Section 306 of the IRC was enacted by Congress to prevent tax avoidance by distributing certain stock to a shareholder in a nontaxable stock dividend. Section 306 prevents shareholders from using a preferred stock bailout to convert ordinary income into a capital gain. Analyze the key provisions of Section 306 of the IRC, and outline a tax- planning strategy geared toward redeeming preferred stock with sale or exchange treatment as an alternative to Section 306.
Per the text, the personal holding company (PHC) tax penalizes taxpayers who enter into tax-motivated transactions designed to shelter passive income of closely held corporations from higher individual tax rates. Suppose you represent a professional athlete who is the majority owner of a corporation. The corporation has several personal service contracts with advertising agencies and endorsements for your client in addition to passive income. Propose a plan in which you eliminate the potential for the PHC tax on the client’s corporation.
From your analysis of Section 306 in the e-Activity, differentiate between the tax treatment of earnings and profit on the distributing corporation of both a sale of Section 306 stock and redemption of Section 306 stock. Suggest the most important reasons for this differentiation in tax treatment.
Disposition of stock is one of the key concepts detailed in section 306 of IRC. The section was enacted by the congress for the avoidance of the tax through distribution of certain stock to the stockholders in the non-taxable stock dividend for the avoidance of tax. The amount realized to the stockholder by selling of such stock is treated as the ordinary income, and would be treated as if it would have been a dividend, if the corporation has paid in cash. When the stock was obtained is very important, when the stock is sold. It would be treated as an ordinary income if, when the stock was purchased, the company was having accumulated earnings or profit which may have been given against it. Sec 306(a)(1)(B) states that if the money that does not originate from the corporation e & p itself would firstly reduce the basis and would be treated as a capital gain if anything remains. (Rupert, Pope, & Anderson, 2014)
Redemption of stocks falling in sec 306 is another important concept discussed here in this section. When a corporation takes back the stock from the holder against money or any kind of property, redemption takes place. Shareholders hand over the holding stock to the corporation from which they have bought it. If the redemption qualifies under this section then a sale treatment is given to the consideration received otherwise it would be treated as the dividend income by the stockholder. This kind of redemption has the impact of reduction of the capital of the corporation and the profits earned by it for the year.
The fact that in the redemption of the stock it is the corporation, which finally pays the dividend while if the stockholder sales, the stock to another third-party, no dividend is paid by the company and the profits of the corporation are not reduced due to non-payment of the same, is the basis for such treatment.
As per the section 306 of the IRC, the profit originating from the sale of stock is further distributed among two portions, one is the portion which is equal to the value of ratable shares which the company had charged as the fair value of the stock, the remaining amount of the income earned is the redemption process. The first part of this whole proceeds is treated as the ordinary income of the stockholder and this would not be treated as the dividend income. It would be taxed at the ordinary rates of taxation for such kind of income. The other part is to be treated as the capital gain from the sale of stock hold by the stockholder. Thus for this section, it is shareholder, not the corporation, which has the power…