Redemption Premiums on Preferred Stock Under 1.305-5

When a corporation makes a distribution of its own stock to its shareholders, the event is not a taxable one. The Internal Revenue Code, however, contains provisions that can treat certain corporate transactions as “deemed” distributions, even when no cash or property is actually paid out. One of the most common scenarios where this occurs involves preferred stock issued with an unreasonable redemption premium. This situation is governed by Treasury Regulation Section 1.305-5. The core principle is that a large premium payable in the future is economically similar to receiving dividends over time, so the regulations require the shareholder to recognize this income over the life of the stock.

Identifying a Redemption Premium on Preferred Stock

A redemption premium on preferred stock can only exist if the stock itself meets a specific definition. For the purposes of these rules, “preferred stock” is stock that has a priority claim on dividends or assets upon liquidation but does not significantly participate in the corporation’s growth. This means its potential for appreciation is limited, much like a debt instrument, and its value is not expected to fluctuate with the company’s success beyond its stated preferences.

The existence of a redemption premium is determined by comparing the issue price and the redemption price. The “issue price” is the amount of money or the fair market value of property the corporation received when it originally sold the stock. The “redemption price” is the price the corporation is obligated to pay to buy back the stock at a future date. A redemption premium exists when the redemption price is higher than the issue price. To illustrate, if a share of preferred stock is issued for $1,000 and the terms state the corporation will redeem it in five years for $1,100, there is a $100 redemption premium.

The De Minimis Safe Harbor

Not every redemption premium results in a taxable deemed distribution. The regulations provide a “de minimis” safe harbor, which exempts small premiums from these rules. If the calculated premium falls at or below this threshold, it is considered reasonable and does not trigger constructive dividend income.

The de minimis threshold is calculated using a formula that mirrors rules for original issue discount (OID) on debt instruments: 0.25% of the stock’s redemption price, multiplied by the number of complete years from issuance to the mandatory redemption date. For instance, consider a share of preferred stock issued for $100 that is mandatorily redeemable in 10 years for $102. The redemption premium is $2.

To determine if this is de minimis, you would multiply the $102 redemption price by 0.25% and then by 10 years ($102 x 0.0025 x 10), which equals $2.55. Since the actual $2 premium is less than the $2.55 de minimis amount, it falls within the safe harbor, and no deemed distribution occurs.

Calculating the Deemed Distribution Amount

When a redemption premium exceeds the de minimis safe harbor, it is considered unreasonable, and a portion must be included in the shareholder’s gross income over time. Only the excess of the premium over the calculated de minimis amount is subject to this treatment, not the entire premium. This unreasonable portion is treated as a series of constructive distributions received over the period the stock is expected to be outstanding.

The regulations mandate the use of the “economic accrual” method to determine the amount of the deemed distribution for each tax period. This method, also used for OID on debt instruments, treats the preferred stock as if it has a constant yield to maturity. The total unreasonable premium is allocated across the tax periods based on this yield, resulting in smaller income inclusions in earlier years and larger inclusions in later years.

To illustrate, assume preferred stock is issued for $1,000 and is mandatorily redeemable in five years for $1,100. The redemption premium is $100. The de minimis safe harbor amount is $13.75, calculated as the $1,100 redemption price multiplied by 0.25% and then by the 5 years to maturity. The unreasonable portion of the premium is $86.25 ($100 total premium – $13.75 de minimis amount).

This $86.25 is accrued as dividend income over the five-year period. The shareholder would calculate the yield to maturity at issuance and report a portion of the $86.25 as income each year, increasing their basis in the stock by the same amount.

Special Rule for Issuer Call Rights

The tax treatment of a redemption premium changes significantly if the redemption is solely at the option of the issuing corporation, known as an “issuer call.” The general rules that create deemed distributions primarily apply to stock that is mandatorily redeemable on a set date or can be redeemed at the shareholder’s option. A redemption premium on stock that is only callable by the issuer is generally not treated as a constructive distribution.

This is because the shareholder has no control over whether the redemption will ever occur, making it uncertain if they will ever receive the premium. The regulations presume that the issuer will act in its own economic interest and not call the stock if it is disadvantageous to do so. This protection is not absolute and is lost if the facts and circumstances at the time of issuance show that redemption is “more likely than not” to occur.

The regulations provide a safe harbor, stating that a call is not considered more likely than not if the issuer and holder are unrelated, there are no agreements compelling the redemption, and exercising the call would not reduce the stock’s yield. An example of a situation that could override this safe harbor would be a pre-arranged plan or agreement between the corporation and the shareholder to redeem the stock at a specific time, effectively making the call a certainty.