values of various shares on the date of the distribution.  §307(a).

3) Tacking of the holding period.  §1223(5).

4) §305 impacts a stock rights distribution.

5) §307(b) – no allocation of tax basis when rights are distributed & rights value less than 15%.

Problem - Hill Corporation page 303

Frank              Fay                 Joyce

100 Class A     50 Class B      50 Class B

(a)  Prorata distribution is made of nonconvertible preferred stock to both classes of shareholders.

This is a nontaxable distribution under §305(a).

The §305(b) exceptions are not applicable.

But, cf., the §306 preferred stock provision.

Problem 1(b)               p.303
Option to Take Cash

(b) Pro-rata distributions are made, but Class B shareholders have the option to take cash. 

§305(b)(1) - Class B shareholders have the option to be paid in either stock or property.

Reg. §1.305-2(a)(5) provides that, if all or part of the shareholders have an election, then, with respect to all shareholders, a §301 distribution occurs - even though only part of the shareholders have the election. 

Problem 1(c)               p.303
Cash Paid on One Class

(c)  Pro-rata distribution of Class A on Class A and cash distribution on Class B.

Class B - §301 taxability on cash distribution.

Class A - distribution is taxable under §305(b)(2).  The distribution has the result of (i) the receipt of property by some shareholders (Class B), and (ii) an increase in proportionate interests (in assets and E&P) of other shareholders, i.e., the Class A shares.

Problem 1(d)               p.303
Preferred Paid on Common

(d) Class B stock is nonconvertible preferred paying cash dividends.  Class B stock is distributed to Class A shareholder.

Cash dividends being paid on the Class B (preferred) shares are included under §301.

Distribution to the Class A shareholder will be within §305(b)(2).  Further, the Class A shareholder will have increased his proportionate interest in Corp's assets and earnings & profits. 

Problem 1(e)               p.303
Upgrade to Junior Stock

(e) Same as (d), but Hill distributes to Class A shareholders nonconvertible preferred stock with rights to assets and E&P subordinate to the existing Class B stock (i.e., distribution of "junior" nonconvertible preferred).

This distribution does not increase the proportionate interest of the Class A shareholder - the distribution is not within §305(b)(2)(B) & no dividend treatment occurs to the Class A shareholder (§305(a)).

Problem 1(f)                p.303
Convertible Debentures

(f) Outstanding are:  (i) One class of common stock, and (ii) 10% debentures convertible into common at the rate of one share of common for each $1,000  debenture.  Interest is paid on debentures and then a “common on common” stock dividend is distributed to common stock holders without a conversion ratio adjustment.

§305(d)(2) – the debenture holders are “shareholders.”   The common stock received is taxable to the common shareholders.

Problem 1(g)               p.304
Conversion Rate Changed

(g)  Debentures are convertible preferred.

Corporation declares a 1-for-1 split on the common.  The conversion rate on the preferred stock is doubled (i.e., two shares common for debenture).

Result: the proportionate interest of the common stockholders is not increased by the stock split - since the preferred conversion ratio is fully adjusted.  The common stock distribution is not taxable - §305(a).

Problem 1(h)               p.304
Preferred & Common

(h)   Class A and Class B are both voting common.

Hill makes a distribution of (i) Class A on Class A and (ii) a new nonconvertible preferred on Class B.

A taxable distribution results to both Class A and Class B shareholders under §305(b)(3).

What relevance of this type of transaction to estate planning  (e.g., “estate planning recapitalization”)?

Reg. § 1.305-3(e), Ex. 12, permits nonrecognition.

Problem 1(i)                    p.304
Convertible preferred stock

(i) Preferred stock distributed is convertible into Class B stock over 20 years at B's market price on the date of the distribution.

See §305(b)(5) - convertible preferred stock.

Distribution to the Class B shareholders will be taxable unless the distribution does not result in a disproportionate distribution.

Here likely nontaxable:  why?  full conversion is probable over 20 years at the distribution price.

Problem 2                   p.304
Z Corporation          §305(c)

Z agrees to redeem annually 50 shares (10%) of stock at the election of each shareholder.

A makes this election for two consecutive years.   §305(c) problem.  What result?  No §301 for A?

Year 1 Before After

A                50%             47.4%           (450/950)

B                30%             31.6%   (300/950)

C                20%             21%               (200/950)

Increase of the share % interests of B and C.

Problem 2  cont.     Year 2
Z Corp. - Share Redemption

Year 2 Before After

A                 47.4% 44.4%          (400/900)

B                 31.6% 33.3% (300/900)

C                 21%             22.2% (200/900)

No §302(b)(1) here for A (& B&C have §305(c). 

Cf., isolated redemptions which are not part of a periodic redemption plan do enjoy immunity from §305(c).   See Reg. §1.305-3(b)(3), (e), Examples 10 & 11.

Code §306 - Preferred Stock Bailout              p.304

Chamberlain decision – noted, p.304

Facts:  Declaration of a preferred stock dividend.

All shareholders sold to insurance companies the preferred stock received in the stock distribution.

The preferred stock was redeemed by the insurance company over a 7 year period.

Held: The stock dividend was a nontaxable issuance of stock in substance and in form. 

Code §306 Structure
p.305

1) The receipt of the preferred stock (i.e., not common stock) is not a current taxable event.

2) The stock bears a "taint" which triggers income recognition at some later date,  i.e., upon a sale or a redemption of the preferred stock.

3) Definition of §306 stock:   Other than common on common - Code §306(c)(1).

Issue: Does the "common" have participation in the growth of the corporation’s equity?

Rev. Rul. 79-163       
fn. 3, p.306

Situation 1:  Corporation had 100x shares of common issued in the exchange:

1) Class A common - voting $20 par.

2) Class B common - nonvoting $100 par.

Cash dividends in the ratio of the par values.

Neither class was redeemable.

Upon liquidation only par value to Class A.

Held:   Class A is §306 stock.           continued

Rev. Rul. 79-163, cont. 
Fn. 3, p.306

Situation 2:   Equal rights to participate in dividends to 6% of the par value after which Class B participates for the remaining cash dividends (i.e., Class B can receive all the additional benefits of the equity growth).

Liquidation distribution will be proportionate to the par values of the shares.

Held:  The Class A stock is §306 stock.

Rev. Rul. 76-386       
fn. 5,   p.306

Recapitalization plan - Code §368(a)(1)(E).

Corporation X issues new voting common and new nonvoting common pro-rata.

Corporation had a right of 1st refusal to purchase voting common at net book value.

Issue: Is the new voting common treated as "common stock" for purposes of §306(c)(1)(B)?     Yes, voting common stock, i.e., not §306 stock, since represents a right to participate in growth.

Possible Acquisitions of §306 Stock                p.306

1)  Preferred stock dividend.

2)  Gift & transferred basis stock.

3)  Tax-free merger (e.g., recapitalization).

4)  Holding company structuring, i.e., drop-down

into sub (see §306(c)(3)).

Not when stock passes through an estate (§1014

basis step-up is applicable to also eliminate the §306

taint).

Dispositions of §306 Stock – Sale                          p.308

1) Sale of §306 Stock - §306(a)(1).         

A ratable share of the earnings and profits when the stock is distributed is ordinary income realized upon the subsequent sale of this stock.

2003 tax legislation:  §306(a)(1)(D) provides for “dividend” treatment for §1(h)(11) purposes (i.e., the 15 % individual tax rate on dividends).  Expiration of this provision?                                      continued

Dispositions of §306 Stock – Redemption              p.308

2) Redemption of §306 stock - §306(a)(2).

The amount realized on the redemption of

§306 stock is treated as a §301 distribution. 

I.e., measurement of the dividend effects (including  E&P) occur as of the date of the redemption (and not as of the date of distribution of the §306 stock).

Dispositions Exempt from  §306 Treatment          p.309

1) §306(b)(1)(A) - non-redemption but a complete termination of interest (e.g., sale).

2) §306(b)(1)(B)  - a §302(b)(3) redemption or a §302(b)(4) partial liquidation.

3) §306(b)(2) - a complete liquidation.

4) §306(b)(3) - a nonrecognition transaction.

5) §306(b)(4) - transactions not in avoidance of federal income taxation.

Fireoved case             p.310

§306(b)(4) issue - concerning what is "not in avoidance of tax".

1) Distribution of stock dividend pursuant to a plan having as one of its principal purposes the avoidance of federal income tax.

2)  Effect of the earlier sale of 24% of the shares of common stock? Immunize from §306?

3) FIFO rule application.  Were 65 of the 451 preferred redeemed from the original issue?

Problem 1                        p.316
Preferred Stock Distribution

Argonaut distributed preferred worth $1,000 to two unrelated equal common shareholders. 

To each shareholder the common had a tax basis of $2,000 prior to the distribution and a value of $3,000 immediately after distribution. 

Corp. had $2,000 prior earnings and profits.  In year 3  Corp. had $3,000 of e&p.                            continued

Problem 1(a)                    p.316
Stock Distribution

What effect of the distribution in year one to: Shareholders:  (i) Nontaxable distribution under §305(a); (ii) preferred stock under §306(c)(1)(A); (iii) tax basis in the preferred stock is determined under §307 allocation rules according to the relative fair market values (1,500 to common & 500 pref.).

Corporation: (i) No gain recognition on the distribution of the preferred - §311(a)(1);

(ii) Earnings and profits are not adjusted.

Problem 1(b)                    p.316
Sale to Third Party

Vera sells the preferred stock to Carl, an unrelated party, for $1,000 in year three.

Amount realized                 1,000

Tax basis                            500

Gain                                    500  LTCG

But, assuming §306(a)(1) applies.

1) Impact to Vera?  1,000 ordinary income? Tax basis back to common stock.

2) Impact to Argonaut? No e&p adjustment.

Problem 1(c)                    p.316
Sale for a Larger Amount

Vera sells the preferred stock to Carl for $1,750.     (Query:  How can this nonconvertible preferred appreciate to $1,750?)

1)  $1,000 of ordinary income. §306(a)(1)(A).

2)    $500  basis recovery.

3)    $250 capital gain.

Problem 1(d)                    p.316
No E&P at Distribution

Argonaut had no E&P at the time of the distribution of the preferred stock.

The preferred stock would not be §306 stock - §306(c)(2).

The sale for $1,000 produces $500 gain. 

($1,000 amount realized less the $500 allocated tax basis).

Problem 1(e)                    p.316
Gift of §306 Stock

Jason gives the preferred stock to grandson, Claude, who later sells stock for $1,000.

1) Gift is not a disposition triggering §306 taint.

2) Claude takes the preferred with:

    a)    $500 basis  -  §1015(a).

    b)    §306 taint  -  §306(c)(1)(C).

3) Sale by Claude - $1,000 ordinary income or $500

basis recovery and $500 capital gain (yes, since

termination of shareholder interest)?

Problem 1(f)                    p.316
Gift of §306 Stock to Charity

Jason gives the preferred stock to charity.

No charitable deduction for the ordinary income component in the preferred stock.

§170(e)(1)(A) – only $500 basis is deductible, since ordinary income for remaining portion? 

Or, is a different result applicable when a 15% tax

rate applies to dividends and capital gains?

Doubtful.

Problem 1(g)                    p.316
Stock Redemption

Argonaut redeems one-half of Jason's common stock for $5,000 and all of his preferred stock for $1,500.

Redemption qualifies for exchange treatment under §302(b)(2).  After the redemption Jason owns 33%  of the combined voting power and Vera owns 67%.  Jason holds (i) less than 50% and (ii) less than 80% of 50%.

Effect on the preferred & common redemptions? $1,500 for preferred treated as dividend distribution - §306(a)(2).  Pref. basis to common.

Problem 1(h)                    p.316
Voting Control Restrictions

Same as (g) but different voting requirements - i.e., unanimous shareholder agreement required for corporate action.

1)  Redemption of the common qualifies as an exchange under §302(b)(2);  but -

2)  Redemption of the preferred -

§306(b)(4)(B) exception will not apply;  corporate control is maintained. 

Problem 1(i)                    p.316
No E&P

Same as (g), but Argonaut has no E&P in year three. Redemption of common under §302(b)(2).

Assuming Code §306(b)(4) does not apply:

Preferred shares are still Code §306 stock; $1,500 distribution - §301;

but, none is dividend, since no e&p.

Recovery of basis of $500 and gain of $1,000?

Problem 2(a)                    p.317
Holding Company Creation

Zapco has 100 com. shares owned by Sam.

Sam forms a holding company by transferring 50 (of 100) Zapco shares in exchange for:

   i) 100 shares of Holding common stock,  &

   ii) 100 shares of Holding preferred stock.

Holding Co. preferred stock will be §306 stock under §306(c)(3).

Problem 2(b)                    p.317
§306 Stock

Step One:

Sam                                    Selma

50 Zapco common      50 Zapco common

Step Two:    All Zapco stock into Holding Co.

Sam receives                Selma receives

100 shares                    50 shares holding com.

holding common              & 50 shares holding pref.

Issue: Is Selma’s preferred §306 stock?  No dividend (under §304(a)(1) if money received).