Ruling sheds light on preferred-stock definition. .

• Author: Madden, David
• Position: Letter ruling 200311002

In Letter Ruling 200311002, the Service provided some guidance on defining preferred stock for Sec. 351(g) purposes.

Background

Congress amended certain corporate nonrecognition provisions in 1997 by adding Sec. 351(g) to treat certain types of preferred stock as boot, referred to as "nonqualified preferred stock." The purpose of this statutory change was to accord taxable treatment to stock that is functionally equivalent to debt. The legislative history notes that these amendments were enacted because "[c]ertain preferred stocks have been widely used in corporate transactions to afford taxpayers non-recognition treatment, even though the taxpayer may receive relatively secure instruments in exchange for relatively risky instruments" (Conf. Rep't No. 105-220, 105th Cong., 1st Sess. (1997), p. 543; Staff of the Joint Committee on Taxation, 1997, p. 209).

In the same vein, a Treasury explanation of the new provision stated "tax-free treatment in a reorganization or section 351 transaction is inappropriate for preferred stock that has an enhanced likelihood of recovery of principal or of maintaining a dividend, or both, or that otherwise has certain nonstock characteristics" (Department of the Treasury, General Explanation of the Administration Revenue Proposals Contained in the Revenue Reconciliation Bill of 1996 (March 1996), p. 82 (Treasury Department Explanations)).

For stock to be classified as nonqualified preferred stock, it must first be classified as preferred stock. To this end, Sec. 351(g)(3)(A) provides, in relevant part, that for Sec. 351(g) purposes, preferred stock is stock that is "limited and preferred as to dividends and does not participate in corporate growth to any significant extent."

Before the issuance of Letter Ruling 200311002, there was little direct guidance defining the meaning of "participates in corporate growth to any significant extent," specifically for Sec. 351(g)(3)(A) purposes. Practitioners were left to rely, for example, on an analogous test under Regs. Sec. 1.305-5(a), under which participation in corporate growth includes a right to receive (1) distributions of current earnings and (2) proceeds on liquidation. The regulations provide a nonexhaustive list of certain factors to be analyzed to determine whether a particular instrument participates in current earnings and liquidation proceeds, including:

[T]he prior and anticipated earnings per share, the cash dividends per share, the book value per share...