305 – Stock Dividends
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305 – Stock Dividends. General Rule: Not taxable under 305(a). Exceptions under 305(b) – Taxable as 301 dividends. 1. Shareholder can take stock or property. 2. Some shareholders get property and proportional interests of others in assets and E & P is increased.

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305 – Stock Dividends

General Rule: Not taxable under 305(a).

Exceptions under 305(b) – Taxable as 301 dividends.

1. Shareholder can take stock or property.

2. Some shareholders get property and proportional interests of others in assets and E & P is increased.

3. Some shareholders get common stock and others get preferred stock.

4. Distribution on preferred stock (other than to maintain conversion equality).

5. Distributions of convertible preferred, unless can prove no change in proportional interests in assets or E & P.

Periodic Redemption Plans Under 305(c): may trigger constructive taxable stock dividend.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 313 - 1

Basic Facts: H Corp two classes voting common, equal rights to assets and E&P; F owns 100 shares class A; E & J each own 50 shares class B. Plenty of E & P.

Non-convertible preferred distributed pro rata to all. Non-taxable under 305(a); no 305(b) exceptions apply. Note: this 306 stock.

Pro rata distribution of A to A and B to B. B shareholders given cash option which J exercises. All have 301 dividend because of cash option. Any cash option taints all under 305(b)(1) exception.

Pro rata A stock to A and cash to B. B shareholders have cash 301 dividend. A shareholders have 301 dividend by virtue of 305(b)(2) – cash to some and increase in proportional interests (assets and E&P) to others.

B stock nonconvertible preferred and B stock distributed to A shareholders. If cash dividends paid to B shareholders (likely), then 305(b)(2) applies – cash to some and increase in interests to others.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 313 - 1

Basic Facts: H Corp two classes voting common, equal rights to assets and E&P; F owns 100 shares class A; E & J each own 50 shares class B. Plenty of E & P.

Same as (d), but subordinated class of nonconvertible preferred issued to A shareholders. If subordinated to B preferred, A shareholders interests in assets or E & P not increased. Hence, no 305(b)(2) exception. Non-taxable.

One class common and 10% convertible debentures. H pays interest on debenture and distributes common-on-common dividend with no adjustment to conversion ratio. Holders of convertible securities are shareholders per 305(d). Some get cash and common has proportional increase. Thus 305(b)(2) applies – taxable dividend.

Same as (f) but convertible preferred. One-for-one stock split on common, conversion ratio on preferred doubled. No increase in anyone’s proportional share. Thus, no 305(b)(2) and no 301 dividend.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 313 - 1

Basic Facts: H Corp two classes voting common, equal rights to assets and E&P; F owns 100 shares class A; E & J each own 50 shares class B. Plenty of E & P.

Classes A & B both voting common. Distribution of class A to A and new non-convertible preferred to B. Taxable under 305(b)(3) – some get common and some get preferred.

Same as (h), but preferred convertible into B common over 20 years. Dead under 305(b)(3). How about 305(b)(5)? Depends on likelihood of having impact on proportional interests of shareholders. Issue is likelihood of exercise. With 20 year window, maybe exercise in short term unlikely.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 308 - 2

Basic Facts: Z Corp has one class common: A 500 shares; B 300 shares; C 200 shares. Z agrees to redeem 50 shares each year from those who elect. A elects in two years.

305(c) concerned with series of redemptions that have effect of increasing proportional interests of shareholders. In year 1, A may qualify under 302(b)(1) for exchange treatment because of loss of control. If so, no impact on B and C. In year 2, no hope for exchange treatment. A has taxable dividend and B & C’s interests go up. Since part of periodic redemption plan, B & C deemed to have received taxable stock dividend.

LLM - Corporate Tax Instructor: Dwight Drake


306 Preferred Stock Bailout

Redeem Preferred

Corp

With E&P

Third

Party

Cash

Preferred

Stock

Tax Free

Preferred

Stock distribution

Under 305

Cash

Common

Stockholder

LLM - Corporate Tax Instructor: Dwight Drake


306 Stock – 306(c)

1. Non-common stock received by shareholder and not included in gross income by reason of section 305(a) – tax free stock dividend.

2. Non-common stock received in tax free corporate division or tax free reorganization.

3. Stock that has basis determined by reference to 306 stock. Carryover taint.

4. Stock acquired in 351 exchange where any money that would have been received would have been taxed as dividend under 304 (related corp redemption).

5. Big Out: No 306 taint beyond limits of E&P at the time of distribution.

LLM - Corporate Tax Instructor: Dwight Drake


306 Impact

Non-Redemption Sale of 306 Stock:

- Ordinary income for amount realized up to ratable share of E&P at time of distribution of preferred. Look back to E&P.

- Excess amount realized applied against basis, then gain. No loss allowed.

- If no amount to apply against basis, reallocate basis to common.

- Not treated as dividend, just tax on sale – thus no 243 deduction or E&P reduction.

Redemption of 306 Stock by Corp:

- Ordinary income for amount realized up to E&P at time of redemption.

- Treated as 301 dividend for all purposes – E&P reduction and 243 deduction.

- Any lost basis reallocated back to common.

LLM - Corporate Tax Instructor: Dwight Drake


Five 306 Exceptions

1. Sale is to non-318 party and terminates entire interest in corporation, tested against full 318 attribution.

2. Redemption that qualifies under 302(b)(3) (complete termination) or 302(b)(4) (partial liquidation for non-corporate shareholder)

3. Complete liquidation.

4. Transaction where no gain or loss recognized on sale of 306 stock.

5. Can prove distribution and sale not have tax avoidance as primary purpose. Best where related common redemption qualify for exchange treatment.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 1

Basic Facts: Year 1: A Corp distributes nonconvertible nonvoting preferred worth 1k to J and V, equal unrelated common holders. J and V common basis 2k prior to distribution and value of 3k after distribution. A E&P 2k at distribution, 3k in year 3.

Tax consequences of distribution? Tax free stock dividend to J and V per 305(a). 306 stock per 306(c)(1)(A). Stock basis allocated between common and preferred based on relatives values at distribution per 307. Thus 75% basis to common (3000/4000) of 1.5k, and .5k allocated to preferred. A Corp has no gain on issue of preferred and no impact of E&P.

V sells preferred to unrelated C for 1k in year three. Vera’s gain against basis is 500 (1k less .5k basis) and would be LTCG absent 306. But here 306(a) treats full 1k realized as ordinary income to extent of V ratable share of E&P at distribution. Here E&P share 1k (50% of 2k). Thus V has 1k ordinary income. Her preferred basis (.5k) allocated back to common. No impact on A Corp E&P because not dividend, but rather treated as income from V sale of preferred.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 1

Basic Facts: Year 1: A Corp distributes nonconvertible nonvoting preferred worth 1k to J and V, equal unrelated common holders. J and V common basis 2k prior to distribution and value of 3k after distribution. A E&P 2k at distribution, 3k in year 3.

Vera sells preferred for 1750 in year 3. 1k ordinary income per analysis in (b). Extra 750 netted against .5 basis for 250 capital gain. No basis reallocation back to common.

Same as (b) (1k sale), but no E&P at time of distribution. No 306 stock because no dividend under 301 if money distributed. Here 500 gain is LTCG. What if 200 E&P at distribution? Then 100 ordinary (half of E&P) and extra 900 netted against 500 basis for 400 LTCG.

J gives preferred to grandson C who sells for 1k. Gift not 306 disposition, but 306 taint continues to C. C sale escape 306 per 306(b)(1)(A) exception (non-redemption sale to unrelated party that terminates entire interest tested against full 318 attribution). Here no attribution from grandfather J. If bequest at death, no 306 taint because of basis step-up under 1014.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 1

Basic Facts: Year 1: A Corp distributes nonconvertible nonvoting preferred worth 1k to J and V, equal unrelated common holders. J and V common basis 2k prior to distribution and value of 3k after distribution. A E&P 2k at distribution, 3k in year 3.

(f) What impact if J contributes preferred stock to a public charity? The issue is the size of the charity deduction under section 170. Normally it would be fair market value of the stock (1k), but section 170(e)(1)(A) requires reduction in contribution for any non-capital gain that would have been recognized on the sale of the stock. Here, the gain would have been ordinary income as a “dividend” under 306. Does this bring in play the 170(e)(1)(A) limitation and limit charitable deduction to basis? Authors think “Yes”. Bittker & Eustice say “No” because dividends are now taxed the same as long-term capital gains so 170(e)(1)(A) should not apply to dividends.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 1

Basic Facts: Year 1: A Corp distributes nonconvertible nonvoting preferred worth 1k to J and V, equal unrelated common holders. J and V common basis 2k prior to distribution and value of 3k after distribution. A E&P 2k at distribution, 3k in year 3.

  • Year 3: A redeems half J’s common for 5k and all J’s preferred for 1.5k. Common stock redemption qualifies as exchange under 302(b)(2) ( 50% and both 80% tests satisfied). Normally preferred redemption would piggy back for exchange treatment. Reg. 1.302-3(a).

  • Not so with 306 stock. Here per 306(a)(2) full 1.5k realized on preferred treated as 301 dividend in year of redemption. Plenty of E&P, so 1.5 taxable dividend. Preferred basis of .5 allocated back to remaining common.

    Note: 306(b)(4) exception if not in furtherance of plan to avoid tax and prior or simultaneous redemption of underlying stock that preferred issued on. Unclear if it applies to partial redemption of underlying common. Logically should if redemption of common reduces or changes control, as here.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 1

Basic Facts: Year 1: A Corp distributes nonconvertible nonvoting preferred worth 1k to J and V, equal unrelated common holders. J and V common basis 2k prior to distribution and value of 3k after distribution. A E&P 2k at distribution, 3k in year 3.

(h) Same as (g), but corporate bylaws require unanimous shareholder approval for corporate action and amendment requires 75%. Here, no change in control of corporate affairs by common redemption and 306(b)(4)(B) exception highly unlikely. Fireoved v. US, 462 F.2d 1281(3rd Cir. 1972).

(i) Same as (f) but no E&P in year three. 1.5k for preferred still 301 distribution, but not taxable as dividend. Reduce basis of preferred (.5). Unclear whether then reduce remaining common basis (.75). Probably does. Hence LTCG on preferred redemption only .25k.

LLM - Corporate Tax Instructor: Dwight Drake


Problem 330 – 2

Basic Facts: Year 1: Z Corp 100 shares common owned by S. Plenty of E&P.

S form H Corp by transferring 50 shares of Z stock in return for 100 H common shares and 100 H preferred shares. Preferred shares are 306 stock per 306(c)(3) because:

- Acquired in 351 exchange, and

- If money had been received, would have been treated as dividend under 304(a)(1), applying 304(b)(2) rules where Z Corp E&P available.

(b) Z Corp owned equally by S and C, unrelated, each with 50 common. Form H Corp by transferring all Z common; S gets 100 shares H common; C gets 50 shares H common and 50 shares H preferred. Is preferred 306 stock? Issue under 306(c)(3) is whether S would have dividend treatment under 304 if money had been received. Here, her Z control goes from 50% to 33%. So qualify for exchange treatment under 302(b)(2). Thus, no dividend issue and preferred not 306 stock.

LLM - Corporate Tax Instructor: Dwight Drake


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