IRC 306 Tainted Stock and the Preferred Stock Bail-Out Rules: Practitioner Guide

What IRC 306 Does and Why Congress Enacted It

IRC 306 tainted stock sits at the center of one of the most persistent traps in corporate tax practice: a shareholder issues preferred stock in a recapitalization, holds it for years, sells it to a third-party buyer expecting long-term capital gain treatment, and discovers that the entire amount realized is ordinary income. No planning fix exists after the disposition has occurred. The statute was designed to operate exactly this way.

The bail-out problem that IRC 306 was enacted to solve arose directly from the preferential rate structure of the income tax. Before IRC 306, a closely held corporation with substantial accumulated earnings and profits could effectively extract those earnings at capital gain rates through a two-step maneuver. In step one, the corporation would distribute preferred stock as a tax-free stock dividend on common stock, with no immediate tax to the common shareholders. In step two, the shareholders would sell the preferred stock to a third party and report the entire proceeds as capital gain -- rather than as a dividend, which would have been ordinary income if the corporation had simply distributed cash. The common stock retained its value because the preferred dividend right, once established, was eliminated on sale; the shareholders had, in substance, received a dividend in the form of preferred stock and converted it to a lower-taxed capital gain on disposition.

Congress responded in 1954 by enacting what became IRC 306. The statute recharacterizes the proceeds from certain dispositions of preferred stock as ordinary income equal to the amount that a cash dividend would have produced at the time of the original distribution. The policy is to deny preferential capital gain treatment to proceeds that are economically equivalent to a dividend on the date the stock was issued. As a result, section 306 ordinary income treatment is not a penalty for something the shareholder did wrong on the disposition; it is the retrospective application of the tax character that should have attached to the economic equivalent of a dividend paid at distribution.

The guide that follows addresses each element of the statute in practitioner depth: how stock becomes section 306 stock, how both dispositions and redemptions are taxed, which exceptions can remove the ordinary income consequence, how E&P interacts with taint creation, how the taint travels through reorganizations and transfers, and where the traps concentrate in M&A due diligence and estate planning.

IRC 306(c): The Three Categories of Section 306 Stock

IRC 306(c) defines section 306 stock through three distinct categories. Each category addresses a different mechanism by which preferred stock can acquire the tainted character that subjects dispositions and redemptions to ordinary income treatment.

Category 1: Stock Received as a Stock Dividend on Common Stock

The first and most common category under IRC 306(c)(1)(A) covers stock distributed to a shareholder with respect to common stock if, at the time of the distribution, the receipt of cash in lieu of the stock would have been a dividend (within the meaning of IRC 316) in whole or in part. In practice, this is preferred stock distributed as a non-taxable stock dividend under IRC 305(a) -- a distribution of additional shares on the shareholder's existing common stock that carries no immediate tax consequence under the non-recognition rule of IRC 305.

The governing condition is whether a cash distribution at the same time would have been a dividend. That determination turns on whether the corporation had earnings and profits (E&P) at the time of the distribution. If E&P is zero or negative, a cash distribution to the shareholder would not have been a dividend (it would have been a return of basis or capital gain under IRC 301(c)); therefore, the distributed stock does not become section 306 stock. If the corporation had sufficient E&P to cover a cash dividend at that moment, the distributed preferred stock is section 306 stock. Verify E&P computation with qualified tax counsel; E&P is a federal tax concept distinct from book earnings and profits.

It is important to note that common stock distributed on common stock is expressly excluded from section 306 stock status under IRC 306(c)(1)(A), which applies only to stock other than common stock (i.e., preferred stock or any other class that would be disproportionate in a 305 analysis). Only preferred stock or similarly disproportionate shares fall within the first category.

Category 2: Stock Received in a Reorganization or Division With Respect to Section 306 Stock

Under IRC 306(c)(1)(B), stock received by a shareholder in a corporate reorganization or a corporate division (under IRC 355) in exchange for, or with respect to, section 306 stock is itself section 306 stock. The taint does not disappear merely because the stock passed through a nonrecognition reorganization transaction; it follows the stock into the new corporate entity. A Type E recapitalization, for example, in which a shareholder exchanges existing section 306 preferred stock for a new series of preferred stock, will produce a new series that is itself section 306 stock.

An important limitation applies: the second category requires that the stock was received in exchange for, or with respect to, section 306 stock. Stock received in a reorganization in exchange for common stock is not section 306 stock under this category (though it could become section 306 stock under the first category if it was distributed disproportionately in a transaction where cash would have been a dividend).

Category 3: Stock with Transferred or Exchanged Basis from Section 306 Stock

Under IRC 306(c)(1)(C), stock with a basis determined by reference to the basis of section 306 stock is itself section 306 stock. This category captures transfers by gift, contributions to partnerships or corporations under IRC 351 or IRC 721, and other nonrecognition transactions in which the section 306 stock is the property transferred and the received property takes a transferred or exchanged basis from it. The taint follows the basis, not the share certificate. A donee who receives section 306 preferred stock as a gift holds section 306 stock; the charitable donee or family member recipient is subject to IRC 306(a) on any subsequent disposition.

IRC 306(a)(1): Ordinary Income on Disposition to a Third Party

When a shareholder sells section 306 stock to a person other than the issuing corporation (a third-party sale or exchange), IRC 306(a)(1) governs the tax consequences. The statute does not simply cap ordinary income at a fraction of proceeds; it applies ordinary income treatment up to the "section 306 amount" and then treats any excess as capital gain (or loss if applicable).

Computing the Section 306 Amount

The section 306 amount is the amount that, if received as cash instead of the stock at the time of the original distribution, would have been a dividend. In the standard case, the distributing corporation had positive E&P, and the preferred stock was distributed as a tax-free stock dividend. The section 306 amount for each share is therefore equal to the fair market value of the stock on the date of distribution, reduced by any portion of that value that was includable as a dividend at the time of distribution. For a stock dividend that was entirely tax-free under IRC 305(a), the section 306 amount is the full fair market value at the date of distribution. Verify the computation against Treas. Reg. 1.306-1 and current IRS guidance at IRS.gov.

A critical asymmetry applies to losses. If the amount realized on a third-party sale is less than the section 306 amount, IRC 306(a)(1) treats the entire amount realized as ordinary income; no loss is recognized. The statute does not permit the shareholder to recognize a loss on the sale of section 306 stock to a third party, even if the fair market value has declined below the section 306 amount. The basis is not recovered through loss recognition; it is reallocated back to the underlying common stock from which the section 306 stock was derived.

IRC 306(a)(2): Redemption Treated as an IRC 301 Distribution

When the issuing corporation redeems section 306 stock rather than having a third party purchase it, a different statutory mechanism applies. IRC 306(a)(2) treats the entire amount received by the shareholder as a distribution of property to which IRC 301 applies. The consequence is that the redemption is taxed like an ordinary dividend rather than like a sale, regardless of whether the redemption would otherwise satisfy any of the exchange-treatment tests under IRC 302(b).

Under the IRC 301 ordering rules applied through 306(a)(2): the distribution is a dividend to the extent of the corporation's current and accumulated E&P; any amount exceeding E&P is a return of the shareholder's basis in the redeemed stock; and any amount beyond basis is capital gain. Unlike a third-party disposition under 306(a)(1), a redemption under 306(a)(2) does reduce the corporation's E&P by the portion treated as a dividend.

The shareholder's basis in the redeemed section 306 stock is not lost. Under the Treasury Regulations, the basis allocable to the redeemed section 306 shares is reallocated to the remaining common shares from which the section 306 stock was originally distributed. This prevents a double-benefit scenario where the shareholder uses basis in the section 306 stock to offset the redemption proceeds and also retains the underlying common stock at its original (undiluted) basis. Verify the basis reallocation mechanics at IRS.gov and under the applicable Treasury Regulations.

The key practical contrast with 306(a)(1) is that 306(a)(2) absorbs E&P. A shareholder whose corporation has minimal E&P at the time of the redemption may find that 306(a)(2) produces less ordinary income than 306(a)(1) would for the same shares, because the ordinary income under 306(a)(2) is limited to the current distribution through the E&P stack. For corporations with large accumulated E&P, the risk under both provisions is comparably severe.

IRC 306(b): Exceptions from Ordinary Income Treatment

IRC 306(b) enumerates five exceptions that can remove the ordinary income consequence of a section 306 stock disposition or redemption. Each exception has a distinct policy rationale, and each carries conditions that must be satisfied before the exception applies. None is self-executing; the taxpayer must establish that all required conditions are met.

IRC 306(b)(1): Complete Termination of Interest

The first and most broadly applicable exception removes ordinary income treatment when the shareholder disposes of all of the stock (both common and all classes of preferred, including section 306 stock) of the corporation in a transaction or series of related transactions that completely terminate the shareholder's entire equity interest. The policy rationale is that the bail-out concern evaporates when there is no remaining common stock to benefit from the preferential extraction of E&P. If no common stock remains, the shareholder could not have used the preferred stock disposition to strip earnings while keeping the corporate investment intact.

The exception applies to both third-party sales and redemptions of section 306 stock, provided the disposition of the section 306 stock is part of the complete termination. A piecemeal sale of the preferred stock before the common stock is sold will not qualify if the transactions are not part of a single integrated plan. Constructive ownership rules under IRC 318 apply in testing whether the interest has truly been terminated; verify the attribution analysis and procedural requirements under Treas. Reg. 1.306-2 at IRS.gov.

IRC 306(b)(2): Partial Liquidation

IRC 306(b)(2) provides an exception for amounts received by a non-corporate shareholder in a partial liquidation of the distributing corporation (within the meaning of IRC 302(b)(4) and IRC 302(e)). A partial liquidation requires a genuine contraction of the corporate business, not merely a distribution of excess liquid assets. The partial liquidation exception removes ordinary income treatment on the theory that the proceeds represent a genuine reduction in the corporate enterprise, not a bail-out of accumulated earnings at capital rates. This exception is available only to non-corporate shareholders, reflecting the IRC 302(b)(4) limitation.

IRC 306(b)(3): Complete Liquidation

When the corporation distributes section 306 stock in a complete liquidation governed by IRC 331 (taxable liquidation) or IRC 332 (tax-free liquidation into a parent corporation), IRC 306(b)(3) provides that section 306 does not apply to the distribution. A complete liquidation distributes all corporate assets and terminates the corporate entity; the bail-out rationale does not apply when the corporation itself ceases to exist. Any gain or loss recognized by a shareholder in the complete liquidation is governed by IRC 331 (or IRC 332 for an 80%-or-more corporate parent receiving a liquidating distribution tax-free).

IRC 306(b)(4): Non-Tax-Avoidance Transactions

IRC 306(b)(4) provides the most flexible but least certain of the exceptions. It removes ordinary income treatment for any disposition or redemption that the IRS determines was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax. The analysis is entirely facts-and-circumstances; there is no bright-line test, no numerical threshold, and no procedural safe harbor.

The IRS has used this exception restrictively. It is most reliably available when: the section 306 stock was issued for a documented, contemporaneous business purpose unrelated to tax rate reduction; the disposition is compelled by business, economic, or legal considerations rather than by the shareholder's desire to extract earnings at favorable rates; and the timing of the disposition does not track periods of low E&P or high basis in the section 306 stock in ways that suggest rate-arbitrage planning.

IRC 306(b)(5): Tax-Exempt Organizations

IRC 306(b)(5) provides that section 306 does not apply to a disposition of section 306 stock by an organization whose income is wholly excluded from gross income under IRC 501(a) or IRC 521, or by a government entity. The policy is straightforward: the ordinary income recharacterization is directed at shareholders who would benefit from a preferential rate differential, and tax-exempt organizations and governments have no taxable income against which the differential operates.

E&P Interaction: How E&P Controls Whether 306 Taint Attaches

Earnings and profits (E&P) is the threshold condition for section 306 taint creation under the first category of IRC 306(c). If a corporation distributed preferred stock as a stock dividend at a time when the corporation had no E&P, the stock is not section 306 stock, because a cash distribution at that time would not have been a dividend. This E&P dependency is what makes the interaction between IRC 306 and the IRC 312/316 E&P rules critically important in practice.

E&P for this purpose is determined at the time of the distribution of the preferred stock -- not at a later date, not when the stock is ultimately disposed of. A corporation that had substantial accumulated E&P when it declared and distributed the preferred stock dividend will have produced section 306 stock, regardless of how E&P has changed in the intervening years. A corporation that had zero E&P on the distribution date (whether because it was newly formed, had prior losses, or had distributed all prior earnings) will not have produced section 306 stock.

The E&P computation itself is a specialized federal tax calculation that can diverge significantly from book accounting income or retained earnings. Timing differences for depreciation, previously excluded income items, and adjustments under IRC 312 can all cause E&P to be positive when book retained earnings appear negative, or vice versa. Verify E&P computation with qualified tax counsel; E&P is a federal tax concept distinct from book earnings and profits. The E&P computation rules are covered in depth in a companion guide on IRC 312 and IRC 316 published as part of this wave.

Once E&P at the time of distribution establishes the section 306 amount (equal to the FMV of the distributed stock, reduced by any amount includable as a dividend at distribution), subsequent changes in E&P do not affect the section 306 amount. The taint is frozen at the distribution-date measure. However, when the stock is redeemed under IRC 306(a)(2), the E&P at the time of redemption determines how much of the redemption proceeds are treated as a dividend (to the extent of then-current E&P) versus a return of basis or capital gain.

IRC 306 Taint in Reorganizations

One of the most consequential features of the section 306 taint is that it does not disappear in nonrecognition transactions. Congress deliberately structured the statute so that a shareholder cannot eliminate section 306 exposure simply by running the tainted preferred stock through a tax-free reorganization. The taint follows the stock through the most common reorganization forms.

Type B Reorganization (Stock-for-Stock)

In a Type B reorganization under IRC 368(a)(1)(B), the acquiring corporation exchanges its own voting stock solely for stock of the target corporation. No boot is permitted. When a target shareholder holds section 306 stock and receives acquiring corporation stock in exchange, the acquiring corporation stock takes an exchanged basis under IRC 358, and IRC 306(c)(1)(C) provides that stock with an exchanged basis from section 306 stock is itself section 306 stock. The shareholder therefore holds section 306 stock in the acquiring corporation after the reorganization, even though the original tainted preferred shares were surrendered in the exchange.

This carries through to subsequent dispositions: if the shareholder later sells the acquiring corporation stock, the ordinary income analysis under IRC 306(a)(1) runs on that stock, measured by the section 306 amount from the original preferred stock distribution. The section 306 amount does not reset through the reorganization. Verify the basis transfer mechanics and taint carryover under Treas. Reg. 1.306-3 at IRS.gov.

Type E Recapitalization

A Type E recapitalization under IRC 368(a)(1)(E) is a recapitalization of a single corporation -- typically an exchange of existing preferred stock for a new series of preferred stock (or for debt, or for common stock). When a shareholder exchanges existing section 306 preferred stock for new preferred stock in a Type E recapitalization, the new preferred is section 306 stock under IRC 306(c)(1)(B) (stock received in a reorganization with respect to section 306 stock). The taint transfers to the new preferred directly under the reorganization-receipt category, not merely the basis-transfer category.

A Type E exchange of section 306 preferred for common stock is a different analysis: common stock received in exchange for section 306 preferred stock may escape section 306 taint if the common stock is not itself section 306 stock under any of the three categories. Whether the exchange triggers IRC 306(a) as a disposition (rather than a nonrecognition event) depends on whether the recapitalization qualifies as a reorganization. Verify the reorganization qualification and taint consequences under IRC 306(c) and the applicable Treasury Regulations before advising on any Type E transaction.

IRC 355 Divisive Transactions (Spin-Offs and Split-Offs)

In a corporate division under IRC 355, section 306 taint can arise in the stock received by shareholders of either the distributing or the controlled corporation. Stock received in an IRC 355 transaction in exchange for, or with respect to, section 306 stock is section 306 stock under IRC 306(c)(1)(B). Additionally, stock distributed in an IRC 355 transaction where the distribution would have been a dividend if made in cash (i.e., where the corporation has E&P and the distribution is disproportionate) may itself be section 306 stock under the first category. The interaction between the IRC 355 rules and section 306 is complex; verify under Treas. Reg. 1.306-3 at IRS.gov.

Due Diligence Traps: Identifying 306 Stock in M&A Transactions

In M&A transactions involving closely held C corporations, section 306 stock is one of the most frequently overlooked items in tax due diligence. Unlike IRC 302 or IRC 304 issues, which arise at the moment of the transaction, section 306 taint is a pre-existing condition of the capitalization table that must be identified through historical research before a transaction is signed.

What to Request in Due Diligence

The due diligence request list for section 306 exposure should include:

• The complete history of preferred stock issuances, including board resolutions, stock certificates, and the stated consideration (if any) for each issuance.
• The corporation's E&P computation (or a reconstruction of E&P) as of the date of each preferred stock issuance, prepared under federal tax principles rather than book accounting.
• Any record of stock dividends paid in preferred stock since the corporation's formation, and whether those dividends were treated as taxable or non-taxable under IRC 305 at the time.
• The capitalization history of each current preferred shareholder: how each current holder acquired the preferred stock (original issuance, gift, purchase, inheritance, reorganization), to trace any transferred or exchanged basis that might carry section 306 taint from a prior holder.
• Prior tax returns (Forms 1120 and associated schedules) reflecting any prior dispositions of preferred stock to verify whether section 306 income was reported.

Transferee Taint and Seller Representations

A buyer in an asset acquisition is not directly exposed to the seller's section 306 taint; section 306 is a shareholder-level tax on the seller's proceeds, not an entity-level tax. However, in a stock acquisition, the target corporation's outstanding section 306 stock remains section 306 stock in the hands of the selling shareholders through the transaction (unless the acquisition itself qualifies under IRC 306(b)(1) as a complete termination or under another exception). If the deal is structured as a stock purchase in which some shareholders are selling their preferred stock to the acquirer, the selling shareholders' section 306 taint will cause ordinary income exposure on those sales unless an exception applies.

In a deal where the acquirer is purchasing common stock from some shareholders and receiving a redemption of preferred stock from the corporation (or purchasing preferred stock from other shareholders), the transaction structure needs to be analyzed under both IRC 306 and IRC 302/304 to avoid inadvertent ordinary income treatment. Representations and warranties in the purchase agreement should include an affirmative representation by the selling shareholders as to whether any preferred stock being sold is section 306 stock, and indemnification provisions should address any undisclosed section 306 tax liability arising from the transaction.

Estate Planning with Section 306 Stock

The interaction between section 306 and the estate and gift tax rules presents a set of planning traps that are distinct from the corporate transaction context. The most important is the relationship between the IRC 1014 basis adjustment at death and section 306 taint.

IRC 1014 Basis Step-Up Does Not Eliminate Section 306 Taint

When a shareholder dies holding section 306 stock, the stock receives a basis adjustment under IRC 1014 to the fair market value of the stock at the date of death (or the alternate valuation date if applicable). That basis adjustment is real and affects the amount of gain or loss the beneficiary will recognize above or below the basis. It does not, however, eliminate the section 306 character of the stock.

The section 306 taint is a statutory character attribute of the shares themselves, not of the shareholder's basis. A beneficiary who inherits section 306 preferred stock holds section 306 stock and will be subject to IRC 306(a) on any subsequent sale to a third party or redemption by the corporation. The IRC 1014 basis step-up affects only the capital gain or loss component -- the amount realized above the section 306 amount may be offset by the stepped-up basis, potentially eliminating capital gain. But the section 306 amount itself, which is taxed as ordinary income under 306(a)(1), is not affected by the basis step-up. Verify the exact mechanics of the interaction between IRC 1014 and section 306 taint under Treas. Reg. 1.306-1 at IRS.gov.

The Gift Trap

A gift of section 306 stock carries the taint to the donee. Under IRC 306(c)(1)(C), stock with a transferred basis from section 306 stock is itself section 306 stock. Because a gift carries a transferred basis under IRC 1015, the donee takes both the transferred basis and the section 306 character. The donee who later sells the gifted preferred stock to a third party will face ordinary income on the section 306 amount, measured by the fair market value of the stock on the original distribution date (not the gift date and not the donee's cost).

This creates a meaningful trap in intrafamily planning. An estate plan that gifts preferred stock in a closely held C corporation to family members or trusts as part of a valuation discount or income-shifting strategy must account for the fact that those recipients will hold section 306 stock. The gift does not convert the tainted stock into clean capital gain property; it exports the taint along with the shares. Practitioners advising on preferred stock gifts in family corporations should verify the section 306 status of the shares before the gift is made and before any disposition by the donee is structured.

One planning alternative is to structure the exit of section 306 preferred as a complete termination under IRC 306(b)(1), timed with or immediately prior to any estate or gift planning transaction involving the common stock. If the preferred is disposed of in a complete termination before the gift, the gifted common stock will not carry section 306 taint. However, the timing, sequencing, and integrated-transaction analysis must be carefully structured to ensure the complete termination exception applies. No such plan should be implemented without independent review by qualified tax counsel.

Comparison Table: Disposition vs. Redemption of Section 306 Stock

The table below summarizes the key differences between a third-party disposition and a corporate redemption of section 306 stock across the dimensions most relevant to practitioners advising closely held C corporations.