Tax Homework Study Problem

LESSON 7

DISTRIBUTIONS of a CORPORATION’S

OWN STOCK and STOCK RIGHTS

7A Nontaxable Stock Distributions; Preferred Stock Bailouts

GENERAL COMMENTS: This lesson attempts to combine § 305(a) with § 306. Another approach is to teach § 305(b) first in its entirety, and then § 306, which can result in the hole of § 305(b) swallowing the doughnut of § 305(a) (viewing the world optimistically). Also, an understanding of the abuse addressed by § 306 may aid understanding of the more drastic remedy of § 305(b). Finally, § 305(b) can be very difficult and it may help to clear away the underbrush first. Although the lesson title refers to distribution, § 306 also applies to preferred stock acquired in reorganization exchanges. But 2003 legislation taxing dividends at the same rate as capital gains (with a top rate of 15 percent for both) has greatly reduced the importance of § 306 and of §305(a) as well.

Ask students to prepare the following § 306 chart as a guide.

§ 306 CHART

Sale of § 306 Stock Redemption of § 306 stock

When is relevant E&P Measured?	Distribution date	Now
Is the transaction treated as a true dividend?	No	Yes
What is the amount of E&P taint?	Pro rata	100%

Consider review of Lesson 5, Part B, Problem (9) and Fender Sales on the issue of whether the stock distribution is “with respect to its stock.”

(1) Under § 305(a), this stock distribution is not included in A’s gross income. Note that X’s stock is not § 317(a) property, so it could not be a § 301(a) dividend anyway (unless § 305(b) applies). Under § 307(a), A’s basis in his shares is $3,000 for the block he originally owned and $6,000 for the new block of 200 shares. The holding period of all shares is the same under § 1223(5). There is no change in X’s E&P under § 312(d)(1). Consider discussing Macomber, depending on whether students have studied the case in an introductory tax course. B&E ¶¶ 8.40, 8.41[1].

Alternative: Perhaps as a precursor of similar discussions in Lesson 7B, discuss why watering the stock here by allowing shares to be issued for $10 below market value of the shares means that the failure of the market price of the stock to drop assumed in the problem must be miraculous. Under § 305(d), the warrants are treated as stock and are not included in A’s gross income. Because the FMV of the warrants (apparently $10) is less that 15 percent of the FMV of the stock, A would be well advised to make the § 307(b) election and allocate $750 (1,000/12,000 x /$9,000) basis to the warrants. A will recognize $250 gain upon selling the warrants. If A did not exercise the warrants and let them expire, A would recognize a capital loss under § 1234(a) equal to the $750 basis, because the last sentence of Regs. § 1.307-1(a) does not apply.