305

1
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.
2
Problem 648 - 1

• Basic Facts H Corp two classes voting common,
  equal rights to assets and EP 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 EP) 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.

3
Problem 648- 1

• Basic Facts H Corp two classes voting common,
  equal rights to assets and EP 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 issues 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
  anyones proportional share. Thus, no 305(b)(2)
  and no 301 dividend.

4
Problem 648 - 1

• Basic Facts H Corp two classes voting common,
  equal rights to assets and EP 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.

5
Problem 648 - 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 Cs interests go up.
Since part of periodic redemption plan, B C
deemed to have received taxable stock dividend.
6
306 Preferred Stock Bailout
Redeem Preferred
Corp With EP
Third Party
Cash
Preferred Stock

Tax Free Preferred Stock distribution Under 305
Cash
Common Stockholder
7
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 EP at the time of
distribution.
8
306 Impact
Non-Redemption Sale of 306 Stock - Ordinary
income for amount realized up to ratable share of
EP at time of distribution of preferred. Look
back to EP. - 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 EP reduction. Redemption of 306
Stock by Corp - Ordinary income for amount
realized up to EP at time of redemption. -
Treated as 301 dividend for all purposes EP
reduction and 243 deduction. - Any lost
basis reallocated back to common.
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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.
10
Problem 655 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 EP 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 EP.
• V sells preferred to unrelated C for 1k in year
  three. Veras 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 EP at
  distribution. Here EP share 1k (50 of 2k).
  Thus V has 1k ordinary income. Her preferred
  basis (.5k) allocated back to common. No impact
  on A Corp EP because not dividend, but rather
  treated as income from V sale of preferred.

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Problem 655 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 EP 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 EP at time of
  distribution. No 306 stock because no dividend
  under 301 if money distributed. Here 500 gain is
  LTCG. What if 200 EP at distribution? Then 100
  ordinary (half of EP) 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.

12
Problem 655 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 EP 2k at
  distribution, 3k in year 3.
• (g) Year 3 A redeems half Js common for 5k and
  all Js 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 EP,
  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.

13
Problem 655 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 EP 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 (g) but no EP 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.

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Problem 655 2

• Basic Facts Year 1 Z Corp 100 shares common
  owned by S. Plenty of EP.
• 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 EP
  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 C would have dividend treatment under 304
  if money had been received. Here, Cs 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.