IRS Guidance: Equity Interests are Nonqualified Preferred Stock if They Do Not Contribute to Growth

The IRS issued a ruling earlier this month stating that, under Section 351(g)(2)(a), a corporation’s preferred stock properly met the criteria as nonqualified preferred – or as property other than stock – because it did not contribute to corporate growth. The IRS said that even though the stockholders could have participated in corporate earnings, there was little likelihood the stock had or would ever contribute to growth. This meant that there was no “meaningful likelihood that dividends beyond any limitation or preference” would have been paid, the IRS said, adding that and the possibility of payments would be disregarded when determining whether a stock was limited and preferred.

Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or person are in control (as defined in Section 368(c)) of the corporation. Section 351(g)(1) provides that tax free treatment does not apply in the case of a person who transfers property to a corporation and receives nonqualified preferred stock.

The guidance provided here by the IRS represents a trap for the unwary, and highlights the importance for business owners and management involved in structuring affiliated legal entities for business purposes to consult professional tax advice.

For more information, please contact Caroprese & Company.

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