The IRS and the Tax Court have each recently addressed whether stock cannot be considered preferred stock because it participates in corporate growth to a significant extent. The IRS addressed the issue in a legal memorandum (ILM 201236025), while the Tax Court tackled it in its decision in Gerdau Macsteel Inc. et al. v. Commissioner (139 T.C. 5).
Under Section 351(g)(3)(A), preferred stock generally must be limited and preferred as to dividend, but cannot "participate in corporate growth to any significant extent." Similarly, Treas. Reg. Sec. 1.305-5(a) states that preferred stock "does not participate in corporate growth to any significant extent." This phrase has not been defined, and no measure has been set forth by the internal revenue code or case law to determine a method for measuring such "significant participation."
In ILM 2012-36-025, the IRS Branch 1 chief concluded that voting, convertible preferred stock should be treated as common stock for purposes of testing for a substantially disproportionate redemption of stock under Section 302(b)(2).
Section 302 provides sale/exchange treatment for redemptions of stock that satisfy one of five criteria as provided under section 302(b); redemptions that do not fall within those criteria are treated as Section 301 distributions (and may be treated as dividends). Section 302(b)(2) provides that Section 302 treatment applies to substantially disproportionate redemptions that meet a mechanical test that looks at the reduction in ownership based upon both the voting stock of the corporation (whether preferred or common) and the common stock of the corporation (whether voting or nonvoting common stock).
The IRS Branch 1 chief concluded that the preferred stock should be treated as common stock, its labeling as "preferred" notwithstanding. The ILM notes that the stock was not preferred within the meaning of Sections 305(e)(5), 351(g)(3) or 1504(a)(4). There were not dividend limitations or preference, the stock received both a liquidation preference and then shared in the liquidation proceeds pari passu with the common stock, and the stock was voting stock. The ILM concluded this was tantamount to participating in corporate growth to a significant extent.
The Tax Court concluded differently in Gerdau Macsteel. The taxpayer in the case transferred medical plan benefits liabilities and cash to a subsidiary in a purported Section 351 transaction. The transfer was done to pursue a loss-generation strategy devised by a service provider in response to Rev. Rul. 95-74.
The court ruled that the stock the taxpayer acquired in the transfer was nonqualified preferred stock under Section 351(g)(3)(A) because the stock did not participate in corporation growth for the subsidiary to a significant extent. As a result, the transfer was not subject to nonrecognition treatment under Section 351(a). The court analyzed the terms of the preferred stock and ruled that the holders were not entitled to receive surplus or profits of the subsidiary because dividends were capped at $9.50 per share. In addition, upon redemption of the preferred stock, the shareholders would receive the higher of $125 per share or the amount calculated pursuant to a "formula value." The formula value was equal to 45% of the cumulative cost savings in relation to the management and disposition of the transferred medical plan benefits liabilities. Although the taxpayer argued that this formula value represented significant participation, the Tax Court concluded that the subsidiary's sole source of income was interest, and cost savings did not amount to participation in corporate growth.
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