For federal income tax purposes, plain vanilla preferred corporation stock has two important effects. Under Section 382, ownership of common preferred stock is not taken into account when calculating owner movements of loss corporations.
A parent corporation must directly hold at least 80% of the total voting power and 80% of the total market value of the stock of at least one other corporation for those corporations to participate in the filing of a consolidated return.
To determine affiliation eligibility, however, only common preferred stock is not taken into account.
For the purposes of federal income taxes, a corporate stock that possesses the four fundamental qualities listed below is regarded as plain vanilla preferred stock.
Nonvoting;
Limited, favoured in terms of dividends, and with no discernible involvement in expansion;
Restricted rights to redemption and liquidation premiums; and
Nonconvertible.
Through different private letter rulings, the IRS and judicial decisions have shed light on whether these conditions have been satisfied.
The U.S. Tax Court determined that stock was pure preferred stock in Gerdau MacSteel, Inc. v. Commissioner when the holder received a fixed dividend and had only an improbable possibility to share in any liquidation proceeds other than a fixed amount.
The dividend terms given as part of the preferred stock are usually used to determine whether the preferred stock holder participates in corporate growth to any meaningful level.
Do a company’s dividends depend more on its ability to grow than it does on its ability to earn money, its ability to finance debt, or the market worth of its current assets?
For instance, if the dividend and liquidation amounts are not guaranteed depending on the firms’ revenues, preferred stock may be seen as contributing to corporate growth.
A taxpayer received Private Letter Ruling 202211008 from the IRS recently in advance of the acquisition of another firm.
The taxpayer was a business that had agreed to merge with its parent company in an all-cash transaction and purchase a target corporation through one of its subsidiaries.
To pay for the purchase of the target company, the subsidiary issued various forms of debt.
A separate investor received both voting and nonvoting preferred stock from the subsidiary.
Whether the non-voting preferred stock would be regarded as regular preferred stock, allowing the subsidiary and the target firm to be a part of the parent’s linked group, was in question.
In other words, if the investor’s nonvoting preferred stock in the subsidiary were not treated as plain vanilla, the parent’s direct ownership would fall below the required 80 per cent value and the connection would end.
The dividends accrued at a stated percentage rate and were payable quarterly on the non-voting perpetual preferred shares.
The dividends accrue at a higher percentage rate if they are not paid on time. The taxpayer claimed in the private letter ruling that the target’s business did not need to expand for the subsidiary to pay all of the voting and nonvoting preferred stock dividends on schedule and meet its debt commitments.
The IRS concluded that the Non-Voting Preferred Stock is not viewed as “particip[ing] in company growth to any considerable amount” within the definition of section 1504(a)(4)(B) because of the dividends payable on it.
Additionally, the IRS determined that the non-voting preferred stock’s claimed value surpassed its purchase price without being an excessive premium. The parent could then include the target company and the subsidiary in its associated group of businesses.
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It can frequently be challenging to determine with any certainty whether nonvoting preferred stock qualifies as plain vanilla preferred stock for federal income tax purposes due to its peculiarities.
Importantly, the taxpayer was able to demonstrate in the judgement that the payment of the dividends on the nonvoting preferred stock was not reliant on the target company’s potential for future earnings growth.
However, corporations seeking certainty in this matter should carefully consider all the characteristics of any preferred stock before deciding how to treat the stock for federal income tax purposes, even though the IRS ruling offers helpful insight into what characteristics may qualify in specific situations.
