Rev. Rul. 54-13

Advice is requested relative to the treatment for Federal income tax purposes of a proposed reorganization of the M Corporation.

The M Corporation manufactures women's highly styled shoes. The capital stock of the M Corporation consists of $100 par value 4 percent nonvoting cumulative preferred stock, and $100 par value common stock. A owns approximately 30 percent of each class of stock. B owns approximately 56 percent of each class of stock and three members of B's family who are not active in the management of the corporation own an additional 14 percent of the stock. B is 65 and A is 47 years old.

A and B have both been with the company since its incorporation. The operation of the corporation requires considerable management skill and ability, and the growth of the corporation is due largely to A's efforts and abilities. A's abilities and continued interest are considered necessary to the future success of the company. A is dissatisfied with the fact that his common stock equity in the corporation is less than B's notwithstanding that he makes at least as great a contribution to the success of the company. In view of the fact that the company desires to retain A's services and the fact that the present arrangement is not conducive to maximum effort on A's part or to his continuing with the company, it is proposed to increase A's common stock interest in the corporation to 40 percent at this time. (The stockholders have also agreed that after B's death A's common stock interest will be increased to 50 percent through a rearrangement of the capital stock at such time.) In order to rearrange the capital structure of the corporation to effect an increase of A's common stock interest to approximately 40 percent at this time, the following transaction is proposed:

(1) The corporation will amend its charter to authorize the issue of a number of shares of a new 4 percent cumulative second preferred stock having a par value of $100. The preferred stock presently authorized will be designated as "first preferred stock." The second preferred stock will be entitled to cumulative dividends of 4 percent per annum and will be callable at, and entitled in liquidation to, par value plus accrued dividends. The second preferred stock will be subordinate to the first preferred stock but preferred over the common stock as to dividends and assets in liquidation.

(2) The corporation will issue the new second preferred stock to the other four stockholders (in proportion to the common stock held by each) in exchange for a sufficient number of their shares of common stock to effect an increase in A's common stock interest to 40 percent of the common stock outstanding after the exchange. The exchange will be made on the basis of one share of second preferred stock for an amount of common stock representing $100 of book value on the date the plan is made effective. No change will be made in the number of shares of stock held by A.

(3) The corporation will transfer from its earned surplus account to its capital stock account an amount sufficient to reflect the increase in the par value of its outstanding stock resulting from the exchange.

Section 112(g)(1) of the Internal Revenue Code provides in part as follows:

(g) DEFINITION OF REORGANIZATION.--As used in this section * * *

(1) The term "reorganization" means * * * (E) a recapitalization * * *.

Section 39.112(g)-1 of Regulations 118 provides in part that the purpose of the reorganization provisions of the Internal Revenue Code is to except from the general rule certain specifically described exchanges incident to readjustment of corporate structures which effect only a readjustment of continuing interests in property under modified corporate forms. Requisite to a reorganization under the Code are a continuity of the business enterprise under the modified corporate form, and a continuity of interest therein on the part of those persons who were the owners of the enterprise prior to the reorganization.

It is held that issuance by the M Corporation of the newly authorized second preferred stock in exchange for part of its common stock will constitute a reorganization under section 112(g)(1)(E) of the Code. No gain or loss will be recognized to the stockholders as a result of the receipt by them of the second preferred stock in exchange for a portion of their common stock (sec. 112(b)(3) of the Code); also, no gain will be recognized to A. The basis to the recipients of the new second preferred stock will be the same as the cost or other basis of the common stock exchanged therefor (sec. 113(a)(6) of the Code). The reorganization will not diminish the accumulated earnings and profits of the corporation available for dividends within the meaning of section 115(a) of the Code.

This ruling shall not be considered as in any way affecting the possible application of section 102 of the Code. Furthermore, opinion is reserved whether the proposed transaction will constitute a gift from the other stockholders to A or from A to the other stockholders or the payment of compensation to any of the stockholders of the Corporation in the event it is ultimately determined that on the date that the exchange is consummated there is a disparity in value between the stock surrendered and the stock received in exchange therefor. Opinion is also reserved on the treatment for Federal income tax purposes of any sale or transfer (other than by bona fide hypothecation) by a shareholder of all or any part of the new second preferred stock issued by the company, or of a redemption of such stock in the hands of either the original holder or a purchaser or transferee thereof.