Section 306 Stock: Chamberlain vs. Commissioner, 207 F.2d 462

On this page we’ll go over a summary of the Chamberlain vs. Commissioner case that resulted in this specific section.

Here are the facts:

  • Metal Moulding Corp issued a pro-rate preferred stock dividend to all of its common shareholders
  • Prior to issuing the stock, it prearranged with two insurance companies to buy the preferred stock from the common shareholders after a waiting period
  • Then, on a preferred basis, the stock was redeemed by Metal Moulding Corp.
  • The end result was that the shareholders got capital gain treatment on the sale of their preferred shares
  • The life insurance companies made a commission on the sales
  • Metal Moulding Corp ended up with the preferred shares again, which were canceled
  • Section 306 came into existence to prevent this type of a transaction from happening
  • Section 306 defers the dividend treatment until one of two events occur:
    • Either the preferred stock is sold by the shareholder, or
    • The preferred stock is redeemed by the corporation
    • When either of these two events occur, then a portion or all of either the sale proceeds or redemption proceeds will be converted to dividend income
    • The way this is done is different for sales than for redemptions

 The Rules for the Sale of Section 306 Stock

  1. Upon the sale of preferred stock, capital gain is converted to dividend income to the extent that:
    1. Original distribution of preferred stock would have been a taxable dividend if cash of equal value had been distributed in place of preferred stock
    2. Any value in excess of the dividend amount is treated first as a reduction to basis and a second as a capital gain
    3. No loss is recognized
    4. Section 306 stock does not reduce the corporation’s E&P either upon the distribution or upon the sale
    5. Terminology = “306 Taint”. This means that the stock being held is or will be treated at 306 stock
    6. Not a significant issue today given the 15% dividend/LTCG rate even though for basis reasons the treatment may not be identical
    7. Look out for taxpayers that gift Section 306 stock to a charity and expect a full fair market value charitable deduction

 Rules on the Redemption of Section 306 Stock

  1. Redemption amount is treated as a dividend to the extent of E&P on the date of redemption, not the date of the preferred stock distribution as in the sale of Section 306 stock. This is true even if the Section 302(b) requirements are met(but there are exceptions to this as well)
  2. The redemption amount realized in excess of the dividend is first a recapture of basis and then a capital gain
  3. Any un-recaptured basis is transferred to the common stock

 Exceptions to Section 306 Stock

  1. Complete termination of the partner’s interest in the corporation (attribution rules under Section 318 apply)
  2. If there’s a complete liquidation of the corporation
  3. Tax-free transfers(such as Section 351, reorganizations, etc.) however, the replacement stock carries the Section 306 taint
  4. Transactions not in avoidance of tax
  5. Death

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