Chapter 6 Flashcards
What is the general rule of stock dividends?
General Rule:
Distributions of company stock or stock rights are not taxable under §305(a) unless one of the five exceptions under §305(b) applies
Calculate the new basis of:
- Shareholder has “old” shares with a basis of $90,000 and a FMV of $210,000
- Corporation distributes two shares of “new” on each share of “old”
What section is this rule in?
- FMV of “old” after distribution = $70,000
- FMV of “new” after distribution = $140,000
- Basis is “spread” as follows:
- “Old” shares get $30,000
- “New” gets $60,000
307(a)
What are the exceptions to the 307a basis rule?
Exception to the §307(a) Basis Rule
- Applies only to stock rights
- If the value of the stock right is less than 15% of the value of the old stock, no basis is allocated to the stock right
- As such, the stock right has a basis of zero
- Shareholder may elect to allocate basis
What are the 5 exceptions to 305(a) tax free treatment?
Five Exceptions to §305(a) Tax-Free Treatment:
- Distributions in lieu of money
- Disproportionate distributions
- Distributions of common and preferred stock
- Distributions on preferred stock
- Distributions of convertible preferred stock
What are the 3 elements of:
Five Exceptions to §305(a) Tax-Free Treatment:
- Distributions in lieu of money
- Applies if shareholder has the option to take cash (or other property) in place of receiving stock
- Applies even if the shareholder elects to take stock (i.e., the stock dividend is taxable under §301)
- Watch out for “variations on a theme”
What are the facts and issues of Rev Ruling 78-375
Facts:
- X is a corporation engaged in commercial banking
- X is publicly traded
- X established an automatic dividend reinvestment plan
- The plan allowed shareholders to purchase stock at a discount by reinvesting their dividends in stock rather than taking cash. Stock so purchased could be purchased at 95 cents on the dollar
- Shareholders also had the right to buy additional shares at the same price
- Shareholders who do not participate in the plan receive cash dividends rather than stock
- Issue:
For the shareholders who participate in the dividend reinvestment plan, are the dividends paid in stock tax-free under §305(a)?
Holding:
No. Such dividends are taxable under §305(b)(1) since the shareholder could choose between receiving cash or stock.
What does ‘disproportionate distributions’ mean in 305(b)(2)?
Classic transaction – stock distributed to one group of shareholders and cash (or other property) distributed to another group of shareholders
What does ‘distributions of common to some and preferred to other shareholders’ mean in 305(b)(3)?
Basically the same rule as §305(b)(2) (disproportionate distributions) if you consider the preferred stock to be “property”
Whate are the elements of 305(b)(4)- Distributions on preferred stock?
Five Exceptions to §305(a) Tax-Free Treatment:
Distributions on Preferred Stock (§305(b)(4))
- Preferred stock is viewed as a “limited interest” in the corporation’s equity
- Any distribution of stock (common or preferred) increases the proportionate interest of the preferred shareholder
- Exception – if distribution does not increase a preferred shareholder’s interest, it is not taxable
What are the facts and issues of Rev Ruling 77-37
Facts:
X Corporation is capitalized with common and preferred shareholders
Preferred shareholders have a conversion privilege at a fixed ratio
X Corporation spun-off subsidiary to the common shareholders
Preferred shareholders were thus penalized since the value of the common stock (to which they could convert their stock) decreased due to the spin-off
Conversion privilege was revised to account for the spin-off
Issue:
Is this a taxable dividend under §305(b)(4)?
Holding:
No. Change in conversion privilege simply permitted the preferred shareholders to remain in the same position post-spin-off as pre-spin-off. As such, the change is not a taxable dividend.
What are the elements of 305(b)(5)- Distributions of convertible preferred stock?
Distributions of Convertible Preferred Stock (§305(b)(5))
- Convertible preferred stock risks the potential that some preferred stock will be converted to common and other preferred stock will not
- End result is potentially the same as a a distribution of common and preferred stock. If some preferred shareholders convert and others don’t, it is as though some shareholders received common stock and others preferred stock
What is the impact of a stock dividend on the distributing corp?
Impact of Stock Dividend on Distributing Corporation
§1032 precludes any gain to the distributing corporation upon issuance of its own stock – common or preferred
As such, a stock dividend (taxable or not) is not taxable at the corporate level (i.e., §311(b) does not apply)
What are the 306 stock rules about the sale of stock?
§306 Stock Rules – Sale of §306 Stock
- Upon sale of preferred stock, capital gain is converted to dividend income to the extent:
- Original distribution of preferred would have been a taxable dividend if cash of equal value had been distributed in place of preferred stock
- Any value in excess of the dividend amount is treated first as a reduction to basis and second as a capital gain
- No loss is recognized
- §306 stock does not reduce the corporation’s E&P (either upon distribution or upon sale)
- Terminology = “306 Taint”
- Not a significant issue today given the 15% dividend/LTCG rate (though for basis reasons the treatment may not be identical)
- Watch out for taxpayers gifting §306 stock to a charity and expecting a full FMV charitable deduction
What are the 306 stock rules on the redemption of stock?
§306 Stock Rules – Redemption of §306 Stock
- Redemption amount treated as a dividend to the extent of E&P on the date of redemption (not the date of the preferred stock distribution as in the sale of §306 stock). This is true even if the §302(b) requirements are met (but see the exceptions on the following slide).
- Redemption amount realized in excess of the dividend is first a recapture of basis and then a capital gain
- Any un-recaptured basis is transferred to the common stock
What are some exceptions to 306?
- Complete termination (attribution rules under §318 apply)
- Liquidations
- Tax-free transfers (§351, reorganizations, etc.) however, the replacement stock carries the §306 taint
- Transactions not in avoidance of tax
- Death!!
