Exceptions to Section 305(a) Tax-Free Treatment: In Lieu of Money

There are five exceptions to Section 305(a) tax free treatment of stock dividend distributions.  The main idea behind these exceptions are that if the distributions enrich some shareholders and while some are not, then it will be taxable. These exceptions are a little easier to understand if you think of preferred stock as property for the most part(which means the distribution is obviously taxable).

The specific exceptions are:

  1. The distribution was in lieu of money
    1. This applies if the shareholder has the option to take either cash or other property instead of receiving stock.
    2. Even if the shareholder chooses to take stock, the distribution is taxable at its fair market value. This is still true even if every single shareholder elects to take stock instead of the cash or property.
    3. Look out for ‘variations on a theme’, meaning a contrived program where the dividend is paid in stock, but redeemable for cash later on… this would be taxable.
    4. If it was a disproportionate distribution
    5. If the distribution had common and preferred stock
    6. If the distribution was in preferred stock
    7. If the distribution was convertible preferred stock

Revenue Ruling 78-375 Facts:

  1. X corp is engages in commercial banking
  2. X is publicly traded
  3. X established an automatic dividend reinvestment plan
  4. The plan allowed shareholders to purchase stock at a discount by reinvesting their dividends in stock rather than taking cash. Stock so purchased could be purchased at 95 cents on the dollar
  5. Shareholders also had the right to buy additional shares at the same price
  6. Shareholders who do not participate in the plan receive cash dividends rather than stock

The Issue: If the shareholders participate in the dividend reinvestment plan, are the dividends that get paid in stock non-taxable under Section 305(a)?

Holding: No. The dividends are taxable under Section 305(b)(1) since the shareholder could choose between receiving cash or stock.

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