Tainted Stock

• Pages: 201-210
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

201

Chapter 7

TAINTED STOCK

7.01 The Preferred Stock Bailout

It may seem as if the exceptions in § 305(b) swallow the general

rule of nonrecognition in § 305(a). To be sure, a host of stock

dividends will be taxable under § 305(b). On the other hand, m any

stock dividends will be tax-free, at least those made on common

stock. Indeed, a pro rata distribution of common stock on common

stock will always be tax-free under § 305(a), while a pro rata

distribution of preferred stock on common stock will be tax -free in

the absence of a companion di stribution of cash or property to other

shareholders.

The rule allowing a tax-free, pro-rata distribution of preferred

stock to common shareholders created what is known as the

“preferred stock bailout.” Consider the case of X Corp. having 100

shares of appreciated common stock outstanding. X Corp. has

earnings and profits of $10,000 that the shareholders would like to

remove from corporate solution as capital gain. Declaration of a cash

dividend will not work, nor will a pro rata stock redemption. If the

shareholders are unwilling to dissolve the corporation, it seems that

the shareholders must recognize dividend income (without any basis

recovery) according to the rules of § 301.

Suppose, though, that the corporation declares a stock dividend

payable in one share of a newly created class of $100 par preferred

stock for each share of common stock outstanding. Such a

distribution will be tax-free under § 305(a). If the shareholders then

sell the preferred stock, they will recognize capital gain on the sale,

thereby accomplishing their goal. Of course, the $10,000 has not been

removed from corporate solution, but that is done easily enough. The

purchaser, having a cost (fair market value) basis in the preferred

stock under § 1012, simply has it redeemed, a transaction taxed as

an exchange under § 302(a) and (b)(3) and producing no gain.

1

In one sense, a taxpayer always can bail out corporate earnings

and profits as capital gain by the simple expedient of selling some or

all of his stock. However, if common stock is sold, the taxpayer may

lose some or all of his interest in the future profits of the corporation.

The virtue of the preferred stock bailout is that earnings and profits

1

An alternate form of the preferred stock bailout is for preferred stock to be

distributed tax-free under § 305(a), followed by a redemption of the preferred stock

under circumstances qualifying for exchange treatment unde r § 302(a) because of

§ 302(b)(1).