Current Treasury Regulations

Under existing regulations, an unreasonable redemption premium for preferred stock is treated as a dividend distribution on preferred stock, and as such, is taxable under IRC Sees. 301 through 305(c). Current regulations |Treas. Regs. Sec. 1. 305-5(b) (2) state that a premium not exceeding 10% of the issue price of the stock which is not redeemable within five years shall be considered reasonable. There is no bright-line-test as found in the OID de minimus rule of IRC Sec. 1273. The inclusion into income is accomplished by ratably including the entire amount of the premium, using the straight-line method, over the time period during which the stock cannot be called.

Example 1. Corporation X issues preferred stock for $60 that has stated redemption price of $80 at the end of five years. Since the premium, $20, is in excess of the guideline (10% x $60 = $6) for a five-year redemption period, the shareholder includes a portion of the premium in income. The amount of the $20 premium included each year determined on a straight-line basis is $4. However, if the stock was callable for its entire term, none of the premium (unreasonable or not) is included in income.

Post October 10, 1990

In many ways, preferred stock is similar to debt. Creditors and preferred stockholders are favored over common stockholders as to distributions and liquidations. However, neither creditors nor preferred stockholders vote nor do they participate in general earnings increases. Preferred stock may also have a fixed redemption date and a fixed redemption price per share, which increases the similarity to debt.

In recognition of these likenesses, the RRA made the treatment of redemptions of OID debt and preferred stock more similar. In general, the OID rules of IRC Secs. 1272 and 1273 apply if the preferred stock is subject to a mandatory redemption or is puttable at a premium, regardless of whether the stock is callable. (A "put" obligates the seller of the "put" to acquire the stock and pay the price specified in the "put contract.") If the stock is not subject to a mandatory redemption and is not puttable, the OID de minimus rule does not apply if the stock is subject to call only at the option of the issuer. When the OID de minimus rule of IRC Sec. 1273 (a) (3) is used to determine if a redemption premium is unreasonable, compute the test amount by multiplying .25% by the redemption price at maturity then by the number of complete years to maturity.

Example 2. Corporation X issues preferred stock for $60 that has a stated redemption price of $80 and is mandatorily redeemable at the end of live years. Since the stock is subject to mandatory redemption and has a premium in excess of the IRC Sec. 1273(a) (3) amount, $1.00, the $20 premium must be accrued over the five year term. The de minimus amount is calculated: .25% x $80 x 5 years = $1.00.

When the OID de minimus rule of IRC Sec. 1273 does not apply, the stock is subject to the more lenient guidelines of the current regulations. A redemption premium failing this more lenient test is subject to the economic accrual rules of IRC Sec. 1272. The entire call premium must be accrued over the period of time that the preferred stock cannot be called.

Example 3. Corporation X issues preferred stock for $60 that has no fixed redemption date, but is callable after five years at the option of the issuer at a price of $80. The existence of excessive premium is determined by the more lenient existing guidelines rather than IRC Sec. 1273 (a) (3). Since the premium ($20) exceeds the ten percent of issue price guideline ($6), the economic accrual rules of IRC Sec. 1272 apply. The accrual term will be the five year non-call period.

As in the current regulations, the amount of the premium taken into income by the shareholder is added to the basis of the stock so that upon sale of the stock the premium is not taxed again. The unreasonable premium is treated as a distribution to the preferred stockholders and subject to the rules of IRC Sec. 301. These amounts would be taxable as ordinary dividend income to the extent of earnings and profits of the corporation.

Example 4. Corporation X issues preferred stock for $100 per share. The stock is mandatorily redeemable in five years for $110. The test amount under IRC Sec. 1273 (a) (3) is $1.38 (.25% x $110 x 5 years = $1.38) and the redemption premium is $10. Therefore, economic accrual rules of IRC Sec. 1272 apply.

The accompanying table presents such an accrual. The amounts in the Income from Premium column are derived by using the yield to maturity interest rate based on the redemption price of $110, issue price of $100, and a nonredeemable period of five years. I used semi-annual periods since the OID rules use this convention. The new regulations may or may not adopt this OID convention since bonds normally pay interest semi-annually but stocks pay dividends quarterly. Notice that the total of the semi-annual amounts taken into income by the shareholder is ten dollars--the premium amount. These calculated redemption amounts are subject to IRC Sec. 305(c) and taxable under the normal dividend rules found in IRC Sec. 301. Assuming adequate corporate earnings and profits, the amounts would be dividend income.

At the end of the fifth year when the stock is redeemed for $110, there are no tax consequences to the stockholder since the taxpayer is simply receiving return of capital. If the stock is sold at the end of year three when the basis of the stock is $105.90, the shareholder computes gain or loss using this adjusted basis. If the stock is sold for $108, the shareholder would have a $2.10 capital gain ($108 - $105.90) and would have included $2.00 in gross income for year three per IRC Sec. 301.

Deemed Premiums

The RRA states that "... the Secretary may determine what constitutes a redemption premium (or a disguised redemption premium)." The example given in the house bill is the issuance of cumulative preferred stock with no intention for the payment of dividends. The bill allows the IRS to treat the unpaid dividends as a disguised redemption premium. This paragraph also allows the Secretary to treat stock that is in form "...merely callable, as being subject to mandatory redemption or a put if the existence of other arrangements effectively require the issuer to redeem the stock."

No mention is made of how the Secretary will determine the intent of the company to pay dividends on the preferred stock in question. One way to determine intent would be a "lookback" period for dividend payments. If no payments are made, then the shareholder would have to include a catch-up amount in income. However, in deciding executive compensation, the court in Elliotts |716 F.2d 1241 (9th Cir. 1983) refused to use the automatic dividend rule put forth in McCandless Tile Service |422 F.2d 1336 (Ct. Cls. 1970). This lack of intent to pay dividends is probably of most concern to closely held corporations. A corporation that issues preferred stock and then does not pay dividends would be wise to document situations which prevented the payments. Unexpected cash flow problems and debt called by a creditor which used up cash reserves may help show that there was an intent to pay dividends, but no cash. The bill also fails to identify what "other arrangements" could cause the Secretary to declare the preferred stock as "in substance" being subject to mandatory redemption. One can speculate that an extremely favorable conversion privilege which is available to the stockholder after a waiting period of, for example, five years might be considered as establishing a mandatory redemption date. This date would then fix the period over which the in substance premium would be accrued.

Dispositions of IRC Sec. 306 Stock

It's possible that the preferred stock to be redeemed could be tainted IRC Sec. 306 stock. In that case, when the preferred stock is redeemed for cash or property the entire amount realized is subject to the rules of IRC Sec. 301. The current regulations make no reference to interaction of IRC Secs. 305 and 306. Therefore, I assume unless the redemption meets one of the Sec. 306(b) exceptions for redemptions, IRC Sec. 306(a) will take precedence causing the entire redemption amount to be ordinary income to the extent of earnings and profits.

Regulators, Where Are You?

Since the redemption of preferred stock with a large redemption premium resembled OID debt, Congress decided to apply the economic accrual rules of IRC Sec. 1272, rather than straight-line method, to the excessive redemption premium. The determination of whether to apply the rules of IRC Sec. 1272 is made by evaluating the call provisions of the stock and by applying IRC Sec. 1273(a) (3). IRC Sec. 305(c) provides the basic guidance with regulations to follow in the future. The regulations will provide guidance on disguised redemptions and other arrangements that might cause preferred stock to be considered mandatorily redeemable. These guidelines may be the most important part of the new regulations.

ACCRUALOFINCOMEFROMREDEMPTIONPREMIUM

IncomefromPremium

(YieldtoMaturity:

YearPeriods.96%)(*)Basis

------$100.00

11$.96100.96

2.97101.93

23.98102.91

4.99103.90

351.00104.90

61.00105.90

471.01106.91

81.02107.93

591.03108.96

101.04110.00

$10.00

Leonard G. Weld, Assistant Professor Auburn University