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Corporate tax practitioners from time to time have close encounters with nonqualified preferred stock. Those debt-like equity shares constitute "boot" for purposes of Section 351, and may even prevent application of that Code section entirely. Since 1997, Congress has deemed such stock unworthy of nonrecognition treatment upon its receipt by shareholders in exchange for property. Nonqualified preferred stock is also treated as something other than stock in some corporate reorganizations and divisions,1 and it cannot be received tax-free under Section 1036.2
In order to be classified as nonqualified under Section 351(g), stock must be "preferred stock" and for this purpose, state law labels are not controlling. Stock is "preferred" for this purpose only if it "is limited and preferred as to dividends and does not participate in corporate growth to any significant extent"3 A recent Chief Counsel memorandum evaluated a class of stock under this definition, and concluded that despite nominal participation rights, the stock was indeed "preferred stock"4
The result was favorable to the IRS, in that the transaction at issue was a sale of the stock, and the taxpayer was seeking to deduct a capital loss. Key to the taxpayers position was the assertion that the stock had a relatively high basis, apparently because it was received in exchange for an asset with a built-in loss, in a previous transaction that the taxpayer said qualified for nonrecognition and carryover basis under Section 351.5 Because the stock was nonqualified preferred stock, the memo concluded that the earlier transaction was not a Section 351 exchange at all, and thus that the basis of the stock was its fair market value on the date of the exchange.6
Facts
The taxpayer was P, the common parent corporation of a consolidated group. P bought from a third party all the stock of a corporation known in the memo as Sub 2. A few years later, P contributed all of the stock of Sub 2 to a consolidated subsidiary, Sub 1. In exchange for the Sub 2 stock, P received from Sub 1 three items: Class A Sub 1 stock, Class B Sub 1 stock, and Sub 1s promissory note.
The Class B stock was conceded to be nonqualified preferred, and the note was presumably true debt, and so...