Ruling Sheds Light on Preferred-Stock Definition

In Letter Ruling 200311002, the Service provided some guidance on defining preferred stock for Sec. 351(g) purposes.

Congress amended certain corporate nonrecognition provisions in 1997 by adding Sec. 351(g) to treat certain types of preferred stock as boot, referred to as nonqualified preferred stock. The purpose of this statutory change was to accord taxable treatment to stock that is functionally equivalent to debt. The legislative history notes that these amendments were enacted because [c]ertain preferred stocks have been widely used in corporate transactions to afford taxpayers non-recognition treatment, even though the taxpayer may receive relatively secure instruments in exchange for relatively risky instruments (Conf. Rept No. 105-220, 105th Cong., 1st Sess. (1997), p. 543; Staff of the Joint Committee on Taxation, 1997, p. 209).

In the same vein, a Treasury explanation of the new provision stated tax-free treatment in a reorganization or section 351 transaction is inappropriate for preferred stock that has an enhanced likelihood of recovery of principal or of maintaining a dividend, or both, or that otherwise has certain nonstock characteristics (Department of the Treasury, General Explanation of the Administrations Revenue Proposals Contained in the Revenue Reconciliation Bill of 1996 (March 1996), p. 82 (Treasury Department Explanations)).

For stock to be classified as nonqualified preferred stock, it must first be classified as preferred stock. To this end, Sec. 351(g)(3)(A) provides, in relevant part, that for Sec. 351(g) purposes, preferred stock is stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent.

Before the issuance of Letter Ruling 200311002, there was little direct guidance defining the meaning of participates in corporate growth to any significant extent, specifically for Sec. 351(g)(3)(A) purposes. Practitioners were left to rely, for example, on an analogous test under Regs. Sec. 1.305-5(a), under which participation in corporate growth includes a right to receive (1) distributions of current earnings and (2) proceeds on liquidation. The regulations provide a nonexhaustive list of certain factors to be analyzed to determine whether a particular instrument participates in current earnings and liquidation proceeds, including:

[T]he 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 Sec. 305 regulations do not elaborate on how much of a right to earnings and liquidation proceeds (i.e., a percentage) is sufficient for an instrument to be deemed to participate in corporate growth to a significant extent. The only quantitative guidance appears in Regs. Sec. 1.305-5(d), Example 10, in which there are two classes of stock, A and B. After guaranteed distributions are made as to these classes, the remaining earnings are to be distributed to both classes of stock equally. Quantitatively, the example could be read to provide a safe harbor for determining when a class of stock will be treated as participating in corporate growth to a significant extent. In essence, a class of stock must share equally with the common stock in a pool of earnings (remaining after preference distributions) that is at least one sixth of the corporations total earnings before the preference distributions.

Stated another way, if three requirements are satisfied, a class of stock will be deemed to be significantly participating in corporate growth. First, it must share in the earnings remaining after all preference dividends (i.e., the residual earnings). Second, the residual earnings must equal at least one sixth of the corporations total earnings. Third, for the residual earnings, that class of stock must share equally with the corporations common stock. Thus, the question remained as to how much less a class of stock in a corporation could share in the corporations earnings and still be participating in corporate growth to a significant extent.

The ruling addresses the percentage of participation in corporate earnings and liquidation proceeds needed for a class of stock to be participating significantly in corporate growth. In the ruling, a corporation planned on entering into a recapitalization qualifying as an E reorganization. It had one class of stock outstanding. In the recapitalization, some shareholders would receive new class B stock, and other shareholders, a combination of new class B stock and new class A stock. The new class A stock was nonvoting and was entitled to stated dividends and a preference as to dividends and liquidation proceeds. The new class B stock was voting stock, entitled to discretionary dividends and junior to the class A stock on liquidation. In addition, on the payment of dividends on both the class A stock and the class B stock, the companys board of directors could declare an excess dividend to which the new class A stock would be entitled to 20%. The ruling stated that the likelihood that the company would liquidate was remote.

The Service concluded that, under Sec. 351(g)(3)(A), the class A stock was participating in corporate growth to a significant extent. As a result, that stock was not nonqualified preferred stock and, thus, not other property that could trigger gain on the recapitalization. Apparently, the IRS concluded that (1) the new class A stocks right to participate in 20% (or on a 1:4 ratio with the new class B stock) of the upside of the company was participating in corporate growth significantly; and (2) the fact that the class A stock had limited rights to liquidation proceeds was inconsequential, because the likelihood of liquidation was remote.

Letter Ruling 200311002 does not analyze why the class A stock was viewed as participating in corporate growth to a significant extent. It may be reasonably inferred that when, in addition to an instruments fixed return, that instrument shares in at least 20% of the corporations remaining earnings and liquidation proceeds, and the corporation is likely to have earnings remaining after preferred distributions are made, that instrument should be viewed as participating in corporate growth to a significant extent for Sec. 351(g)(3) purposes.

Note: Although affirmatively ruling that the class A stock was not preferred stock for Secs. 305 and 351(g) purposes, the Service did not rule that the class A stock was not stock other than common stock for Sec. 306 purposes. This raises the question, at least to the IRS, as to whether the same stock class may be viewed as both nonpreferred stock and noncommon stock. The IRS did, however, rule that if the class A stock is deemed to be Sec. 306 stock, the disposition or redemption of that stock will not be in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax under Sec. 306(b)(4).

From Scott Levine, J.D., Washington, DC