Understanding and determining stock ownership is critical in the corporate tax system. However, merely identifying the legal owner of corporate shares is often not enough. Two examples of that surround the exclusion of section 1504(a)(4) stock from stock ownership determinations. Both sections 1504(a) and 382 exclude section 1504(a)(4) stock in determining the ownership of stock for their respective sections; thereby providing planning opportunities as well as traps for the unwary.
Plain vanilla preferred stock
In order to qualify as an affiliated group eligible to file a consolidated tax return as well as liquidate tax-free under sections 332 and 337, the parent of an affiliated group must own 80 percent of the vote and value of a subsidiary.1 However, plain vanilla preferred stock as defined in section 1504(a)(4) is excluded.2 Similarly in determining ownership of a corporation under section 382, which operates to limit the use of net operating losses following an ownership change, this same plain vanilla preferred stock is excluded.3 Section 1504(a)(4) vanilla preferred stock must meet four requirements:
- It is non-voting
- It is limited and preferred to dividends and its holders do not significantly participate in corporate growth
- It has a redemption and liquidation rights that do not exceed the issue price, except for a reasonable premium
- It is not convertible to other classes of stock
It is in the third requirement where there is often uncertainty. What represents a reasonable redemption premium is not defined in the code or regulations. Previously, the IRS accepted premiums consistent with the safe-harbors in Reg. section 1.305-5(b)(2).4 Unfortunately, these safe-harbors have since been removed. Many preferred stock instruments include an annual dividend that if not declared or paid, increases the amount due upon redemption of the stock. Questions arise as to whether this could result in an unreasonable redemption premium. The answer would appear no, and in a 2011 chief counsel advice the IRS concurred ruling that dividends in arrears on preferred stock are not generally considered redemption premium.5 Additional uncertainty surrounds redemption premiums that change over time. In a recent private letter ruling the IRS looked to this issue.6 While the fluctuation in redemption premium was not stated in the ruling, the IRS held the premium was not unreasonable based upon the specific facts and circumstances. Consider the following example with similar facts:
Company XYZ issues preferred stock with the following redemption values: 120 percent of issue price within 12 months, 112 percent of issue price between months 12 and 24, 105 percent of issue price between months 24 and 36, and no premium thereafter. The premium is contingent upon an early redemption and non-existent after three years.
Would a 20 percent redemption premium represent a reasonable redemption? Assuming the company represents that it does not expect to redeem the preferred shares prior to three years from issuance, would this represent a reasonable redemption premium? If we assume likelihood of redemption is remote, then the premium would seem reasonable and only serving to guarantee a return to the investor much like an early redemption premium on a debt instrument; however, the answer is not clear.
The consequences of being on the wrong side of section 1504(a)(4) include the inability to consolidate for federal purposes, taxability of an otherwise tax-free liquidation and the inadvertent limitation of tax attributes; all of which can lead to administrative headaches and unwanted tax bills. With the lack of authoritative certainty and negative consequences, what is clear is that proper planning is essential when contemplating the issuance of preferred stock. Contact your tax advisor for more information.
This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. RSM LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person.
1 Section 1504(a)(2)
2 Section 1504(a)(4)
3 Section 382(k)(6)(A)
4 PLR 8753005 (Dec. 31, 1987)
5 CCA 201152016 (Dec. 30, 2011)
6 PLR 201505006 (Jan. 30, 2015)