When payments on debt are considered a deemed dividend.

• Author: Borghino, Jeff

A primary distinction between debt and stock is that a debt holder receives interest on debt, and a stockholder receives dividends on stock. However, Sec. 305 provides that a debt holder can receive a deemed dividend under certain circumstances for federal income tax purposes. Recently, the IRS applied Sec. 305 in Letter Ruling 201446013 to determine that certain convertible debt provided its holders with a deemed distribution under Sec. 301. This item summarizes the current law and discusses the facts and ruling in Letter Ruling 201446013.

Sec. 301

Sec. 301(a) provides that a distribution of property by a corporation (the distributing corporation) to a shareholder of the distributing corporation's stock is treated by the shareholder according to Sec. 301(c). Sec. 301(c) treats the distribution as:

1. A dividend to the extent of the distributing corporation's earnings and profits (Secs. 301(c)(1) and 316(a));

2. A reduction of the shareholder's adjusted basis in the distributing corporation's stock to the extent that the distribution is not a dividend (Sec. 301(c)(2)); and

3. Gain from a sale or exchange to the extent that the nondividend portion of the distribution exceeds the shareholder's adjusted basis in the distributing corporation's stock (Sec. 301(c)(3)).

   The amount of any distribution is the amount of money plus the fair market value (FMV) of other property received (Sec. 301(b)). The basis of property received in a distribution under Sec. 301(a) is the FMV of the property (Sec. 301(d) and Regs. Sec. 1.301-1(h)).

   Sec. 317(a) defines property as money, securities, and any other property except stock in the distributing corporation (or rights to acquire that stock).

   Sec. 305

   Sec. 305(a) generally provides that gross income does not include a distributing corporation's distribution to its shareholders on its stock if it is made in distributing corporation stock (i.e., a stock distribution).

   Sec. 305(b) provides certain exceptions to Sec. 305(a) including: (1) "distributions in lieu of money" under Sec. 305(b)(1); and (2) "disproportionate distributions" under Sec. 305(b)(2). If an exception under Sec. 305(b) applies to a stock distribution, the stock distribution is treated as a distribution of property to which Sec. 301 applies.

   Sec. 305(b)(1) provides that a distribution in lieu of money is a distribution payable at the election of any recipient shareholder in either (1) distributing corporation stock; or (2) property (e.g., cash). Under...