A dominant or controlling shareholder may, for valid business reasons (e.g., to improve the marketability of an investment), voluntarily surrender shares to the capital of a corporation, which raises questions of how the surrender impacts the other shareholders in the corporation. In PLR 202406002, the IRS ruled that a proposed voluntary surrender of shares to the capital of a corporation will not create deemed dividend income for the noncontributing shareholders and will not result in a taxable gift to the noncontributing shareholders.
The company, a publicly traded corporation, has three classes of common stock. The Class A common shares are widely held and publicly traded. The Class B common shares are super-voting shares but are otherwise identical to the Class A common shares. The Class B common shares are owned by an executive of the company and a series of trusts established by that executive. One of the trusts owns Class A common shares. The Class C common shares are all owned by a disregarded entity of the company (LLC) and, thus, are not considered outstanding for U.S. federal income tax purposes. Pursuant to the terms thereof, the Class C common shares must be exchanged for Class A common shares on a share-for-share basis if transferred to any person other than the LLC.
In the proposed transaction, the executive and the trusts will contribute a proportionate amount of Class A and/or Class B common shares to the company for no consideration. The contribution of the shares may occur in one or more installments. The company has in place a share repurchase program, but neither the executive nor the trusts have participated in the program. The share repurchase program and the proposed contribution each have separate independent business purposes.
Citing Commissioner v. Fink, 483 U.S. 89 (1987), the Service ruled in PLR 202406002 that the executive and the trusts will not recognize gain or loss as a result of the contribution and that the basis in the shares contributed will be preserved in the basis of the executive’s and the trusts’ respective retained shares. In addition, the Service ruled that the contribution will be a contribution to the capital of the company and, therefore, will not be taxable to the company under Internal Revenue Code (IRC) Section 118(a).
Notably, the Service also indicated that the noncontributing shareholders will not recognize income as a result of the contribution and specifically provided that the contribution will not be treated as a distribution of property to the noncontributing shareholders. The ruling is subject to many key representations, including that (i) there is no belief that any purchase pursuant to the share repurchase program will be taxed as a dividend to the participating shareholder or is a dividend within the meaning of IRC Sections 301 and 302; (ii) the contribution is an isolated transaction; and (iii) the contribution is not part of a plan to periodically increase the proportionate share of any shareholder in the assets or earnings and profits of the company. Nevertheless, the contribution will have the economic effect of increasing the noncontributing shareholders’ proportionate interest in the assets and earnings and profits of the company.
IRC Section 305(c) provides a broad rule that creates a deemed distribution of stock in certain transactions involving a corporation and its shareholder(s) (e.g., recapitalizations), which may be taxable under the general distribution rules of Section 301. By ruling that the contribution will not result in a deemed distribution to the noncontributing shareholders (likely because no deemed dividend results when a recapitalization is not undertaken pursuant to a plan to increase a shareholder’s proportionate interest in the assets or earnings and profits of the corporation), the IRS eliminated any potential taxation of the economic benefit conferred on the noncontributing shareholders under Section 305 or Section 301.
The Service also ruled that gift tax will not apply to the increase in value bestowed on the noncontributing shareholders by the executive and the trusts as a result of the contribution, because the contribution is a transaction occurring in the ordinary course of business (i.e., it is undertaken for bona fide business reasons, it is an arm’s length transaction, and the executive and the trusts lack donative intent). The Service also recognized that the executive and the trusts are conferring an economic benefit on each other and between each of the trusts. However, the Service ruled that these are effectively value-for-value exchanges and, therefore, will not be subject to gift tax.
PLR 202406002 closes the loop started by Commissioner v. Fink and provides sensible answers that avoid adding unintended tax consequences and complexity to a transaction that is usually undertaken for independent, nontax business reasons. In Fink, the Supreme Court denied a loss to a corporation’s dominant shareholder following the shareholder’s voluntary surrender of shares to the corporation, viewing the surrender as a contribution to capital. Instead, the Court held that the basis in the contributed shares must be added to the shares retained by the shareholder. The Supreme Court case serves as authority for the shareholder’s gain or loss and basis consequences resulting from a stock surrender. The classification of the transaction as a contribution to the capital of a corporation supports the application of IRC Section 118(a) to prevent the transferee corporation from including any amount in its gross income. With the issuance of PLR 202406002, taxpayers and practitioners now have an indication of the Service’s view of the other aspects of a stock surrender—namely, the treatment to the noncontributing shareholders.
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