The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 2, September 2001, Panel Publishers, New York, NY.

PREFERRED STOCK DISTRIBUTED IN RECAPITALIZATION HELD NOT TAXABLE

By Robert W. Wood

Technical Advice Memorandum 200116002, Tax Analysts Doc. No. 2001-11252, 2001 TNT 78-21, considers shareholders who receive preferred stock in a recapitalization. The question is whether the distribution of the preferred is considered a taxable distribution under Section 305(b) or 305(c). The Tech Advice Memo rules that a shareholder's receipt of preferred stock in a recapitalization is not a taxable distribution under Sections 305(b) or (c).

Facts and Assumptions

Consider the following: Target, an S corporation, is owned by three unrelated shareholders. Target's sole asset is a contract to provide a fixed quantity of product to one customer. Publicly traded LossCo acquired an 80 percent interest in Target for cash and a note after Target recapitalized, created Newco, and merged with and into Newco under state law. Target common then converted into Newco preferred.

The Service reasoned that Section 305(b) is inapplicable because the distribution did not increase the shareholder's proportionate interest in Newco. The Service also determined that Section 305(c) was inapplicable because the preferred stock participates in corporate growth to a significant extent.

Go Figure?

Ordinarily, of course, a corporate distribution of property to a shareholder with respect to the corporation's stock is taxed under Section 301(c). Section 305(a) provides an exception to the taxation of distributions to shareholders under Section 301(c): gross income does not include the amount of any distribution of the stock of a corporation made by the corporation to its shareholders with respect to its stock. Section 305(b) eliminates the exclusion from gross income contained in Section 305(a) for distributions of stock that meet the requirements of paragraph (1), (2), (3), (4) or (5) of Section 305(b). Section 305(b)(1) applies to distributions payable, at the election of any shareholders, either in stock or property. Section 305(b)(2) applies to disproportionate distributions in which the distribution has the effect of the receipt of property by some shareholders and an increase in the proportionate interests of other shareholders in the assets or earnings and profits of the corporation. Section 305(b)(3) applies to the receipt of preferred stock by some common shareholders and the receipt of common stock by other common shareholders. Section 305(b)(4) applies to distributions with respect to preferred stock. Section 305(b)(5) applies to a distribution of convertible preferred stock that have the effect of distributions described in section 305(b)(2).

Of course, an actual distribution of stock is not always necessary for a transaction to be taxed as a distribution of property under section 301. Section 305(c) can treat certain described circumstances as a deemed distribution of stock. A change in conversion ratio, a change in redemption price, a difference between redemption price and issue price (i.e., a redemption premium), a redemption treated as a distribution to which section 301 applies, or any other transaction (including a recapitalization) having a similar effect on the interest of any shareholder is a "distribution" with respect to a shareholder where the distribution has the result described in paragraph (2), (3), (4) or (5) of Section 305(b).

Such a distribution will only be deemed to be made with respect to any shareholder whose proportionate interest in the earnings and profits (or assets) of the corporation is increased by the change (difference, redemption, or similar transaction).

On the facts of the ruling, Shareholders A, B, and C owned 100 percent of the outstanding stock of Newco. Then, they received (pro rata) 100 percent of the Newco preferred stock, and their common stock interest was reduced to 20 percent of the outstanding Newco common shares. Section 305(b)(2) does not apply to Shareholder A, B, or C because they did not increase their proportionate interest in the assets or earnings and profits of Newco in the transaction, either as a class of shareholders or relative to each other. Section 1.305-3(e) of the Regulations (Examples 1 and 2), demonstrate that Section 305(b)(2) does not apply to a distribution of additional common stock to a corporation's common shareholders and property to the corporation's preferred shareholders. The reason is that the distribution does not increase the common shareholders' proportionate interest (as a class), in the assets or earnings and profits of the corporation.

Section 305(c), Etc.

Sections 305(b)(1), (3), (4) and (5), for clear reasons, also did not apply. Section 305(c) reflects the notion that income from a financial instrument payable on a deferred basis is generally better measured by requiring the accrual of such income on an economic basis over the period during which payment is deferred. H.R. Rep. No. 881, 101st Cong., 2nd Sess. at 98 (1990). Congress expressed its intention to not limit the authority of the Secretary and the IRS regarding the proper treatment of redemption premiums on preferred stock. Thus, the Secretary may determine what constitutes a redemption premium (or a disguised redemption premium). For example, if at the time of the issuance of cumulative preferred stock there is no intention for dividends to be paid currently, the IRS may treat such dividends as a disguised redemption premium. H.R. Rep. No. 881, 101st Cong., 2nd Sess. at 99 (1990).

Fortunately, in a long and somewhat convoluted analysis, the Service concluded that Section 305(c) did not apply.

Preferred Stock Distributed in Recapitalization Held Not Taxable, Vol. 10, No. 2, The M&A Tax Report (September 2001), p. 5.