Rev. Rul. 81-91

ISSUE

Is the class B stock described below "section 306 stock" within the meaning of section 306(c) of the Internal Revenue Code?

FACTS

A corporation had outstanding a single class of common stock held by 10 individuals, each of whom owned 20 shares. For valid business reasons the corporation entered into a plan of recapitalization under which each outstanding share of common stock was surrendered to the corporation in exchange for one share of new class A stock plus one share of new class B stock of the corporation.

The recapitalization was a reorganization defined in section 368(a)(1)(E) of the Code and the exchanges were nontaxable under section 354(a)(1).

Each share of the class A and class B stock had a par value of 10x dollars. The class B shares were entitled to an annual cumulative dividend of 6 percent of par value payable before any dividend was payable on the class A shares, and a prior right to repayment up to par value in the event of liquidation. After the satisfaction of the class B stock's preferences, each share of class A and class B stock shared equally as to dividends and on liquidation. Each class of shares carried equal voting rights and neither class was by its terms redeemable.

LAW AND ANALYSIS

Section 306(c)(1)(B) of the Code provides, in part and in effect, that "section 306 stock" is any stock, except common stock, that is received by a shareholder pursuant to a plan of reorganization under section 368 with respect to the receipt of which gain or loss to the shareholder was to any extent not recognized by reason of section 354, but only to the extent that the effect of the transaction is subsantially the same as the receipt of a stock dividend.

The term "common stock" as used in section 306 of the Code is not defined in that section or the related regulations. In determining whether newly issued stock is "common stock" for purposes of section 306, the "preferred stock bailout" abuse Congress sought to prevent by enactment of that section provides guidance. See S. Rep. No. 1622, 83d Cong., 2d Sess. 46 (1954). See also Chamberlin v. Commissioner, 207 F.2d 462 (6th Cir. 1953), cert. denied, 347 U.S. 918 (1954). A bailout occurs if shareholders, through section 306 stock or some other device, withdraw a corporation's earnings and profits at the more favorable tax rates for capital gains. The potential for a preferred stock bailout exists if the shareholders receive a pro rata distribution of two classes of stock in a recapitalization when the corporation has earnings and profits, and the stock of one class, because of its terms, can be disposed of without a surrender by the shareholders of significant interests in corporate growth. Thus, stock is other than "common stock" for purposes of section 306 not because of its preferred position as such, but because the preferred position is limited and the stock does not participate in corporate growth to any significant extent.

The class B stock enjoys voting rights on an equal basis with the class A stock, the only other class of stock outstanding. After satisfaction of its preference as to dividends and as to assets in the event of liquidation, the class B stock shares equally with the class A stock. These rights in the class B stock to participate in corporate growth are significant. Thus, a sale of the class B stock cannot occur without a loss of voting control and interest in the unrestricted growth of the corporation. Therefore, the bailout abuse that Congress sought to prevent by the enactment of section 306 cannot be effected through a sale of the class B stock.

HOLDING

The class B stock is "common stock" and is, therefore, excepted from the definition of section 306 stock under section 306(c)(1)(B) of the Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 66-332, 1966-2 C.B. 108, concerns a recapitalization meeting the definition of a reorganization under section 368(a)(1)(E) of the Code. Under the plan the only outstanding stock (common) was reclassified as class A voting stock and the shareholders could continue to hold the class A stock or exchange all or part of such class A stock for units of one share of preferred stock and one share of Class B voting stock. The exchange ratio was one share of class A stock for each unit of one share of preferred stock and one share of class B stock.

The question presented in Rev. Rul. 66-332 is whether the class A stock and preferred stock are "section 306 stock" as defined in section 306(c) of the Code.

The preferred stock was entitled to a cumulative dividend of $7 per share before any dividend was paid on either class A or class B stock. The class A stock was entitled to a cumulative dividend of $7 per share before any dividend was paid on class B stock. After all cumulative dividends on the preferred and class A stock had been paid, the class A and class B stock shared equally in all further dividends. The preferred stock was entitled to a preference on any distributions of assets in the amount of its par value. After this preference had been satisfied the class A stock was entitled to a preference on any distribution in the amount of one and one-half times the amount of its par value and thereafter the class A and class B stock shared equally in any further distribution of assets. The class A and class B stock both had voting rights. The preferred stock was nonvoting except in the case of dividend arrearage.

With regard to shareholders who exchanged all of their class A stock for units of preferred and class B stock (situation 1), Rev. Rul. 66-332 concludes that this exchange was substantially the same as the exchange of the old common stock for shares of class B stock and the receipt of a stock dividend in shares of preferred stock. Rev. Rul. 66-332 correctly holds under section 306(c)(1)(B) of the Code that the preferred stock is section 306 stock in the hands of these shareholders.

With regard to shareholders who exchanged only part of their class A stock for units of preferred and class B stock (situation 2), Rev. Rul. 66-332 concludes that since these shareholders still owned class A stock, which was preferred both as to dividends and distributions in liquidation over the class B stock, the class A stock was not common stock for purposes of section 306(c)(1)(B) of the Code. Thus, the effect of the transaction as to them was substantially the same as the exchange of their old common stock for shares of class B stock and the receipt of a stock dividend in shares of class A stock and other preferred stock. Rev. Rul. 66-332 holds that both the class A stock retained and the preferred stock are section 306 stock.

Although the class A stock in situation 2 of Rev. Rul. 66-332 had a preference as to dividends and assets in the event of liquidation, after the satisfaction of these preferences the class A stock and the class B stock shared equally in dividends and the assets of the corporation on liquidation. Thus, a sale of the class A stock could not occur without a loss of an interest in the unrestricted equitable growth of the corporation. Therefore, the class A stock is "common stock" and, thus, is properly excepted from the definition of "section 306 stock" within the meaning of section 306(c)(1)(B) of the Code.

With regard to those shareholders who exchanged none of their class A stock for units of preferred and class B stock (situation 3), Rev. Rul. 66-332 concludes that the transaction as to them was the exchange of their old common stock for participating class A stock, which was not "common stock" because of its preferences as to dividends and distributions in liquidation, but that the effect of the receipt of the class A stock was not the same as the receipt of a stock dividend. Therefore, Rev. Rul. 66-332 holds that the class A stock retained by shareholders in this situation is not "section 306 stock." While this holding is proper, the reason is that the class A stock is "common stock" (since it has an interest in the unrestricted growth of the corporation) and, thus, is excepted from the definition of section 306 stock under section 306(c)(1)(B) of the Code, which makes it unnecessary to consider whether the receipt of the class A stock was the same as the receipt of a stock dividend.

Rev. Rul. 66-332 is modified with regard to situation 2 and situation 3.