Congress' Reaction to the Holding in Chamberlin v. Commissioner (1953)
Prior to passage of the IRS Tax Code by the 83rd Session of Congress in 1954 the tax status of stock dividends relative to its recipient was debatable, but this did not stop corporate tax planners from devising 'preferred stock bailouts' (Bailine, 2004). Under normal circumstances, when an owner of a company invests earnings and profits in another company through the purchase of common stock, the monies received are treated as a dividend for tax purposes. Dividends were taxed at a much higher rate than capital gains, so to avoid paying the additional tax the preferred stock bailout was conceived. Essentially, a preferred stock bailout uses a third party to exchange preferred stock for cash under more favorable capital gains treatment.
The ambiguous tax status of preferred stock bailouts was rendered unambiguous in Chamberlin v. Commissioner (1953) when the 6th Circuit Court of Appeals held that stock dividends are nontaxable. The Commissioner of the IRS had argued that the net result of a preferred stock bailout was an exchange of stock for cash and therefore should be taxed as ordinary income. The 6th Circuit disagreed, citing several Supreme Court decisions that held each individual transaction should stand on its own for tax purposes, not the net result.
In response, Congress included provision §306 in the 1954 Tax Code that prevented the tax-free sale of preferred stock more than once (Bailine, 2004). Although the sale of the preferred stock would be tax free, it subsequent sale to a third party would be taxed as ordinary income. Preferred stock after the first sale was therefore considered "Section 306 stock."
Applying Section §307
Under Section §305(a), stock distributions to shareholders are not considered income for tax purposes as long as these distributions do not meet the exceptions outlined in Section §305(b) (LII, n.d.). Section §307(a) holds that the stock basis of the distributed stocks (new stock) should be allocated between the old and new stock based on the fair market value (Justia U.S. Law, n.d.). The same applies for the rights to purchase stock. Both distributions are calculated in the year made, regardless of whether the rights were exercised or not.
If the basis for both the new and old shares is identical, then the basis for all shares is determined by dividing the old stock basis by the total number of shares. However, if the basis for the new and old stocks is unequal, then the allocation is based on the old stock basis and the fair market value of both the new stock and the rights (Justia U.S. Law, n.d.). For example, if 1,000 shares of stock were originally purchased for $10, the fair market value of the current stock offer is $11 for another 1,000 shares, and the rights to purchase has a market value of $2 per share, then the amount allocated to the old stock is (11,000/13,000)*10,000 = $8,461.54 for 1,000 shares. The amount allocated to the old stock for rights is (2,000/13,000)*10,000 = $1,538.46 for all 1,000 shares.
If the stock offer had 1,000 additional shares for $9 ($2 below fair market value), then the basis would be $9 plus the rights basis when exercised ($1.54), or $10.54. Should this stock be sold, then the gain or loss will be based on the $8.46 basis per share. Should the shareholder decide to sell the stock rights, then the gain or loss would be based on the rights allocation of $1.54 per share.
Section §307(b) provides exceptions to §307(b). If the fair market value of the rights is below 15% of the fair market value of the old stock on the date that the rights are distributed, then the rights basis will be zero as long as the stock offered is tax exempt under §305(a) (Justia U.S. Law, n.d.). When this is the case the shareholder need not take any action, although they have the right to allocate the rights basis between the old shares and the rights under Section §307(b)(2). In the above example, the fair market value of the old stock and rights is $11 and $2, respectively, which is 18%. If the shareholder intends to exercise the stock rights then they need to elect the basis distribution option.
Meeting the Substantially Disproportionate Criteria
A corporation may want to redeem its shares for any number of reasons (Ricketts, n.d.). For example, a shareholder may want to reduce or eliminate their stake in a company or the company may feel cash holdings would be best spent redeeming shares when the price is low. Of primary concern is how the redemption is treated; whether it is a qualified or non-qualified sale under Section §302(b)(2). If the transaction can be treated as a sale or exchange then it will be taxed as capital gains or losses, but if it is treated as a dividend then it will be taxed as ordinary income.
Redemption occurs when the corporation exchanges cash, securities, debt, or other property for the stock (Ricketts, n.d.). Property cannot include stock or rights to purchase stock in the same corporation making the redemption. The buyback can be treated as a qualified redemption if it is not equivalent to a dividend under Section §302(b)(1), is substantially disproportionate under Section §302(b)(2), terminates the shareholders interest in the corporation under Section §302(b)(3), or the redeemed shares will be used to partially liquidate the corporation and were held by a noncorporate shareholder as defined by Section §302(b)(4).
For the redemption to be substantially disproportionate and therefore qualify for capital treatment, the stockholder cannot own more than 50% of the voting power in the corporation immediately after the redemption per Section §302(b)(2)(B) (Ricketts, n.d.). In addition, ratio of the voting stock held by the shareholder must be reduced to less than 80% of the ratio before the redemption, according to Section §302(b)(2)(C). Finally, the percent of common stock held by the shareholder after the redemption must be reduced to less than 80% of what was held before the redemption [Section §302(b)(2)(C)]. In other words, there must be a substantial reduction of the shareholder's voting power and corporate holdings before the redemption can qualify for favored tax treatment as a capital gain or loss.
Favorable Treatment under Section §318.
Section §318 defines stock ownership rules for families, corporations, trusts, and partnerships (Ricketts, n.d.). For the purposes of a stock redemption, the shares owned by the shareholder and his or her parents, spouse, and children are attributed to the shareholder. This means that under §318 the shares owned by siblings, aunts or uncles, or cousins would not be counted as owned by the shareholder during a stock redemption.
As discussed above, favorable tax treatment of a redemption requires satisfaction of the dividend non-equivalency test, be substantially disproportionate, completely liquidate the shareholders interest in the corporation, or involve the shares of a noncorporate shareholder during partial liquidation (Ricketts, n.d.). In addition, if a shareholder sold a controlling stake in a corporation to a trusted sibling they might avoid paying regular income taxes on the property received.
The problem with this strategy is that the transfer will likely be viewed as a change in ownership under Section §382(g) and therefore be viewed as regular income by the IRS (Raby, 2004). In Garber Industries Holding Co. Inc. v. Commissioner (2005) the court held that the stock transaction between two brothers created a reduction in controlling ownership from 68% to none for one and an increase from 26 to 84% for the other, within a two-year period. Under Section §382 a 50% change in ownership within a three-year period is considered a change in ownership. Accordingly, if the redemption had been carried out to ensure that the change in ownership never exceeded 50 percentage points in any three-year period the transaction would likely have qualified for favorable treatment under Section §302.
Acquiring Assets through Liquidation
The assets of a company can be acquired in three basic ways (Forte, 1980). The assets can be distributed by the corporation to its shareholders, who then sell the assets to the acquiring company. The company may choose to sell the assets directly to the acquiring corporation and then distribute the proceeds to the shareholders. Or, the acquiring corporation could purchase controlling stock in the target company and then liquidate, thereby acquiring the assets.
Both parties to the liquidation can have substantial tax concerns due to the cost basis of the acquisition and how the distribution to shareholders is treated (Forte, 1980). A direct sale of assets always provided a normal cost basis; however, when a corporation acquired assets through a stock purchase the cost basis was tied to the original cost of the assets for the target corporation. This practice sometimes resulted in substantial deviations from the fair market value. In Kimbell-Diamond Milling Co. v. Commissioner (1950) the tax court held that cost basis for the acquired assets will be determined by the purchase price…