Plain vanilla preferred corporate stock has two significant consequences for federal income tax purposes. Ownership of plain vanilla preferred stock is not included in measuring owner shifts of loss corporations under Section 382.[1] For eligible corporations to join in the filing of a consolidated return, a parent corporation must own directly at least 80% of the total voting power of stock and 80% of the total value of stock of at least one other corporation.[2] Plain vanilla preferred stock, however, is not included in determining affiliation eligibility.

Corporate stock with the following four basic characteristics is considered plain vanilla preferred stock for federal income taxes:

1. nonvoting;

2. limited and preferred as to dividends and without any significant growth participation;

3. limited redemption and liquidation premium rights; and

4. nonconvertible.

The IRS and judicial decisions have provided insight on whether these requirements have been met through various private letter rulings. In Gerdau MacSteel, Inc. v. Commissioner,[3] the U.S. Tax Court held that stock was pure preferred stock where the holder received a fixed dividend and had only an unrealistic opportunity to participate in any liquidation proceeds apart from a fixed amount. Determining whether the holder of the preferred stock participates in corporate growth to any significant extent is typically based on the dividend terms included as part of the preferred stock. Are the dividends contingent on the growth of a corporation rather than on available earnings, debt financing capacity, or existing asset liquidation values? For example, preferred stock could be viewed as participating in corporate growth if the dividend and liquidation amounts are not guaranteed based on the corporations’ profits.

The IRS recently issued Private Letter Ruling 202211008 to a taxpayer in anticipation of an acquisition of another corporation.[4] The taxpayer was a corporation and parent of an affiliated group of companies that agreed to acquire a target corporation through a subsidiary of the parent corporation in an all-cash merger. The subsidiary issued various types of debt to fund the acquisition of the target corporation. The subsidiary also issued voting and nonvoting preferred stock to an unrelated investor. At issue was whether the nonvoting preferred stock would be considered plain vanilla preferred stock that would allow the subsidiary and the target corporation to be part of the parent’s affiliated group. That is, the investor’s nonvoting preferred stock in the subsidiary if not considered plain vanilla would reduce the parent’s direct ownership below the 80% value requirement and break affiliation.

The nonvoting perpetual preferred stock had a stated amount with dividends that accrued at a stated percentage rate payable quarterly.[5] If the dividends are not paid on time, they accrue at the higher percentage rate. The taxpayer represented in the private letter ruling that the growth in the target’s business was not necessary for the subsidiary to meet its debt obligations and pay all the dividends on voting and nonvoting preferred stock on time. The IRS ruled: “The dividends payable on the Non-Voting Preferred Stock do not cause it to be treated as “participat[ing] in corporate growth to any significant extent” within the meaning of section 1504(a)(4)(B).” The IRS also ruled the stated amount of the nonvoting preferred stock exceeded its acquisition price and was not an unreasonable premium. Thus, the parent would be able to include the subsidiary and the target corporation in its affiliated group of corporations.

The characteristics of nonvoting preferred stock can often make it difficult to qualify with any certainty as plain vanilla preferred stock for federal income tax purposes. Importantly, the taxpayer in the ruling was able to represent that the payment of the dividends on the nonvoting preferred stock was not dependent on the future earnings growth of the target corporation. Although the IRS ruling provides helpful insight as to what characteristics may qualify in certain circumstances, corporations looking for certainty in this area should review all the characteristics of any preferred stock before reaching a conclusion on how to treat the stock for federal income tax purposes.

[1] Section 382(k)(6)(A); Treas. Reg. Section 1.382-2(a)(3)(i). Unless otherwise stated, all references to “Section” are to the Internal Revenue Code of 1986, and all references to “Regulation” or “Treas. Reg.” are to the Treasury Regulations promulgated thereunder.

[2] Section 1504(a). The same ownership test is required for other includable corporations in the affiliated group.

[3] 139 T.C. 67 (2012).

[4] March 18, 2022.

[5] The subsidiary also had the ability to redeem the nonvoting preferred stock. The nonvoting preferred stockholder did not have put rights to the subsidiary.