Rev. Rul. 82-72

ISSUES

(1) When a corporation redeems preferred stock that is section 306 stock and section 303 of the Internal Revenue Code applies to the redemption, does the corporation charge the entire redemption price to earnings and profits under section 312(a) or must it charge part of the redemption price to its capital account under section 312(e)?

(2) If section 312(e) applies, what is the proper charge to earnings and profits for a redemption of section 306 stock?

FACTS

X was capitalized upon its incorporation, after March 1, 1913, solely with no-par value common stock. In 1978 X issued two shares of newly authorized $100 par value non-voting cumulative preferred stock as a nontaxable stock dividend, under section 305 of the Code, on each share of outstanding common stock. The preferred stock issued was section 306 stock as defined in section 306(c).

Some of the preferred shares (section 306 stock) were redeemed in 1981 from the estate of a deceased shareholder in a transaction qualifying under section 303 of the Code for capital gain treatment.

The preferred stock has preference over the common as to dividends. Once the preference has been met, the preferred stock does not participate with the common stock on further distributions.

LAW AND ANALYSIS

Section 306(a)(2) of the Code provides that distributions in redemption of section 306 stock shall be treated as distributions of property under section 301.

Section 303(a) of the Code provides that distributions in redemption of stock held by the estate of a decedent shall be treated as a distribution in full payment in exchange for the stock so redeemed, to the extent that the amount of the distribution does not exceed death taxes owed by the estate and the amount of certain funeral and administrative expenses.

Section 1.303-2(d) of the Income Tax Regulations provides that a distribution in redemption of stock can qualify under section 303, even if the stock redeemed is section 306 stock.

Section 316(a) of the Code provides that, except as otherwise provided in subtitle A, every distribution made by a corporation is made out of earnings and profits to the extent thereof.

Section 312(a) of the Code provides that, on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation are decreased by the sum of (1) the amount of money, (2) the principal amount of the obligations of the corporation, and (3) the adjusted basis of other property so distributed. However, as an exception to the general rule of sections 316(a) and 312(a), section 312(e) provides that the part of the distribution in a redemption to which section 303 applies that is properly chargeable to capital account is not treated as a distribution of earnings and profits.

Even though the distribution would have been treated by the shareholder as a distribution of property under section 306(a)(2) of the Code but for the provisions of section 303 that permit the treatment of the redemption distribution by the shareholders as an exchange, section 312(e) is applicable. Section 303 changes the income tax treatment of the redemption from a distribution of property (section 306(a)(2)) to an exchange (section 303), not only at the shareholder level but also at the corporate level.

Section 1.303-2(d) of the regulations states that a redemption of section 306 stock can qualify for treatment under section 303, and section 312(e) contains no exception for its application to a section 303 redemption involving section 306 stock. Furthermore, the requirement of section 312(e) that the redeeming corporation charge part of the redemption distribution to its capital account parallels the exchange treatment of the distribution under section 303 that results in the redeemed shareholder treating the redemption distribution as a return of capital to the extent of the shareholder's adjusted basis in the redeemed stock.

Therefore, pursuant to section 312(e) of the Code, the reduction of X's earnings and profits because of the redemption distribution does not include the amount of the distribution that is properly chargeable to capital account.

Neither the Code nor the regulations define the term "capital account" nor do they indicate how to determine the amount "properly chargeable" thereto. However, Rev. Rul. 79-376, 1979-2 C.B. 133, consistent with several court decisions that disagreed with a previously published position of the Internal Revenue Service (Rev. Rul. 70-531, 1970-2 C.B. 76), construes the term "capital account" as representing only the amount paid in to the corporation for the common stock redeemed. Rev. Rul. 79-376 holds that the correct method for determining the proper charge to the capital account of a corporation, incorporated after March 1, 1913, under section 312(e) of the Code is the method in which the ratio between the charge to capital and the capital before retirement is the same as the ratio between the number of shares retired and the number of shares outstanding before retirement. The resulting charge to the corporation's earnings and profits is the balance of the redemption distribution. These principles are equally applicable to redemptions of preferred stock.

In the present case, the X preferred stock was distributed as a stock dividend and, therefore, was not issued for paid-in capital. Under these circumstances it is appropriate to allocate part of X's capital account attributable to its common stock to the preferred stock. The correct method for doing this is to allocate X's capital account attributable to its common stock on the date the preferred stock was issued between the common stock and preferred stock in proportion to the fair market value of each on the date of distribution. Compare section 307 of the Code and the regulations thereunder, which provide a similar allocation rule for determining a shareholder's basis of a nontaxable stock dividend under section 305; that is, part of the basis of the stock on which the stock dividend was issued is allocated to the dividend stock in proportion to the fair market values of the stocks on the date of distribution.

HOLDINGS

(1) The charge to earnings and profits computed under section 312(a) of the Code on the redemption of section 306 stock is subject to the limitation of section 312(e). Therefore, a portion of the redemption price must be allocated to X's capital account.

(2) X's capital account should be proportionately allocated between its common stock and preferred stock, and the amount of the redemption payment that exceeds the capital attributable to the preferred stock should be charged to earnings and profits.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 74-266, 1974-1 C.B. 73, holds that on a redemption at a premium of nonparticipating preferred stock issued for cash at par only the amount of the distribution corresponding to the dividend arrearages is chargeable to earnings and profits. The amount of the distribution in excess of those dividends plus the expenses of redemption are properly chargeable to capital account.

Rev. Rul. 74-266 is modified to hold that the amount paid into the corporation (par value) is chargeable to capital account and the dividend arrearages, redemption premium, and redemption expenses are chargeable to earnings and profits.

Rev. Rul. 74-266 is modified.