Section 305(b)(4): Distributions on Preferred Stock Exception

Section 305(b)(4) is an exception to Section 305(a) that deals with distributions on preferred stock. This is a little bit different because preferred stock in this case really isn’t considered a stock. This exception is essentially saying that any distribution on preferred stock, whether the distribution itself is common or preferred stock will be taxable. The exception has three elements:

  1. Preferred stock is considered a “limited interest” in the corporation’s equity. Usually preferred stock is just given a dividend rate, which just results in a dividend being paid… nothing to do with equity in the corporation.
  2. Any distribution of stock, whether it’s common or preferred, increases the proportionate interest of the preferred shareholder
  3. There’s an exception to this exception… if the distribution doesn’t increase a preferred shareholder’s interest in the corporation, then it isn’t taxable.

Revenue Ruling 77-37 Facts:

  1. X corp is capitalized with common and preferred shareholders
  2. Preferred shareholders have a conversion privilege at a fixed ratio
  3. X corp spun-off a subsidiary to the common stock shareholders
  4. The preferred shareholders were therefore penalized since the value of the common stock decreased because of the spin-off
  5. The conversion privilege was revised to account for the spin-off

Issue: Is this taxable under Section 305(b)(4)?

Holding: No. Change in conversion privilege simply permitted the preferred shareholders to remain in the same position post-spin-off as pre-spin-off. Because of this, the change is not a taxable dividend.

The Last Exception to Section 305(a) Tax Free Treatment

The last exception deals with the distributions of convertible preferred stock, which is Section 305(b)(5). It says that convertible preferred stock risks the potential a that some preferred stock will be converted to common and other preferred stock will not. In the end, this is essentially the same as a distribution of common and preferred stock.

If some preferred stockholders can convert and some don’t, then it’s as through some shareholders received common stock and others received preferred stock.

Leave A Response

* Denotes Required Field