## Facts

- Eugene W. Fireoved was the controlling common shareholder of Fireoved & Company, Inc., a business-forms printing company.
- Fireoved negotiated a combination with a partnership owned by Karl Edelmayer and Kenneth Craver, restructuring ownership so the three would share the business.
- Because Fireoved’s capital contribution exceeded the partnership’s, the corporation recapitalized and issued Fireoved 100 shares of common stock and a stock dividend of 535 shares of preferred stock to equalize ownership interests.
- At issuance, the corporation had sufficient earnings and profits, making the preferred shares “§ 306 stock” for federal tax purposes.
- After the reorganization (and a corporate name change), Fireoved sold 24 of his 100 common shares to another principal, but bylaws requiring unanimous consent for significant actions left him with effective veto power and continuing control.
- The corporation later redeemed 451 preferred shares from Fireoved for over $47,000.
- Fireoved reported the redemption gain as long-term capital gain; the IRS treated it as ordinary income under I.R.C. § 306.
- The taxpayers filed a refund suit; the district court awarded a partial refund, and both sides appealed.

## Issues

1. Whether the preferred stock issued to Fireoved in the recapitalization was “§ 306 stock” such that proceeds from its redemption are generally treated as ordinary income under I.R.C. § 306(a).
2. Whether the taxpayers qualified for the I.R.C. § 306(b)(4) exception by establishing that the preferred stock distribution was not made pursuant to a plan having as one of its principal purposes the avoidance of federal income tax.

## Decision

- The Third Circuit held the preferred shares were § 306 stock.
- The court held the redemption proceeds were taxable as ordinary income under § 306.
- The court rejected application of the § 306(b)(4) exception because the taxpayers did not establish the distribution lacked a principal tax-avoidance purpose, emphasizing Fireoved’s retained effective control despite the partial common-stock sale.
- The appellate disposition adjusted the district court’s judgment to conform to ordinary-income treatment under § 306.

## Legal Principles

- Preferred stock distributed as a stock dividend out of earnings and profits may constitute “§ 306 stock,” and its redemption or sale is treated as ordinary income to the extent of earnings and profits under I.R.C. § 306(a).
- The § 306(b)(4) exception applies only if the taxpayer establishes that the distribution was not made pursuant to a plan having as one of its principal purposes federal income tax avoidance; the taxpayer bears the burden of proof.
- Retention of effective corporate control, including control mechanisms such as unanimity requirements that confer veto power, is strong evidence supporting a tax-avoidance purpose when preferred stock operates as a device to extract earnings at capital-gain rates.
- The presence of business motives for recapitalization does not by itself satisfy § 306(b)(4) when the structure and subsequent redemption function to convert dividend-like earnings into capital gain.

## Conclusion

The Third Circuit treated the redemption of Fireoved’s preferred shares as ordinary income under I.R.C. § 306 and denied capital-gain treatment because the preferred-stock distribution, viewed in light of Fireoved’s continuing effective control, was not shown to be free of a principal tax-avoidance purpose under § 306(b)(4).


Fireoved v. United States, 462 F.2d 1281 (3d Cir. 1972)