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) - 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.
Stock Split vs. Stock
Dividend p.303
What financial
accounting and 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.305
Eisner v. Macomber - a
distribution of a stock dividend is not "income" in the U.S.
Constitutional sense (16th amendment).
But, does (should) the power
to tax income include the power to define “income”?
Sequel: (1) Code §305(a) -
gross income does not include amount of any distribution of stock on
stock. (2) Code §306 - preferred stock bailouts produce postponed ordinary
income.
Code §305(b) Exceptions -
Income Recognition
1) §305(b)(1) -
distribution in lieu of money - election to the shareholder to take cash
or stock - results in a change in 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) - distribution
resulting in the receipt of (i) preferred stock by some common shareholders,
and (ii) common stock by other common shareholders.
4) §305(b)(4) - distribution on
preferred stock (except for capital adjustments).
5) §302(b)(5) distribution of
convertible preferred - unless establishing that not resulting in a
disproportionate distribution.
Treatment to Recipient
Shareholder - Other Effects
1) Allocation of tax basis in
proportion to the relative fair market values of various shares on the date of
the distribution. Code §307(a).
2) Tacking of the holding
period. §1223(5).
3) §305 impacts a stock rights
distribution.
4) Code §307(a) - allocation
of tax basis when rights are distributed, but, not if rights value is less than
15% of the total stock value. §307(b).
Problem - Hill Corporation page
313
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.
Nontaxable distribution under
§305(a).
The §305(b) exceptions are not
applicable.
But, cf., the §306
preferred stock provision.
Problem 1(b)
p.313
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.313
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.313
Preferred Paid on Common
(d) Class B stock is
nonconvertible preferred paying cash dividends. Class B stock is distributed
to Class A shareholder.
If cash dividends are being
paid on the Class B shares the distribution to the Class A shareholders 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.313
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) and no dividend
treatment occurs to the Class A shareholder.
Problem 1(f)
p.313
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 and then a “common on common” stock dividend is distributed to common
stock holders without a conversion ratio adjustment. What distribution
amount? 1:1?
§305(d)(2) – the debenture
holders are “shareholders.” The common stock received is taxable to the
common shareholders.
Problem 1(g)
p.314
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.
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.314
Preferred & Common
(h) Class A and Class B are
both classes of voting common stock.
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?
Problem 1(i)
p.314
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 –
full conversion probable over 20 years at distribution price.
Problem 2
p.314
Z Corporation §305(c)
Z agrees to redeem annually 50
shares of stock at the election of each shareholder.
A makes this election for two
consecutive years. §305(c) problem. What result?
Year 1 Before After
A 50% 47.4%
(450/950)
B 30% 31.6%
(300/950)
C 20% 21%
(200/950)
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)
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.314
Chamberlain decision - p.314
Declaration of a preferred
stock dividend.
All shareholders sold to
insurance companies the preferred stock received in the 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.319
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., 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. 4, p.319
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. 4, p.319
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.320
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,
common stock, i.e., not §306 stock.
Possible Acquisitions of §306
Stock p.320
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 through an
estate (§1014 is applicable to eliminate the §306 taint).
Dispositions of §306
Stock – Sale p.321
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). continued
Dispositions of §306
Stock – Redemption p.321
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.321
1) §306(b)(1)(A) -
non-redemption but a complete termination of interest.
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.323
§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?
3) FIFO rule application. Were
65 of the 451 preferred redeemed from the original issue?
Problem
1 p.330
Preferred Stock Distribution
Argonaut distributed preferred
worth $1,000 to two unrelated equal common shareholders.
To each 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.331
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 preferred
is determined under §307 allocation according to the relative fair market
values.
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.331
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? Ordinary
income? Basis?
2) Impact to Argonaut? No
e&p adjustment.
Problem 1(c)
p.331
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.331
Effect of No E&P
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.331
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.
2) Claude takes the
preferred with:
a) $500 basis -
§1015(a).
b) §306 taint -
§306(c)(1)(C).
3) Sale - $1,000 ordinary
income or $500 basis recovery and $500 capital gain?
Problem 1(f) p.331
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?
Problem 1(g)
p.331
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?
Problem 1(h)
p.331
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.331
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: Still Code
§306 stock? Yes; $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.331
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.331
§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?