- Distribution of Stock and Stock Rights.
- Nontaxable Stock Dividend.
- In general, gross income of the shareholder does not include the amount of any distribution of the corporation's stock made by the corporation with respect to its stock (§ 305(a)).
- For this purpose, stock includes stock rights (§ 305(d)(1)).
- In addition, a shareholder includes a holder of stock rights or of convertible debentures (§ 305(d)(2)).
- The shareholder allocates basis of the old stock between the old stock and the new stock or stock rights based on relative fair market value and may tack the holding period of the old stock to the new stock (§ 307(a); Reg. § 1.307-1(a); § 1223(5)).
- Basis is allocated to stock rights only if the rights are sold or exercised (Reg. § 1.307-1(b)).
- If the rights are exercised, the allocated cost of the stock rights is added to the cost of the shares purchased through the exercise of the rights.
- If the rights are sold, the allocated cost is used to determine gain or loss.
- If the rights expire, no loss is realized and any basis reverts to the old shares.
- No basis is allocated to the rights if the fair market value of the rights is less than 15% of the fair market value of the old stock, unless the taxpayer makes an election to do so (§ 307(b) and Reg. § 1.307-2).
- No gain or loss is recognized to the distributing corporation under § 311(a)(1).
- The distributing corporation does not reduce its E&P (§ 312(b)(1)).
- A distributee shareholder does not increase its E&P (§ 312(f)(2)).
- Taxable Stock Dividend.
- Stock dividend is a distribution of property under § 301 if:
- Distributions in Lieu of Money - Any shareholder can elect to receive corporate stock or property, regardless of the actual exercise of such election (§ 305(b)(1)).
- Disproportionate Distributions - The distribution has the result of the receipt of property by some shareholders and an increase in the proportionate interests of other shareholders in the assets or E&P of the corporation (§ 305(b)(2)).
- Convertible securities and rights are treated as outstanding stock (Reg. § 1.305-3(b)(5)).
- Each class of stock is considered separately (Reg. § 1.305-3(b)(6)).
- Cash in lieu of fractional shares is not considered (Reg. § 1.305-3(c)).
- The conversion ratio or price of convertible securities must be adjusted to reflect the stock dividend (Reg. § 1.305-3(d)).
Example 1: Cash paid on class A common stock and a stock dividend on class B common increases the proportionate interest of the B shareholders as a class. Therefore, the distribution is a taxable stock dividend (Reg. § 1.305-3(b)(2)). A cash dividend on class A common and a dividend of cash on class C non-convertible preferred does not increase the proportionate interest of the class A common shareholders as class. Therefore, the stock dividend is not taxable (Reg. § 1.305-3(e), Ex. 2). A dividend of class C non-convertible preferred on class A common and a dividend of cash on class B common increases the proportionate interest of the class A common shareholders as a class. Therefore, the distribution to the A shareholders is a taxable stock dividend (Reg. § 1.305-3(a)). A dividend on rights of class A common with convertible stock or securities (fixed conversion ratio) outstanding increases the proportionate interest of class A common shareholders. Therefore, the distribution is a taxable stock dividend (Reg. § 1.305-6(b)).
Example 2: Single and isolated redemptions and recapitalizations are not considered to increase the proportionate interest of the continuing shareholders. Therefore, such distributions are not taxable stock dividends (Reg. § 1.305-3(e), Ex. 12).
- Distributions of Common and Preferred - Common stock is distributed to some shareholders and preferred stock to other common shareholders (§ 305(b)(3)).
- Distributions on Preferred - A distribution is made on preferred stock (§ 305(b)(4)). Thus, only stock dividends on common stock are eligible for tax free treatment.
- However, stock dividends on convertible preferred stock distributed to avoid dissolution of conversion rights are also tax free (Reg. § 1.305-5(a)).
- An unreasonable redemption premium is considered to be a constructive distribution of stock on preferred stock (Reg. § 1.305-5(b)(1)).
- A redemption premium is considered reasonable if it is in the nature of a penalty for a premature redemption and the premium does not exceed the normal premiums existing under current market conditions. A redemption premium not exceeding 10% on stock not redeemable for five years from date of issue is considered reasonable (Reg. § 1.305-5(b)(2)).
- Distributions of Convertible Preferred - Under § 305(b)(5), if convertible preferred stock is disproportionately distributed, such distribution is a taxable dividend.
- A distribution is not disproportionate if the conversion right may be exercised over a period of many years and the dividend rate is consistent with market conditions such that it is unlikely that a disproportionate dividend will result (Reg. § 1.305-6(a)(2) and Reg. § 1.305-6(b), Ex. 2).
- Under regulations prescribed by the Secretary, other changes in the capital structure may be taxable if they are disproportionate with regard to shareholder interests and corporate assets or earnings and profits (§ 305(c)).
- Amount of Distribution to the Shareholder.
- If the shareholder elects to receive corporate property under § 305(b)(1), the normal distribution rules apply (i.e., FMV for both corporate and noncorporate shareholders).
- If the shareholder receives other taxable stock dividends, noncorporate and corporate shareholders each treat the fair market value of the stock dividend as the amount of the distribution (Reg. § 1.305-2(b) and Reg. § 1.301-1(d)(1)(ii)).
- Basis of Distributed Stock.
- If the shareholder elects to receive corporate property under § 305(b)(1), the normal basis rules apply for both noncorporate and corporate shareholders (i.e., under § 301(d), the basis in the property received is that property's FMV).
- If the shareholder receives other taxable stock dividends, the basis of such stock dividends equals the fair market value for both corporate and noncorporate shareholders (§ 301(d)).
- No gain or loss is recognized to the distributing corporation on the distribution of its stock or stock rights (§ 311(a)(1)).
- The holding period of taxable stock dividends begins on the day of receipt.
- Adjustments are made to the earnings and profits of the distributing corporation (§ 312).
- If the shareholders elect to receive corporate property under § 305(b)(1), the normal earnings and profits rules apply to the distributing corporation (i.e., the distributing corporation reduces its earnings and profits by the greater of the distributed property's adjusted basis or FMV).
- If the shareholders receive other taxable stock dividends, the distributing corporation's earnings and profits is reduced by the fair market value of the stock distributed (Reg. § 1.312-1(d)).
- Call Premiums on Preferred Stock.
- In General. The IRS has proposed regulations dealing with preferred stock that can be redeemed at a premium (Prop. Reg. § 1.305-3, -5, and -7). In certain cases the redemption premium is treated as a taxable constructive dividend of additional stock. Under the proposal, this result usually would occur if the issuer of the stock were more likely than not to call the stock.
- Taxable Deemed Distributions. Under § 305(b)(4) stock dividends paid with respect to preferred stock are generally taxable when paid. Section 305(c) gives the IRS the authority to issue regulations specifying when the difference between the redemption price and the issue price of stock will be treated as a taxable distribution. When a redemption premium is treated as a distribution (or series of distributions), the premium is taken into income over the period beginning with the issuance of the stock and ending with its redemption, using the economic accrual principles of the original issue discount rules (§ 305(c)(3)).
- Issuer Call Rights.
- The primary focus of the proposed regulations is on the treatment under § 305(c) of stock callable at a premium at the issuer's option. If the payment of a call premium merely reflects increases in the value of the holder's stock resulting from market fluctuations after the date of issuance, the call premium is not the equivalent of a distribution. It is more appropriately taxed on realization. However, if on the date of issuance it is more likely than not that the issuer will exercise its call option, the holder's anticipated increase in his interest in the earnings and assets of the issuer through the call premium is equivalent to a periodic return on the stock that should be taxed over time as a distribution. Such a call has the effect of a mandatory redemption provision, and should have comparable tax consequences.
- The proposed regulations require constructive distribution treatment with respect to an issuer call only if, based on all the facts and circumstances as of the issue date, redemption pursuant to the call right is more likely than not to occur. Even in this case, constructive distribution treatment does not apply if the redemption premium is solely in the nature of a penalty for premature redemption. A penalty for premature redemption is a premium paid as a result of changes in economic or market conditions over which neither the issuer nor the holder has control (Reg. § 1.305-5(b)(3)(i)).
- Safe Harbor. Constructive distribution treatment is avoided if:
- The issuer and the holder are unrelated.
- There are no arrangements that effectively require the issuer to redeem the stock, and
- Exercise of the option to redeem would not reduce the yield of the stock (Reg. § 1.305-5(b)(3)(ii)).
- De minimis Rule. The proposed regulations reflect the statutory de minimis rule under § 305(c)(1) for mandatorily redeemable stock and stock that the holder can put to the issuer and would extend the rule to issuer calls as well. Under this rule, a premium is ignored if it is less than the issue price times one-quarter of 1% times the number of years from issuance to redemption.
- Effective Dates. The proposed regulations will apply to stock issued on or after the date final regulations are filed with the Federal Register. The rules of § 305(c)(1), (2) and (3) apply to stock issued on or after October 10, 1990.