SCOTUS Reports

Tag: Section 306 Stock

  • Pescosolido v. Commissioner, 91 T.C. 52 (1988): When Charitable Contributions of Section 306 Stock Are Limited to Cost Basis

    Pescosolido v. Commissioner, 91 T. C. 52 (1988)

    Charitable contributions of section 306 stock are limited to the donor’s cost basis if not proven to be free from a tax avoidance plan.

    Summary

    Carl Pescosolido, Sr. , donated section 306 stock to Harvard and Deerfield Academy, claiming a fair market value deduction. The IRS challenged this, arguing the stock’s disposition was part of a tax avoidance plan. The Tax Court ruled against Pescosolido, limiting the deduction to cost basis due to his inability to disprove tax avoidance intent, given his control over the corporation and the tax benefits of the contributions. This decision emphasizes the scrutiny applied to controlling shareholders’ dispositions of section 306 stock and the burden of proving non-tax-avoidance motives.

    Facts

    Carl A. Pescosolido, Sr. , a successful businessman, consolidated his oil companies into Lido Corp. of New England, Inc. , in a tax-free reorganization. He received voting and nonvoting preferred stock, classified as section 306 stock. Pescosolido, a graduate of Deerfield Academy and Harvard College, donated this stock to both institutions in 1978 and 1979. He claimed charitable deductions based on the stock’s fair market value. The IRS challenged these deductions, arguing that the stock’s disposition was part of a tax avoidance plan due to Pescosolido’s control over Lido and the tax benefits of the contributions.

    Procedural History

    Pescosolido and his wife filed a petition in the U. S. Tax Court after the IRS issued a notice of deficiency disallowing their charitable contribution deductions. The IRS later conceded that the deductions should be allowed at cost basis rather than disallowed entirely. The Tax Court heard the case and ruled on July 18, 1988, as amended on July 26, 1988.

    Issue(s)

    1. Whether Pescosolido’s charitable contributions of section 306 stock to Harvard and Deerfield Academy should be deductible at fair market value or limited to his cost basis under section 170(e)(1)(A).

    Holding

    1. No, because Pescosolido failed to establish that the disposition of the stock was not part of a plan having as one of its principal purposes the avoidance of federal income tax, as required by section 306(b)(4). Therefore, his charitable contribution deductions are limited to the cost basis of the stock under section 170(e)(1)(A).

    Court’s Reasoning

    The court applied section 306, designed to prevent shareholders from extracting corporate earnings as capital gains, and section 170(e)(1)(A), which limits deductions for contributions of section 306 stock to cost basis unless the disposition is not part of a tax avoidance plan. Pescosolido, as a controlling shareholder, bore a heavy burden to prove no tax avoidance intent. The court was not persuaded by his evidence of charitable intent alone, especially given his control over Lido and the substantial tax benefits of the stock’s disposition. The court inferred tax avoidance from the unity of purpose between Pescosolido and Lido and the potential for tax savings. It also noted Pescosolido’s awareness of the stock’s tax status, as evidenced by his tax return filings and the IRS ruling he received during the reorganization.

    Practical Implications

    This decision impacts how contributions of section 306 stock by controlling shareholders are treated for tax purposes. It emphasizes the need for clear evidence negating tax avoidance motives when such shareholders donate section 306 stock. Practitioners should advise clients to document non-tax motives for stock dispositions thoroughly. The ruling may deter controlling shareholders from using section 306 stock for charitable contributions due to the limited deduction to cost basis. Subsequent cases, like Bialo v. Commissioner, have continued to apply this principle, reinforcing the scrutiny applied to dispositions of section 306 stock by those in control of the issuing corporation.

  • Bialo v. Commissioner, 88 T.C. 1132 (1987): Limitations on Charitable Deductions for Section 306 Stock

    Bialo v. Commissioner, 88 T. C. 1132, 1987 U. S. Tax Ct. LEXIS 63, 88 T. C. No. 63 (1987)

    Charitable contribution deductions for section 306 stock are subject to limitations when one of the principal purposes of the stock distribution and redemption is tax avoidance.

    Summary

    Walter Bialo, the majority shareholder of Universal Luggage Co. , Inc. , received a pro rata dividend of preferred stock, which he donated to a charitable trust. The stock was later redeemed by Universal. The IRS challenged the $100,000 charitable deduction Bialo claimed, arguing it was section 306 stock and thus subject to limitations under section 170(e)(1)(A). The Tax Court held that the transaction was part of a plan to avoid federal income tax, thus the deduction was limited. The decision underscores the scrutiny applied to transactions involving section 306 stock and the burden on taxpayers to prove non-tax avoidance motives.

    Facts

    Walter Bialo, president of Universal Luggage Co. , Inc. , owned 86% of its common stock. In February 1978, his accountant advised on the tax benefits of contributing appreciated stock to a charity. On August 18, 1978, Universal declared a pro rata dividend of 2,500 shares of preferred stock, which Bialo received proportionately. On August 30, 1978, Bialo contributed 1,000 shares to the New York Community Trust, valued at $89,000. The trust received dividends from Universal before selling the stock back to the corporation for $68,000 on October 26, 1979. Bialo claimed a $100,000 charitable deduction for the donation.

    Procedural History

    The IRS disallowed Bialo’s charitable deduction, asserting it was section 306 stock and subject to limitations. Bialo petitioned the U. S. Tax Court for a review of the deficiency determination. The Tax Court heard the case and issued its opinion on April 30, 1987, finding in favor of the Commissioner.

    Issue(s)

    1. Whether the preferred stock distributed to Bialo and subsequently contributed to the New York Community Trust constitutes section 306 stock under section 306(c)(1)(A)?
    2. Whether the distribution and redemption of the preferred stock was part of a plan having as one of its principal purposes the avoidance of federal income tax, thus not qualifying for the exception under section 306(b)(4)?
    3. Whether Bialo’s charitable contribution deduction for the stock should be limited under section 170(e)(1)(A)?

    Holding

    1. Yes, because the preferred stock was distributed to Bialo without recognition of gain under section 305(a) and met the definition of section 306 stock.
    2. No, because Bialo failed to prove that tax avoidance was not one of the principal purposes of the transaction, thus not qualifying for the section 306(b)(4) exception.
    3. Yes, because the transaction involved section 306 stock and was part of a tax avoidance plan, the charitable contribution deduction must be reduced under section 170(e)(1)(A).

    Court’s Reasoning

    The court found that the preferred stock was section 306 stock as defined by section 306(c)(1)(A) since it was distributed without recognition of gain and Bialo did not dispose of the underlying common stock. The court rejected Bialo’s argument that the distribution and redemption were not part of a tax avoidance plan, noting that Bialo had the burden of proof to show otherwise. The court cited legislative history and regulations indicating that section 306(b)(4) was intended for isolated dispositions by minority shareholders, not for transactions like Bialo’s where control was maintained. The court also referenced case law such as Roebling v. Commissioner and Fireoved v. United States to support its finding that Bialo’s transaction had tax avoidance as a principal purpose. The court emphasized that the tax benefits illustrated in the pre-transaction memorandum outweighed Bialo’s post-hoc rationalizations for the use of preferred stock.

    Practical Implications

    This decision highlights the strict scrutiny applied to transactions involving section 306 stock and the high burden on taxpayers to demonstrate non-tax avoidance motives. Practitioners must advise clients carefully when planning charitable contributions of section 306 stock, ensuring that any non-tax avoidance purpose is well-documented and substantiated. The case also illustrates the limitations on charitable deductions for section 306 stock and the need for clear evidence of non-tax motives to avoid these limitations. Subsequent cases and IRS guidance have continued to reference Bialo in analyzing the tax implications of similar transactions. Practitioners should be aware of these implications when structuring charitable contributions to avoid unexpected tax consequences.

  • Roebling v. Commissioner, 77 T.C. 30 (1981): Dividend Equivalence and Section 306 Stock in Corporate Recapitalization

    Roebling v. Commissioner, 77 T.C. 30 (1981)

    A stock redemption is not essentially equivalent to a dividend when it is part of a firm and fixed plan to reduce a shareholder’s interest in a corporation, resulting in a meaningful reduction of their proportionate ownership and rights, and when capitalized dividend arrearages in a recapitalization can constitute section 306 stock, taxable as ordinary income upon redemption or sale unless proven that tax avoidance was not a principal purpose.

    Summary

    In Roebling v. Commissioner, the Tax Court addressed whether the redemption of preferred stock was essentially equivalent to a dividend and the tax treatment of capitalized dividend arrearages. Mary Roebling, chairman of Trenton Trust, received proceeds from the redemption of her preferred stock and treated them as capital gains. The IRS argued the redemptions were essentially equivalent to dividends, taxable as ordinary income, and alternatively, that a portion was section 306 stock. The Tax Court held that the redemptions were not essentially equivalent to a dividend due to a firm plan to redeem all preferred stock, resulting in a meaningful reduction of Roebling’s corporate interest, thus qualifying for capital gains treatment. However, the portion of the stock representing capitalized dividend arrearages was deemed section 306 stock and taxable as ordinary income because Roebling failed to prove that the recapitalization plan lacked a principal purpose of tax avoidance.

    Facts

    Trenton Trust Co. underwent a recapitalization in 1958 to simplify its capital structure and improve its financial position. Prior to 1958, it had preferred stock A, preferred stock B, and common stock outstanding. Preferred stock B had accumulated dividend arrearages. The recapitalization plan included: retiring preferred stock A, splitting preferred stock B 2-for-1 and capitalizing dividend arrearages, and issuing new common stock. The amended certificate of incorporation provided for cumulative dividends on preferred stock B, priority in liquidation, voting rights, and a mandatory annual redemption of $112,000 of preferred stock B. Mary Roebling, a major shareholder and chairman of the board, had inherited a large portion of preferred stock B from her husband. From 1965-1969, Trenton Trust redeemed some of Roebling’s preferred stock B pursuant to the plan.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Roebling’s income tax for 1965-1969, arguing that the preferred stock redemptions were essentially equivalent to dividends and/or constituted section 306 stock. Roebling petitioned the Tax Court, contesting these determinations.

    Issue(s)

    1. Whether the redemption of Trenton Trust’s preferred stock B from Roebling was “not essentially equivalent to a dividend” under Section 302(b)(1) of the Internal Revenue Code.
    2. Whether the portion of preferred stock B representing capitalized dividend arrearages constituted section 306 stock, and if so, whether its redemption or sale was exempt from ordinary income treatment under section 306(b)(4) because it was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax.

    Holding

    1. No, the redemptions were not essentially equivalent to a dividend because they were part of a firm and fixed plan to redeem all preferred stock, resulting in a meaningful reduction of Roebling’s proportionate interest in Trenton Trust.
    2. Yes, the portion of preferred stock B representing capitalized dividend arrearages was section 306 stock, and no, Roebling failed to prove that the recapitalization plan did not have a principal purpose of federal income tax avoidance; therefore, the proceeds attributable to the capitalized arrearages are taxable as ordinary income.

    Court’s Reasoning

    Regarding dividend equivalence, the court applied the standard from United States v. Davis, requiring a “meaningful reduction of the shareholder’s proportionate interest.” The court found a “firm and fixed plan” to redeem all preferred stock, evidenced by the recapitalization plan, the sinking fund, and consistent annual redemptions. The court emphasized that while business purpose is irrelevant to dividend equivalence, the existence of a plan is relevant. The redemptions, viewed as steps in this plan, resulted in a meaningful reduction of Roebling’s voting rights and her rights to share in earnings and assets upon liquidation. Although Roebling remained a significant shareholder, her percentage of voting stock decreased from a majority to a minority position over time due to the redemptions. The court distinguished this case from closely held family corporation cases, noting Trenton Trust’s public nature and regulatory oversight. The court stated, “We conclude that the redemptions of petitioner’s preferred stock during the years before us were ‘not essentially equivalent to a dividend’ within the meaning of section 302(1)(b), and the amounts received therefrom are taxable as capital gains.”

    On section 306 stock, the court found that the portion of preferred stock B representing capitalized dividend arrearages ($6 per share) was indeed section 306 stock. Roebling argued for the exception in section 306(b)(4), requiring proof that the plan did not have a principal purpose of tax avoidance. The court held Roebling failed to meet this “heavy burden of proof.” While there was no evidence of tax avoidance as the principal purpose, neither was there evidence proving the absence of such a purpose. The court noted the objective tax benefit of converting ordinary income (dividend arrearages) into capital gain through recapitalization and subsequent redemption. Therefore, the portion of redemption proceeds attributable to capitalized arrearages was taxable as ordinary income.

    Practical Implications

    Roebling v. Commissioner provides guidance on applying the “not essentially equivalent to a dividend” test in the context of ongoing stock redemption plans, particularly for publicly held companies under regulatory oversight. It highlights that a series of redemptions, if part of a firm and fixed plan to reduce shareholder interest, can qualify for capital gains treatment under section 302(b)(1), even for a major shareholder. The case also serves as a reminder of the stringent requirements to avoid section 306 ordinary income treatment when dealing with recapitalizations involving dividend arrearages. Taxpayers must demonstrate convincingly that tax avoidance was not a principal purpose of the recapitalization plan to qualify for the exception under section 306(b)(4). This case underscores the importance of documenting the business purposes behind corporate restructuring and redemption plans, especially when section 306 stock is involved.