Historically, taxpayers could receive preferred stock in a § 351 exchange without recognizing gain. Preferred stock looks a lot like debt – it has a fixed dividend, often a redemption feature, and may not participate in corporate growth. So taxpayers could use preferred stock to effectively “cash out” part of their investment without immediate tax.
Congress addressed this in the Taxpayer Relief Act of 1997 by creating “nonqualified preferred stock.” Under § 351(g), nonqualified preferred stock is treated as boot – taxable to the extent of gain – even though it’s still treated as stock for other purposes (like the 80% control test).
What makes preferred stock “nonqualified”? Four characteristics:
- The holder can require the issuer to redeem the stock within 20 years.
- The issuer is required to redeem the stock within 20 years.
- The issuer has a right to redeem the stock that is likely to be exercised.
- The dividend rate varies by reference to an index.
So if you receive preferred stock that is redeemable in less than 20 years or has a variable dividend, you’ll have to recognize gain up to the value of that stock. This makes planning more complicated – you can’t just use preferred stock to bail out earnings tax‑free.
The regulations are still developing, but the basic rule is clear: nonqualified preferred stock is bad news if you want a tax‑free exchange.This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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