Revenue Code 306: What Is Section 306 Stock?

Before the enactment of Internal Revenue Code (IRC) Section 306, a tax loophole known as a “preferred stock bailout” allowed shareholders to extract corporate earnings at favorable tax rates. The process involved a corporation with substantial profits issuing a tax-free dividend of preferred stock to its common stockholders. The shareholders would then sell this preferred stock to a third party, reporting the proceeds as a capital gain, often without diluting their control of the corporation. Shortly after, the corporation would redeem the stock from the third party, effectively distributing corporate profits to the original shareholders indirectly. Congress enacted Section 306 in 1954 to close this loophole by creating a special category of stock with specific tax consequences upon its sale or disposition.

Defining Section 306 Stock

Section 306 stock, also called “tainted” stock, is a designation created by the tax code to prevent the preferred stock bailout. It most commonly arises from a tax-free distribution of preferred stock to existing common stockholders. For example, when a corporation issues a pro-rata dividend of new preferred stock to its common shareholders, those shares are immediately classified as Section 306 stock.

Stock can also be tainted during corporate reorganizations. If a shareholder exchanges common stock for both new common and preferred stock in a tax-free reorganization, the preferred stock received may be classified as Section 306 stock. The classification is based on a “cash substitution” test: if a cash distribution in place of the stock would have been a dividend taxable as ordinary income, then the stock is tainted.

An element in this definition is the corporation’s “earnings and profits” (E&P), a tax measure of its ability to pay dividends. For stock to be classified as Section 306 stock, the issuing corporation must have E&P at the time of distribution. If a corporation has no current or accumulated E&P when it issues the preferred stock, the stock cannot be tainted because a cash distribution at that time would not have been a taxable dividend.

Tax Treatment Upon Disposition

The tax consequences for disposing of Section 306 stock depend on whether it is a sale to a third party or a redemption by the corporation. The rules recharacterize what would otherwise be a capital gain into ordinary income, neutralizing the benefit of the bailout strategy.

When a shareholder sells Section 306 stock to an unrelated third party, the proceeds are treated as ordinary income. This treatment is limited to the stock’s ratable share of the corporation’s E&P at the time the stock was issued. If proceeds exceed this E&P amount, the excess is a tax-free return of capital against the shareholder’s basis. Any remaining amount is treated as a capital gain, but no loss can be recognized on the sale.

If the corporation redeems the stock directly, the treatment is different. The entire amount received is a distribution of property under IRC § 301. This means the proceeds are taxed as a dividend to the extent of the corporation’s E&P at the time of the redemption. A corporation’s E&P may be much higher at redemption than at issuance, which can result in a larger portion of the proceeds being taxed as a dividend.

Exceptions to Section 306 Treatment

The Internal Revenue Code provides several exceptions that remove the “taint” from Section 306 stock, allowing for normal tax treatment. When an exception applies, the proceeds are treated as payment for the stock, resulting in capital gain or loss rather than ordinary income.

• A complete termination of a shareholder’s interest in the corporation. If a shareholder disposes of their entire stock holdings in the company, both common and preferred, to an unrelated party, the Section 306 rules do not apply. This can be through a sale or a complete redemption that qualifies under IRC § 302.
• A redemption in a complete liquidation of the corporation. A corporate liquidation is a final event, and all distributions made during this process are treated as payments in exchange for stock, leading to capital gain or loss treatment.
• A disposition where gain or loss is not recognized for tax purposes. This includes an exchange of Section 306 stock for other stock in a qualifying tax-free corporate reorganization under Section 354 or 355.
• A transaction not part of a plan for tax avoidance. The shareholder must establish to the satisfaction of the IRS that both the initial distribution of the stock and its subsequent disposition were for legitimate business reasons. For example, if a shareholder sells their underlying common stock before selling their Section 306 stock, the subsequent sale of the tainted stock would not ordinarily be considered part of a tax avoidance plan.