IRS concludes equity interests are nonqualified preferred stock

Tax Hot Topics: IRS concludes equity interests are nonqualified preferred stockThe IRS concluded in an internal legal memorandum (ILM 201716045) that certain equity interests were properly treated as nonqualified preferred stock under Section 351(g)(2).

In the ILM, the corporate taxpayer held interests in two subsidiaries (Sub 1 and Sub 2). In Year 1, the taxpayer contributed the stock of Sub 2 to Sub 1 in exchange for Class A stock of Sub 1 and other property. The holders of Class A stock were entitled to dividends equal to a percentage of the dividends paid to the common shareholders of Sub 1. Upon liquidation of Sub 1, the holders of Class A stock were entitled to the face value of the Class A stock in addition to a “redemption premium” equal to a percentage of the increase in value of the common shares of Sub 1. Sub 1 had income in Year 1 and losses in Year 2 and Year 3.

Section 351(a) provides generally that no gain or loss is recognized when property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation, and immediately after the exchange such person or persons are in control of the corporation. Section 351(g)(1) provides, however, that “nonqualified preferred stock” is not stock for purposes of Section 351(a). Thus, in general, taxpayers that transfer property to a corporation in exchange for non-qualified preferred stock in a transaction that otherwise satisfies the requirements of Section 351 may be required to recognize gain on the transfer. Nonqualified preferred stock is defined by Section 351(g)(2) as preferred stock that satisfies one of four criteria that mostly concern whether the corporation has the right to redeem the stock.

The taxpayer addressed by the ILM apparently conceded that the Class A stock satisfies one of those four criteria to be “non-qualified,” and thus the sole issue considered in the ILM is the threshold question of whether the Class A stock is “preferred” stock. Preferred stock is defined in Section 351(g)(3) as stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent.

In considering whether the Class A stock was preferred stock, the IRS relied on regulations under Section 305 for purposes of interpreting section 351(g). Those regulations under Treas. Reg. Sec. 1.305-5(a) provide in part that stock is preferred for purposes of Section 305 if “there is little or no likelihood of such stock actually participating in current and anticipated earnings and upon liquidation beyond its preferred interest,” and that factors to consider in conducting that analysis include “the prior and anticipated earnings per share, the cash dividends per share, the book value per share, the extent of preference and of participation of each class, both absolutely and relative to each other, and any other facts which indicate whether or not the stock has a real and meaningful probability of actually participating in the earnings and growth of the corporation.”

The IRS, noting that Sub 1 had “only one aberrational year of taxable income that was immediately followed by two consecutive tax years with net operating losses,” concluded that the Class A stock was preferred. Essentially, even though the holders of the Class A stock had a right to participate in corporate earnings, the perceived poor performance of Sub 1 meant that “there was no real and meaningful likelihood the Class A stock would participate in the corporate growth of Sub 1 to any significant extent” and that “there was no real and meaningful likelihood that dividends beyond any limitation or preference would actually be paid.”

This ILM is significant for two reasons. First, the IRS relied on the regulations under Section 305 to conclude on a Section 351 issue, although, on their face, those regulations only concern whether stock is preferred for purposes of Section 305. Second, in relying on the earnings performance of Sub 1 after a purported Section 351 event, the IRS appears to have applied ex post facto evidence to a test that is generally conducted prospectively.

Andy Cordonnier
Partner, Washington National Tax Office
T +1 202.521.1502

Jeff Borghino
Partner, Washington National Tax Office
T +1 202.521.1532

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