By Anthony Diosdi
In the corporate tax context, the term “reorganization” is a statutory term of art. Rather than providing a general definition, the Internal Revenue Code attempts to provide precise definitions for the term “reorganization” in Section 368(a)(1) with an exclusive list of seven specific types of transactions that will be considered “reorganizations.” Subparagraphs (A) through (G) of Section 368(a)(1) each provide a description of a particular reorganization transaction. Unless a transaction fits into one of the seven categories stated in subparagraphs (A) through (G), it is not a corporate reorganization.
A tax-free reorganization sometimes involves only a single corporation which is undergoing a readjustment to its capital structure. The most common form of a reorganization that involves recapitalization is a Type E reorganization. Internal Revenue Code Section 368(a)(1)(E) provides that a “recapitalization” is a reorganization. A recapitalization has been defined as a “reshuffling of a capital structure within the framework of an existing corporation.” In other words, a corporation’s shareholders or creditors exchange their interests for other equity or debt interests. The assets of the corporation generally remain unchanged.
Virtually all stock-for-stock exchanges, including preferred for common and common for preferred, will qualify as a Type E reorganization if they are carried out pursuant to a plan. A shareholder does not recognize taxable gain on a Type E stock-for-stock recapitalization unless boot (boot is the money or fair market value of “other property” received in a transaction). In that event, realized taxable gain is recognized to the extent of boot. The gain is capital gain unless the transaction has the effect of the distribution of a dividend, in which case the dividend income is limited by both the shareholder’s recognized gain and his or her ratable share of the corporation’s earnings and profits.
A recapitalization may result in a deemed stock distribution 1) pursuant to a plan to periodically increase a shareholder’s proportionate interest in the assets or earnings and profits of the corporation, or 2) is with respect to preferred stock with dividend arrearages and the preferred shareholders increases his or her proportionate interest in the corporation as a result of the exchange. In these cases, the dividend is the amount of the increase in the shareholder’s liquidation preference or the amount of the dividend arrearages that were eliminated. Recapitalizations fall into four broad categories depending upon the consideration exchanged. These categories will be discussed below.
Bonds Exchanged for Stock
The Income Tax Regulations provide that if a corporation discharges outstanding bonds by issuing preferred shares to bondholders, the transaction qualifies as a Type E reorganization. See Treas. Reg Section 1.368-2(e)(1). The result is the same if a corporation uses common stock to discharge its obligations to the bondholders. Under Internal Revenue Code Section 354(a), the bondholders generally will recognize no gain or loss on the exchange of their debt instruments solely for stock. Section 354(a)(2)(B) creates an exception to nonrecognition to the extent stock received is attributable to accrued and untaxed interest on the bound. On the corporate side, a debtor corporation that transfers its stock in satisfaction of its debt is treated as if the corporation satisfied the debt with an amount of money equal to the fair market value of the transferred stock.
Stock for Bonds
An exchange of stock for bonds may qualify as a Type E tax-free reorganization. If so, the bonds constitute boot, and the shareholder’s realized gain is recognized to the extent of the fair market value of the bonds received. If the bonds are issued pro rata to all the shareholders, this gain will likely be characterized as a dividend to the extent of each shareholder’s ratable share of the earnings and profits of the corporation.
Bonds for Bonds
The bondholder in a bond-for-bonds exchange generally will not recognize gain or loss unless the bonds received are attributable to accrued and untaxed interest or the principal amount of bonds received in the exchange exceeds the principal amount of the bonds surrendered. Income attributable to interest will be recognized as taxable income in the excess of the value of the bonds.
Stock for Stock
The Income Tax Regulations provides three examples of stock-for-stock exchanges which qualify as reorganizations. Two examples involve exchanges of outstanding preferred stock for common stock and the third involves an exchange of outstanding common for preferred, See Treas. Reg. Section 1.368-2(e)(2)-(4). In addition, exchanges of common stock in a corporation for common stock in the same corporation or preferred stock for preferred stock will qualify for nonrecognition of tax treatment. Most equity-for-equity exchanges will qualify for Type E tax-free reorganization treatment. However, corporate shareholders will recognize taxable gain to the extent they receive boot in the exchange of stock.
There Must be a Business Purpose for the Reorganization
As with any other tax-free reorganization, a recapitalization will not qualify as a tax-free reorganization unless it has a business purpose. For example, the Treasury Department held that the conversion of stock pursuant to a conversion privilege may constitute a recapitalization if there is a sufficient business purpose for the conversion privilege. Another example of a business purpose for a recapitalization can be found in Rev. Rul. 77-238. This Revenue Ruling involved a manufacturing business whose corporate employees held a significant amount of corporate common stock. Upon retirement, the employees were entitled to either have their stock brought out for cash or to convert the common stock into preferred shares according to the terms of the articles of incorporation. The Treasury Department concluded that the retiring shareholder employees’ conversion of common stock into preferred stock was a recapitalization for purposes of a Type E reorganization. The Treasury Department stated that the purpose of the conversion was to “eliminate common stock ownership by retiring employees and to reduce the cash expenditures…that would otherwise result if the common stock of retiring employees were redeemed for cash. The shareholder conversions in accordance with this privilege were also considered recapitalization since the business purpose of the privilege was to “encourage the conversion of preferred stock into common stock in order to simplify the capital structure of the corporation by eliminating the preferred stock.” A note of caution, one should not assume that all stock conversions pursuant to a conversion privilege in the articles of incorporation will necessarily be viewed as recapitalizations. Each case should be individually examined.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.