What Is Section 306 Stock and How Is It Taxed?

Section 306 of the Internal Revenue Code was established to counter a strategy known as the “preferred stock bailout.” This technique allowed shareholders of a profitable corporation to extract earnings not as dividends, which can be taxed at higher ordinary income rates, but as proceeds from a stock sale, taxed at more favorable long-term capital gains rates. The classic bailout involved a corporation with significant profits issuing a non-taxable dividend of preferred stock to its existing common stockholders. The shareholders would then sell this preferred stock to a third party and report the proceeds as capital gain. Shortly thereafter, the corporation would redeem the stock from the third party, so Section 306 was enacted to close this loophole by creating a special category of stock with specific tax consequences.

Defining Tainted Stock

Section 306 stock, often called “tainted stock,” is a designation created to prevent the bailout strategy. The most common way this stock is created is when a corporation distributes preferred stock as a tax-free dividend to its shareholders with respect to their common stock. For example, if a company issues a dividend of 100 shares of newly created preferred stock to its sole common stockholder, those preferred shares are classified as Section 306 stock.

Another path to creating this stock is through certain corporate reorganizations. If a shareholder receives preferred stock in a tax-free reorganization that has the same economic effect as receiving a stock dividend, that new preferred stock will also be tainted. The principle is that if receiving cash instead of the stock would have been treated as a dividend, the stock received is likely Section 306 stock.

A key factor in this definition is corporate “earnings and profits” (E&P), a tax measure of a company’s economic ability to pay dividends. If a corporation has no current or accumulated E&P when it distributes the preferred stock, the stock cannot be classified as Section 306 stock. The taint only applies if the distribution taps into corporate profits that would otherwise be taxable as ordinary income.

The taint can also carry over in certain transfers. If a shareholder gifts their Section 306 stock, it remains tainted in the hands of the recipient. The recipient’s tax basis is determined by referencing the donor’s basis, which preserves the character of the stock. This rule prevents shareholders from simply giving the stock to a family member to sell.

Tax Consequences of Dispositions

The tax treatment for Section 306 stock depends on the method of disposition. The rules recharacterize what would otherwise be capital gain into ordinary income, similar to the tax treatment of a dividend.

When a shareholder sells Section 306 stock in a transaction that is not a redemption, the amount realized is treated as ordinary income. This is limited to the stock’s share of the corporation’s E&P at the time the stock was distributed. If sale proceeds exceed this E&P amount, the excess is treated as a tax-free return of the shareholder’s basis. Any remaining proceeds are treated as capital gain, and no loss can be recognized on the sale.

For example, a shareholder receives Section 306 stock with a basis of $1,000. At distribution, the corporation’s E&P attributable to the stock is $8,000. If the shareholder sells the stock for $12,000, the first $8,000 is ordinary income. The next $1,000 is a tax-free return of basis, and the remaining $3,000 is capital gain.

If the corporation redeems the Section 306 stock, the entire amount received is treated as a corporate distribution. The proceeds are taxed as a dividend to the extent of the corporation’s E&P at the time of the redemption, not at the time of the original issuance. Any amount exceeding E&P is a return of basis, followed by capital gain.

If the same stock from the previous example was redeemed for $12,000 when the corporation’s E&P was $15,000, the entire $12,000 would be taxed as a dividend. The shareholder’s $1,000 basis is not used to offset the proceeds but is added to the basis of their common stock. The different E&P measurement dates and basis rules between a sale and a redemption can lead to different tax liabilities.

Exceptions Removing the Taint

The Internal Revenue Code provides several exceptions that remove the “taint” from Section 306 stock, allowing for more favorable tax treatment. These exceptions recognize that not every disposition is part of a tax avoidance plan. When an exception applies, the transaction is treated under normal tax rules, often resulting in capital gain rather than ordinary income.

One exception is the complete termination of a shareholder’s interest in the corporation. If a shareholder disposes of their entire stock interest, including both common and preferred stock, to an unrelated party, the ordinary income rules do not apply. This is based on the logic that a shareholder who completely severs their ties with the corporation is not bailing out earnings, but rather liquidating their investment. This termination can occur through a sale to a third party or a complete redemption of all stock by the corporation.

Another exception applies when the Section 306 stock is disposed of in a complete liquidation of the corporation. A corporate liquidation is a terminal event for the business, and distributions made during this process are treated as payments in exchange for stock. This treatment typically results in capital gain or loss for the shareholder.

Certain transactions where gain or loss is not recognized also provide an escape. For instance, if a shareholder exchanges Section 306 stock in a qualifying tax-free corporate reorganization, the taint is not triggered at the time of the exchange. A transfer upon the death of a shareholder also completely removes the taint, as the heir receives the stock with a basis equal to its fair market value at the date of death.

An exception also exists for transactions that are not part of a plan with tax avoidance as a principal purpose. This is a subjective test that depends on the specific facts and circumstances of the case. Proving the absence of a tax avoidance purpose requires a clear business reason for the original stock issuance and its disposition.