Timing and Character of Tax on Preferred Stock Received as a Dividend

Worldview Consulting & Accounting, Inc., as a Portland CPA firm, provides tax advisory services to help its clients understand the code. An issue that comes up is what to do when you receive preferred stock as a dividend. When preferred stock is received in a stock dividend, you want to know the timing and character of tax, or what is the tax implication of receiving such a dividend.

The issue is whether preferred stock received as a stock dividend is taxable. If so, whether it is taxable when received, sold, or redeemed, and how is the tax calculated. The issue is also whether the difference between sales price and basis, or the earnings and profits of the corporation limits the gain recognized and taxed.

Section 305(a) provides that “gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.” Section 305(b) then describes where 305(a) does not prevail, or cases that are considered exceptions to 305(a). The first is per 305(b)(1), in cases of distributions made in lieu of money, for example where cash dividends are in arrears and the corporation distributes preferred stock in its stead. Second, per 305(b)(2) disproportionate distributions are considered an exception, along with 305(b)(3), with distributions of common and preferred stock simultaneous to different shareholders, 305(b)(4), with distributions “in respect of preferred stock,” and 305(b)(5), with distributions of convertible preferred stock. Section 305 also defines that if something is required to be included in “gross income” for the period, this means the income is ordinary.

Reg. Sec. 1.305-1(b) states as follows: “where a distribution of stock or rights to acquire stock of a corporation is treated as a distribution of property to which section 301 applies by reason of section 305(b), the amount of the distribution, in accordance with section 301(b) and §1.301-1, is the fair market value of such stock…”.

Section 306(a) provides that if a shareholder “sells or otherwise disposes of section 306 stock,” and the transaction is not a redemption, then the “amount realized shall be treated as ordinary income.”

Section 306(c)(1)(A) defines “Section 306 stock” to include stock “which was distributed to the shareholder selling or otherwise disposing of such stock if, by reason of section 305(a), any part of such distribution was not includable in the gross income of the shareholder.” However, Section 306(c)(2) excludes from Section 306 where no earnings and profits exist.

Section 301(c)(1) states that the amount considered a dividend as defined in Section 316(a) shall be included in gross income. The amount not a dividend reduces the adjusted basis of the stock according to Section 301(c)(2). The amount not recognized as a dividend, and in excess of adjusted basis, shall be treated as a gain from sale of property per Section 301(c)(3).

Section 316(a)(1) and Section 316(a)(2) defines a dividend as “any distribution of property made by a corporation to its shareholders” out of current or accumulated earnings and profits.

Here, the facts for one client provided that the distribution is preferred stock, per 305(a), not in respect of preferred stock already owned, not in lieu of cash, and not to any other exception provided in Section 305(b) as immediately triggering inclusion in gross income. Section 306 applies in this case where the stock is defined as Section 306 stock and is sold. When sold, it is treated as a gain at full market value or proceeds of that stock sale, and per Section 306(c) and Section 316(a) is only taxable where it comes out of earnings and profits. If there were no earnings and profits, it would be considered a redemption.

Thus, in this case, the preferred stock received without a known exception to 305(a), and is taxable when sold on full value of the sale, and limited to the amount of earnings and profits.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, CPA, CFF, MBA, CPIM, is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Massachusetts.

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