Q—Recapitalization and Section 306 Stock

A preferred stock recapitalization can offer an effective and versatile estate planning technique for corporate stockholders who wish to make gifts to children or other heirs. 

In a recapitalization, preferred stock issued as a dividend on outstanding common stock is generally considered Section 306 stock, to the extent that the issuing corporation has undistributed “earnings and profits.” For this purpose, the term “earnings and profits” has a special meaning. Section 306 stock is said to be “tainted,” in that a subsequent sale of the stock will produce ordinary income, not capital gain.

Upon the subsequent sale of Section 306 stock, such ordinary income treatment can cause adverse tax consequences beyond the loss of favorable capital gains treatment. If the sale is a
capital transaction, the seller can subtract his or her basis in calculating any gain subject to taxation. If the sale is of Section 306 stock, the amount realized is first treated as a withdrawal
of earnings and profits and the seller could be taxed on the full amount received.

Even in a “true” recapitalization (i.e., an exchange of all of a stockholder’s stock for a different class of stock), the problem of tainted Section 306 stock cannot be avoided if, at the time of the recapitalization, other family members are, and continue to be, stockholders. The family attribution rules have been extended to apply to such “true” recapitalizations. However, this whole problem can be avoided if the stock is not sold until after the death of the stockholder. If the stock is then sold at a price representing the fair market value on the date of death (or on the optional valuation date), the “stepped-up basis” at death will eliminate any taxable gain.