Section 306 Stock

The rules making up and incorporated into Section 306 of the Code are intended to prevent capital gain “bailouts” of the earnings and profits of the corporation. The first step in classic capital gain bailout is the issuance of a tax-free stock dividend. Stock dividends are typically tax-free under Section 305 of the Code. The second step involves the sale of the shares to a third party with the understanding that the corporation will soon redeem the shares at the same price or slightly more. Typically, nonvoting, preferred stock with a fixed redemption price is used as the shares issued to the shareholders. The shareholder recognizes capital gain on the transaction. The final step involves the corporation redeeming the shares from the third party. The result is that the shareholder receives distributions from the corporation at capital gains rates rather than ordinary income tax rates.

Section 306 prevents this type of capital gain “bailout” by providing that the gain from the sale of such stock issued as a dividend shall be “ordinary” income to the seller rather than “capital” gain. Thus, such stock has been said to have a “Section 306 taint.”

There are several exceptions to Section 306, the most significant of which is the common stock exception. Such exception states that a common stock dividend issued with respect to common stock shall not have a Section 306 taint.