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.