Basically, Section 306 stock is stock that is “tainted” when received in a nontaxable stock dividend and the sale of such stock produces ordinary income rather than capital gain. These proceeds from Section 306 stock are eligible for a reduced tax rate applicable to dividend income.
Earnings and Profits Requirement
The distributing corporation must have earnings and profits at the time of the distribution in order for the preferred stock to receive the taint of Section 306. The amount of earnings and profits in this regard is irrelevant to the taxing procedures. Even a small amount of earnings and profits will trigger the stock to be considered 306 stock.
If the corporation has no current or accumulated earnings and profits at the time of distribution, then any and all distributions would not be taxable as dividends. The basic effect and idea of the earnings and profits requirement is to put the non common stock distribution on equal footing with other distributions.
Disposing of Section 306 Stock
The tax consequences of Section 306 stock occur when the stockholder disposes of the tainted stock. These taxable dispositions are divided into two sections:
1. Sale or other disposition
If the sale is a disposition, any amount realized by the stockholder is ordinary income to the extent of the amount that would have been a taxable dividend if cash had been distributed rather than Section 306 stock. There are two limitations on the amount of ordinary income. The recognized ordinary income is limited to the lesser of:
1. The corporate current and accumulated earnings and profits at the time of the distribution
2. The fair market value of the Section 306 stock on the date of distribution by the corporation
The ordinary income from the non redemption sale is treated as a dividend that will be taxed at a rate of 0% or 15%, depending on the shareholder’s tax bracket.