LTR 201308001 rules on sections 305 and 306 are bread and butter subchapter C provisions that were designed for “tax shelters” that are so quaint and old fashioned that the sections mostly serve today as traps for the unwary. The ruling also involves tracking stock, a more up-to-date matter.
Facts. Taxpayer is a closely held corporation, the parent of a consolidated group. All of its shareholders are either directors or employees. Employees have been allowed to buy stock based on book value. The stock has become too expensive due to group members’ ownership of substantial investment assets that are dispersed throughout the group members—possibly cash. The ruling refers to these investment assets as working capital.
For the stated reason of reducing the price of sales of new stock to employees in the future, the taxpayer proposes the following steps:
- Revise the charter to make the original stock (which becomes Class C) track the assets of the group members other than the investment assets and create a new Class T stock that tracks the investment assets. The C stock will pay dividends; the T stock will not. The C stock will continue to be valued for purposes of employee purchases from the parent and redemptions from employees at book value; the T stock at FMV. Both classes will have the same vote per share. Both classes must be sold back to the parent upon the holder’s death, retirement or termination. Each class is entitled to its part of the value of the respective asset pools upon liquidation. The Class C stock can be put to the parent at book value; the Class T stock can be put to the parent at FMV, but the parent has discretion not to buy.
- Parent will redeem a pro rata part of each current shareholder’s stock in exchange for new T stock. Thereafter, the original stock still held will be C stock.
- Future sales to employees (including current employee/shareholders) will be of C stock only. Current shareholders can use their T stock to buy new C stock, and if they do, a portion of the investment assets will be reallocated to be treated as class C assets.
The ruling does not state that the stock is held by an ESOP, but the shareholding is unusual. One shareholder holds all of the parent’s stock as the formal owner on behalf of the beneficial owners. Perhaps this is simply a means of insuring unauthorized transfers do not occur.
Rulings. The taxpayer represented that each class of stock was stock. The IRS ruled that the stock exchange will be an E reorganization, none of the stock is section 306 stock, the recap is not a section 305 income recognition event, and the repurchase of the T stock will not produce section 305 income to the C shareholders.
What is going on? A reason for the the recapitalization may be the price reduction, but it seems unlikely that was the principal reason.
The effect of the transaction will be to give the current shareholders complete beneficial ownership of the investment assets as they now exist. All stock issued in the future to employees will track only the remaining business assets. Moreover, existing shareholders who are offered the opportunity to buy more stock are encouraged to spend their T stock to do so, because it is exchangeable for C stock at FMV; moreover, only C stock pays dividends. The other shareholders, such as directors who likely are the actual principal owners, will keep their C and T stock and will tend to wind up with all of the T stock (although the T assets will be reduced pro rata for T shares spent for C shares).
The discretion reserved to the parent not to buy the T shares on a put likely was required to get the ruling, but could be meaningless as to the directors’ T shares. Presumably, the directors can have their T shares redeemed at FMV at will. When redeemed, it will be redeemed at FMV, which will include earnings on the investment assets that were not paid out as dividends, because no dividends will be paid on the T stock.
Therefore, it appears that the parent group is a cash-rich business whose primary owners want to freeze the cash for themselves, while continuing to issue to employees stock that will only track the business.
Tracking stock. Since 1999, the annual no-ruling revenue procedure has stated that the IRS will not rule on whether “the classification of an instrument that has certain voting and liquidation rights in an issuing corporation, but whose dividend rights are determined by reference to the earnings of a segregated portion of the issuing corporation’s assets, including assets held by a subsidiary.” Rev. Proc. 2010-3, sec. 3.01(a)(80).
For that reason, the taxpayer in the ruling had to represent that the tracking stock is stock. A few rulings had previously been issued with such representations, but not that many. The last time a letter ruling mentioned tracking stock was 2009. LTR 200906033 contained a representation that it was stock. It was a spinoff ruling, the tracking classes were not described in the ruling and the representation (the last of numerous reps) appears to have been added at the last minute when someone remembered that Distributing had tracking stock. Before that, LTR 200645015 ruled that a recap to distribute tracking stock to public shareholders was a reorganization, based on a representation that the stock was stock. LTR 200139009 approved a spinoff to create a market and permit offering of a new class of tracking stock; the taxpayer represented the stock was stock. Reg. section 1.355-6(e)(5) refers to tracking stock.
This combination of guidance and lack of guidance suggests that the Treasury has accommodated itself to the view that at least sometimes tracking stock can be equity, though it may be unwilling to say exactly what is required for that result.
Section 306 stock. Section 306 was designed to guard against a preferred stock bailout wherein a corporation would issue preferred with respect to common and the shareholders would sell the preferred at a capital gain, which would be taxed more favorably than dividends. The issue in the ruling is whether the Class T stock is preferred.
The IRS has ruled that if stock is restricted to a maximum amount of dividends or liquidation distribution, it is not common stock and so can be section 306 stock. Rev. Rul. 79-163, 1979-1 CB 131. The Class T stock in the ruling was not section 306 stock, because there is no cap on its liquidation rights, although they are limited to the proceeds of the investment assets. Evidently, the fact that Class T stock would receive no dividends at all was not viewed as capped dividends.
How could the section 305 have applied to the recap? Possibly in three ways, two based on the possibility that the Class T stock is preferred stock and on on the possibility that the Class C stock is preferred. The definition of preferred stock is not the same for 306 as for 305 purposes. Section 305(b)(3) might apply. It describes a stock distribution of preferred to some shareholders and common to others. That does not occur in form, but the regulation shows that it can occur in substance if the distributed preferred is convertible and conversion is likely to occur within a short period. Reg. 1.305-4(b) Ex. 2.
The Class T stock also might be viewed as convertible preferred—to which section 305(b)(5) would apply. The convertible question, perhaps, is presented by the fact that the Class T stock can be used to buy new Class C stock.
Reg. section 1.305-5(a) defines preferred as preferred and not participating in growth. Evidently, the ruling concluded that the tracking stock participates in growth, even though only the growth of certain assets. Also, evidently, it concluded that the Class C stock was not preferred stock by virtue of having a redemption price based on book value. If it were preferred stock, the distribution of the Class T stock with respect to it would be taxable under section 305(b)(4).
By ruling that a repurchase of the Class T stock would not be subject to section 305, the ruling must be referring to an exchange of Class T for new Class C stock. Having found none of the stock is preferred, the exchange could possibly be a section 305 stock distribution only if somehow the exchange were to increase the proportionate interest of the class that got the stock distribution—the T Class—while the C class got cash, or that there was a deemed interest increase for the C class while the T class got cash. But the T class can’t get cash because it does not receive dividends and the T class has to give up T interests to get the C interests.
Takeaway. Tracking stock might be either section 305 or section 306 stock; at least this taxpayer thought it was worth asking. The peculiar conversion feature of the potential preferred tracking stock made it even more uncertain. This illustrates, again, that concern about sections 305 and 306 cannot be limited to stock labeled preferred.
