FIREOVED AND IT'S EFFECT ON
BRUCE
E.
TURNER
§
306
FIREOVED AND IT'!S EFFECT ON ' ~ 306
' The objective ' of
%
306 'is best exemplified by Chamberlin v.
Commissioner, 207 ,F 2 d 462 (6th Cir. 1953), cert. den. 347
U.S. ' 918, (1954),
a 1939 Code decision by the
,
,
Sixth Circuit. There,
the shareholder-defendants caused their ' corporation to issue a
,tax-free stock
dividend.
, Shortly thereafter
the preferred stock was
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sold to, purchClsers on the basis of negotiations conducted prior to
,the issuance. ' The Con,missioner
contended, and the Tax Court
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" upheld, that the,' stock ~as taxable because it was essentially
equivalent to a
divid~~~
The Court of Appeals in reversing held
, that the solution of thi!3bailout problem \'Vas solely within the
: ambit of the legislatiVe power.' J. Chommie, Federal Income Taxation
437 (1st. ed. 1968).
The Congr:essional answer was provided by!! 306.
The defini tion
of II 306 stock is aimed primarily at what is referred to as a "preferred
stock bailout ."
'he purpose of~ ' 306 is ' to ,block the above described
"bail-out" as well as any similar
de\llc~s
that might be used in
lieu -of a preferred
stoc~dividend
'.;,'1 0 remove' corporate ' earnings at
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capital gains rates, Thus,
§ 306 ,attempts to, pr~vent a shareholder
withdrawing earni'ngs and, 'profits from a corporation without paying
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income tax at ordinary rates and yet retaining' his original control,
, and participating inte,re?t in it.
Since "§ 306, is ,intricate, complex, 'and ambiguous it is
remarkable thai:' until Firevoed v. U. S., 462 F2d 1281 (1972), there '
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was no case law interpretating it. Therefore, this writer will
analyze § 306 as, it rel,a tes ,to the Fireoved case, l:\1ere, in 1954 the
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plaintiff and principal shareholder caused his corporation to issue
additional common stock.to combine his business with the partnership
of Girard Business Forms. ' The commOn stock was increased from '
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100 to 300 shares and the preferred stock was increased to 1000.
shares. GIrard Business received 200 shares 'of common and 298
shares of preferred in return for their assets. ' Mr.
excha~ged
Fireoved
his 100 shares ' of ,common and 65 shares!,; of preferred for
equal amounts of the new stock. Then to equalize the disparity in
the capital contribution, Mr. Fireoved was issued 535 shares of the
'new preferred 'stock
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a dividen:l.
Five years later the company
redeemed 451 shares of the plaintiff's preferred stock.
attempted to report the gain as a long term capital gain.
,
Plaintiff
When the
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Commissioner, assessed a dieficiencyof $15,337.13, the plaintiff
paid and instituted 'an action for refund in the District Court. The
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courtdete~mined ,tha't $8",885,,50 should"be refunded and bcith parti'es
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have appealed.
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The thrust of § 306 stock, disallows long term capi tal gain '
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" treatment upon it5redemption i:lf the corporation has sU/Ticlent
. retained earnings at that time. The. entire amouht paid for-the 'stock; .
. redeemed (irrespective of the pro rata share of available earnings
and profits) .is treated as a distribution of property under' § 301; ,..CJndelr3()1(c)
\~e distribution wltlbe' tpeated
as a dividenil to .the , e><tent o:ththe '
:corporatlon's entire earnings arid profits at · the date of redemption • .'
'. $47,355 was the
amount used to redeem
the stock. Therefore,
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' Fireov~d' would
be taxedat ·ordinary income tax rates
bec~use
the
" co~pany had" earnings ,of $48 , 235 • . Mr. Fireoved asserts certain
exceptions to
the general rule which
serves. to' remove the taint o(
a "preferred, stock bailOut."
Appellant-shareholder claims that the entire transaction
fits §306(b)(4XA). This exception is for transactions that in the
opinion of the TreasurY,;;lre not In pursuance of a plan to avoid
f~deral
income taxes as .one of its prinCipal mdlives. Thus to fit
§
306
(b)(4)(A), one of the pr.i mclpal purposes In both the initial distribution ·
and
Ultima~e'disPpSitl6n
: may' not be the avoidance of income taxes.
rf,' the tax-avoida;"ce pl>an existed at the date of distribution but
was abandoned prior to'. the red.e mption., the exception would not be
applicable anc:i.·§ 306(a) .co~~d not be avoided •. SOloman', How to Deal
with§ 306, 20\JJ.. So ~ Cal; .Tax Insto'.lS,7 (1968) •
.:os..; .
If § 306 stock was distributed as, a stock dividend the Treasury,
' ha,s cited only ,'o ne situation known to fan withil:hthe exception. The
:,.'e gUlations I"efel"to ':'isolateq dispositions of
'shal"eholdel"s." Treas. Reg.
§
§
306 stock by minority
l.306-2(bX3). The
woI"~
',' isolated"
indicates that in the absence of 'a corporate adopted tax-avoidance
plan,dispositions of§ G06 stock in widely held
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publically owned
corporations would not 'be subjected to §306(a) t .... eatment.
In' analyzing the present transaction ,the 3rd Circuit applied
the Sub,s tance over
Form Principle. The fedEil"al courts uniformly
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state': 'ttiat tax
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~annot. 'be eluded
by a device' contrived to disguise
natul"'
e of the
:tl"ansaction
and upon judicial challenge they
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will penetrate through form in ,!,ost careful search for substance.
' District ~f COiumbiav.Neyman, ' 4171f2 d ll40 (Dist. Col. Cil". 1969).
The court fOund that M'I". Fil"eoved could hav,e received a cash
' divtdend [in lieu :of a sto,
c k divider)d]
and then made a loan to the
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company, bYVllh'ic,\1h~W£ld have subjected hi~self to taxation at
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ordinary
rates. ..This' alternate procedure showed the exi~tance
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a tax , avoidance purpose. Therefore the court stated that the tax- .
, payer fai led to stJstain the burden of negating the tax avoidance
purpose , even' though he , affirmatively demonstrated a business
pUl"po's e for the tl".ansac~ion. ' In essenc~, the COU'l"t stated that in '
order to meet the exception provided by § 306(b)C4XA) any othe ....
form , which ,a chieves ;~h~;-Same end must.notresul,t in less favorable '
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, tax consequences. ' However, the "(sola ted dispositions 'o f § 306 stock
' ,by a minority shar:eholder" should not be ,affected by the Fireoved ,
hO'l ding because
the alternative procedure would be adopted by the
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ma:jority.
Mr. -Flreoved 'asserted that the prior sale of 24% of his common
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,stock immunized that portion of the redeemed stock under § 306(b)(4XB).,
'The district court agreedarid the Government appeals this point,. The
exceptio'n 'provides that § 306(a) will not apply if it Is established 'to 'the ,
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s"atlsfactton of the Secretary or his delegate-""In the case of a prior or simultaneous disposition
(or' redemption) of the stock with respect to which '
, § 306 stock disposed of (or redeerne'd)".) was Issued ..
that the dlsposltlon(or redemption) of the § 306
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stock was not In pursuance of a plan having as one '
of its principal purposes the avoidance of Federal
Income taxes. "Int. Rev. Code of 1972, § 306(b)
(4)(B) , , ,
' I't shciuld be noted that under this exception ,the determinative pOint
"Is whether there was a tax avoidance motive involved in the ultimate,
, disposition or redemption; the motives of the shareholder in the
' I~Itial
distribution of
§
306 stock are Immaterial.
The operation of this exception Is best exemplified by the' Se,n ate"
Finance Report which declared:
"Subparagraph ,(b) of subsection(b)(4) applies
to a case where a shareholder, has made a prior
or simultaneous disposition (or redemption) of
the , under.lying stock with respect to which § 306
'stock was receiVed ;' Thus, if a shareholder received a dtstrtbGtion of 100 shares of § 306 ;;tock
pn hlsholdi"gs
of 100
shares
,o f voting common
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stock in .a corporation and sells his voting
common stock before re disposes of his
§ 306 stock, the subsequent disposition of
his S 306 stock would not ordinarily be
considered a tax avoidance disposition since
he has previously parted with the stock which
allows him to participate In the ownership of
the business." S. Rep. No. 1622, 83rd Cong.;
2nd Sess., 244 (1944).
The examples in the Committee Report and the Regulations
,.as·s ume a complete disposition of the underlying stock. With the
· disposition goes also the control of the shareholder and thus, the
removal of taint from the § 306 stock.
Until Fireoved, authorities
· felt that a pro rata disposition should logically result in a pro rata
· exemption from S 306(a) treatment.
Blttker and EUstice, Federal
Income Taxation of Corporations and Shareholders 10-12, (3rd ed. 1971);
Soloman,
Howto
.Deal with 1i'306, 20U. So. Cal.. Tax Inst. 167
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For
example,
if 500 shares
of
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. a, dividend
on 100· shares of
§
306 stock are received as
co~mon, and' 50 shares of common ·a re
.sold,
then those authorities
felt that 1/2 or 250 shares of the
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§
306
, stock. should become free oftlie Ii 306 taint •
. Fireoved disputed these authorities to' the extent that they
suggested It is a:n.,~nqU,allfled pro :rata exemption'.
The exemption depends
on the decline in control. The bylaws required a unanimous vote .of"
Mr . Fir·eoveda('KI the,\oth~r< two directors to affect·a:ny corporate
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In addltion~-:7.6%
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ou~tandlng
connmonstock
was
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necessary to amend the bylaws. The percentage of common he ld by
,the' three shareholders was such that a ,unanimous vote was' requi red.
to even attain ,the 76% ,'Under these circumstances, since the ~­
'payer
retained essentially
all the 'contl"Ol he previously held, it
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: is not consistent with thel~glslat\ve Intent to allOllli an exemption
on 24% of the redemption.
To fortifY this decision the court cited U.S. v. Davis, 397 'U.S.
301, 90 S. Ct. 104,1; (l970)~ ' They felt that while Davis supports
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a statement of law dlffer.ent
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this fact pattern, that I twas
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anl;l,lilgous
to.lend' ,sQme support to their decision.
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In the Davis case 'the
Supreme Court was faced with a
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•red~mptlon of pref~r':'ed ' stock by a corporation of which the taxpayer
.owned 25%
' Ofthe
,c~~mon . sto~k and all the preferred. ' His wife and
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two children 'each 'o Wned 26% of the common. The lower court's
'decision was In favor of"a '§ 302(bXl) qualification which al\ows exchange
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treatment If .the redemption Is not essentially equl~lent to a
dividend. The regulations, although stating that dividend equivalence "
depends on the facts arld,' cl'rcumsta~es of each case, provide .that
the constructive owhershlp rules must be considered In making this
determination. ' Treas. Reg.
!i 1.302-2(bXI972); In rever,s lng the
lower: court,
the' Supreme
In the
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. endorsed,: thlS provision
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Regs.
Also,,'
If,. "' there
Is' only one,:Ciass, .cif,stOck
"ou~tandlng
In the
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redeeming corporation, the regulations state that a pro rata
,r~dernptiongenerally
will be ',treated as adistribution, '"and::tnis
, , Posi~ionw~s also endorsed by Davis. Tr-eas. Reg. § 1.302-2(bXI972).
' The pertil'lentinquiry : in Davis
is ownership, either actual
' or "'c onstructive" , while the relevant inquiry in Fireoved
is
con~ol.
, Control, as Owner~hip, is not determined ' through the percentage :
of, stock held. , It is' embOctied in the' surrounding c{rcumstances
of the case.
Even though Fireoved
stock his cOl')trol had not declined.
sold 24% of his underlying
His vote was still required
..in any corporate action ' ar)cr was also needed to effect a change in
' the bylaws.
Presumably, from the dicta expounded by the court;
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if the bylaws" could .'have been' amended or a corporat:e:action;:taken
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by a lesser percentage not requlril'19 Mr. Flreoved's vote then
a , portion of r~eemed stock would qualify for the exemption due
to tl:'Ie shareholder's decline In controL
The 'district. court . held that of the 451 shares of preferred stock
. redeemed ,that 65 shares represented the original preferred issued
to him • .· Therefore; they 'w erenot § 306 stock and were entitled Ito "
' long-term capital gain treatment.
:The court reached this deter-
minatlon bX .relylng on Treas. Rf;l9, § 1.10I2.,.I(c) (1972).
This
regulation provides
that. the
rule 'of
the :fir:stin-flrst
out 'a pplies
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,when a taxpayer', acquires ,s"ares In ' the same class ofstpck in ' t/:le
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same corporation at differentdate~
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or : ~t ' different
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prices. '
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The circuit court states that although this analysis
appears to
be correct tt reltes ,on a ,g eneral
secUon of the Code. : Since there .
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, i. a .pecific .ection of ; t;tIe Code deal!"" with this' t)tpe of trans' action that section ml,!st be uti I ized.
enacted to determine~' ,
§ 1223(5) of' the' Code was "
the holding period if the basis of stock is
determined under ' § 307.
§ 307(a) determines 'the basis of the ' stock if it is received
in a 'd istribution to wh'i ch ' !i 305(a) appUes.
§
305(a) covers
distributions of stock of a corporation made by such corporations
to its shareholders with ,respect to its stock where no amount is
,'Included in gross income.
The preferred stock dividend of 535
shares was issued with respect to the underlying , common stock.
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Therefore, it meets of provisions of !i , 305(a) and § 307(a) and the
holding period is determined under ~ 1223(5). ' § 1223(5) states that the
' holding period : is, to be the same as that for the underlying ,
"com,m on stock. ' , Since the 65 shares of preferred were issued to', Mr.
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Fireoved on the same date a,s the common a pro rata portion of
, the' ip5 shares .were redeemed in 1959 [65/600 of 451 ]' , and are
entitled to long-term capital gain treatment.
Using, the
specif~c ,
prOvision of
first in-first out will neyer
b~
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1223(5) the rule of the
used , un I,e sli
,~e
non-§ 306 stock is
a ,c qutred prior : to ." the common stock o~nersl;lip. , ' In any ,other situation
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' where § 1223(5) applies the best, po~sible tax treatment that could
,be obtained is , pro rata treatment 'on the non-~ 306 stock.
The
circuit court then remanded the cause, to the district court to
' dete'rmine the actual 'amounts allowed long-term capital gain "
'treatment.
If Mr. Fir'eoved had been successful in
avo~dinQ
!f,'306 he would
not be assured , cap'ital ,'gain' treatment on ,a ; redemption because
, the transaction win : be cover~ by
§ '
302 and a pro rata rede:, niption
' will almost surely , be taxed as a dividend under ' that section. Int.
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, Rev. Code of 197:?,
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302(d).
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The' taxpayer would
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be faced
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with the holding
in the Davis "case in asserting that the redemption
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shOUld be ' treated as an exchange because it is not essentially
equivalent to
a,diVidend. ,
Under that holding the taxpayer's
, business purpose is irrelevant in determining dividend equivalency
under
§
302(b)(l) and in order to avoid dividen\:1 equivalency, the
redemption must result ,in a meaningful red'uctlon in the shareholder's
proportionate interest in the corporation.
The taxpayer could noiN
argue that 24% of his stock has been, ', sold which has decreased
his ownership interest.'
After analyzing the reaching effect of
the Davis decision It is probable that the, court would view control
as a main attribute to ', oWnership and since the control level remained
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essentially, ,constant' there 'is nO meaningful reduct~on in ' the ownership ,
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interest.
The , court could simply state that while the form of the
transaction showed a change in ownership, the essence of owner- ,
ship is control which showed ' no appreciable decltne and therefore
' the redemption was essentially , equivalent to a dividend.
' In Fir,e oved
of § 30.6.
the , court 'attempts to interpret certain provisions '
In analyZing the exceptions 'possible, the court ' further
,'limits the, "preferred stock bailolllt."
The , an0wance of an exception
win depend on the :facts and circumst.inces 'of each case.
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The
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exception 'al1owed by! 3o.6(bX2)(B) is conditioned on the amount
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limited to definite situations;'
in-~ir.st
And although § 306
(~)(4)
out is
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is phrased
as to the taxpayer's motives, those motives tend to be judged on an
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, objective , standard; ', Though 'this is' th~ first court ' of appeals
asked ' to decide, questions of: l~w qn
§
3()6, it"surely will not
be the last~ ,' As ~='Davis is
~ alode';5tar.
:, to points ' of §, 30.25,
0 wHl
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Fir'eoved be , to
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§
30.6.,
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