Rev. Rul. 80-33
1980-1 C.B. 69, 1980-6 I.R.B. 5.
Internal Revenue Service
Revenue Ruling
CHARITABLE CONTRIBUTION; SECTION 306 STOCK
Published: February 11, 1980
Section 306.--Disposition of Certain Stock, 26 CFR 1.306-2: Exception.
(Also Section 170; 1.170A-4.)
Charitable contribution; section 306 stock. A corporation issued section 306 stock to its controlling shareholder in a reorganization to accomplish a valid business objective, although an issue of long term bonds would have accomplished the same objective. The shareholder has not shown that none of the principal purposes of the stock issue was the avoidance of federal income tax. The shareholder's charitable contribution of the stock will be reduced under section 170(e)(1)(A) of the Code.
ISSUE
Whether under the circumstances described below, the distribution of voting preferred stock, which is section 306 stock, was in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax within the meaning of section 306(b)(4)(A) of the Internal Revenue Code so that upon the contribution of the preferred stock to a charitable organization
described in section 170(c) of the Code, the amount of the charitable contribution will be reduced under section 170(e)(1)(A).
FACTS
X corporation has outstanding 28,000x shares of voting common stock and 2,000x shares of voting preferred stock. Individual A owns 8,500x shares of the common stock and all of the shares of the preferred stock. Individual B owns 10,000x shares of the common stock. The remaining 9,500x shares of the common stock are widely held and are traded in the over-the-counter market.
A is not related to any of the other X shareholders. B was formerly the sole shareholder of corporation Z which was acquired by X in 1969 in a stock-for- stock exchange. A, who is 80 years old, served as chief executive officer of X from 1933 until 1969, when A turned over the management and control of X to younger officers, including B. B is on the board of directors of X.
The laws of the state of incorporation of X require a two-thirds vote of the outstanding stock of corporations in order for mergers, consolidations, liquidations and sales of substantially all of the assets to be undertaken.
Prior to 1964, X had only 10,000x shares of voting common stock outstanding, all of which were owned by A. In 1965, X and A sold, respectively, 1,000x and 1,500x shares of common stock to the public, reducing A's ownership of X to approximately 77 percent.
Shortly after the public offering, A received 2,000x shares of X voting preferred stock in exchange for all of the outstanding stock of corporation Y in a stock-for-stock exchange in accordance with section 369(a)(1)(B) of the Code. The preferred stock received by A was 'section 306 stock.' A's ratable share of X's earnings and profits exceeded the fair market value of the preferred stock issued by X. A caused X to acquire Y because Y was engaged in financing sales of some of the products manufactured by X, and A wanted to avoid any conflict of interest charges by the minority shareholders of X. Although A was willing to accept X common stock in exchange for the Y stock, the underwriters who had managed the public sale of X stock advised X to issue preferred stock to A. The issuance of additional common stock would dilute the earnings per share of X common stock, and the underwriters believed it would appear as if A was taking advantage of the new public shareholders. The underwriters' advice was also motivated by X's plans to make another public offering of common stock. They believed the dilution of earnings per share that would result from the issuance of common stock in the acquisition would make the planned offering more difficult.
In 1969, X issued 10,000x shares of common stock to B in the acquisition of Z corporation. In 1973, X made an additional public offering of 7,000x shares of common stock. As a result of the issuance of these additional shares of common stock, A's voting power in X was reduced to 35 percent.
A now wishes to give the 2,000x shares of the voting preferred stock to several charitable organizations described in section 170(c) of the Code. The fair market value of the preferred stock exceeds its adjusted basis to A. There is no plan for the contributed stock to be redeemed by X.
LAW AND ANALYSIS
Section 170(a) of the Code provides for the deduction of charitable contributions. Section 170(e)(1)(A) provides that the amount of any charitable contribution of property will be reduced by the amount of gain that would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value. Section 1.170A-4 of the Income Tax Regulations provides that section 170(e)(1)(A) applies to section 306 stock to the extent that, after applying section 306, gain on the
disposition of the stock would not have been long-term capital gain if the stock had been sold at its fair market value at the time of its contribution to the charities.
Section 306(a)(1) of the Code provides that if a shareholder sells section 306 stock, the amount realized will be treated as ordinary income to the extent the amount realized does not exceed the stock's ratable share of the amount that would have been a dividend at the time the stock was distributed if the corporation had distributed money, in lieu of section 306 stock, in an amount equal to the fair market value of the stock at the time of the distribution.
Section 306(b)(4)(A) provides an exception to the general rule of section 306(a), if it is established to the satisfaction of the Secretary or his delegate that the distribution, and the disposition or redemption, were not in pursuance of a plan having as one if its principal purposes the avoidance of federal income tax. The Congressional intent of this section is to provide an exception to the general rule in the case of distributions and isolated dispositions of section 306 stock by minority shareholders who do not in the aggregate have control of the distributing corporation because it was inappropriate to impute to noncontrolling shareholders an intention to bail-out earnings and profits at capital gains rates. S. Rep. No. 1622, 83rd Cong., 2d Sess. 243 (1954); see section 1.306-2(b)(3) of the regulations.
Consistent with the limited application of section 306(b)(4)(A), the Service has ruled that the receipt of section 306 stock by a shareholder in a merger with a widely-held corporation in which the shareholder was not a controlling shareholder and the disposition of that stock not in redemption or in anticipation of redemption, other than pursuant to the terms of a sinking fund, is not pursuant to a plan having as one of its principal purposes the avoidance of federal income tax. See Rev. Rul. 56-116, 1956-1 C.B. 164; Rev. Rul. 57- 103, 1957-1 C.B. 113; Rev. Rul. 57-212, 1957-1 C.B. 114. See also Rev. Proc. 77-37, 1977-2 C.B. 568.
In Fireoved v. United States, 462 F.2d 1281 (3d Cir. 1972), the taxpayer received a preferred stock dividend as part of a business combination of his wholly-owned corporation and an unrelated two-person partnership. The preferred stock was section 306 stock. When the corporation later redeemed deemed some of the preferred stock, the Government argued that the amount realized should be treated as a distribution of property under section 301 of the Code, as provided for by section 306(a)(2). The taxpayer claimed the exception of section 306(b)(4)(A), arguing that the sole purpose of the stock dividend, to leave needed capital in the business while equalizing the common stock interests of the shareholders of the surviving corporation, was motivated by business considerations and not by a desire to avoid tax.
The court reviewed the legislative history of section 306 of the Code and concluded that section 306 was enacted to prevent the 'preferred stock bail- out' by which the controlling shareholders withdraw earnings from the corporation at the more favorable tax rates for capital gains while retaining their ownership interests in the corporation. In analyzing the issuance of the preferred stock, the court pointed out that the taxpayer could have accomplished his business objective by taking a cash dividend and loaning the proceeds to the corporation. The court concluded that if the reason for distributing a stock dividend instead of a cash dividend was to avoid the tax at ordinary income rates, then one of the principal purposes of the stock dividend would have been the avoidance of federal income tax. Finally, the court concluded that the taxpayer had not borne his burden of proving that none of the principal purposes of the plan was the avoidance of federal income tax.
In the present case, A was in control of X at the time A received the voting preferred stock. A has shown that one of the
principal purposes for the issuance of the preferred stock was to prevent the adverse effect of the issuance of common stock on X's ability to raise capital from the public in the future. However, A has not shown that X could not have accomplished the same business objective by issuing A long term bonds, instead of preferred stock. If one of the principal purposes for which X issued the preferred stock instead of long term bonds was to avoid the ordinary dividend to A that would have resulted upon the receipt of the bonds, then one of the principal purposes for the issuance of the preferred stock was the avoidance of federal income tax. Consequently, A has not borne the burden of showing that none of the principal purposes for the issuance of the preferred stock was the avoidance of federal income tax.
HOLDING
Section 306(b)(4)(A) of the Code would not be available to except a sale by A of the section 306 stock from the ordinary income characterization of section 306(a)(1). Therefore, A's charitable contribution will be reduced under section 170(e)(1)(A).
Rev. Rul. 80-33, 1980-1 C.B. 69, 1980-6 I.R.B. 5.