Rev. Rul. 55-112

Advice has been requested with respect to the tax consequences, for Federal income tax purposes, of a change in the capital structure of M Corporation.

All the stock of the M Corporation (which had only common stock outstanding) was held by 5 men interested in its management and operation and by the wives of these individuals. Three of these men, due to ill-health and other reasons, desired to cease all activity in connection with the corporate business, while the other 2 desired to remain active in the business. The 2 who wished to remain active wanted complete control of the corporation and the others were willing to let them have such control.

Accordingly, all the interested parties agreed that the stockholders who did not wish to remain active would exchange their common stock for preferred stock. Therefore, the corporate charter was amended to authorize the issuance of nonvoting stock, preferred as to dividends and on liquidation, having no pre-emptive rights and redeemable at the option of the corporation. The 3 stockholders who desired to cease being active, and their wives, surrendered all their common stock (totalling 54 percent of all the stock) and received in exchange preferred stock of equal fair market value and of equal book value (such book value being determined by the corporation's basis for its assets for tax purposes). The corporation redeemed and cancelled all the common stock received by it in the exchange. After the transaction all the preferred stockholders owned no common stock, and were not officers, directors or employees of the corporation. None of the preferred stockholders was related by blood or marriage to any common stockholder, or to any officer, director or employee of the corporation, and no preferred stockholder had any economic interest whatever in the affairs of the corporation except that evidenced by his preferred stock shares.

Section 112(a) of the Internal Revenue Code of 1939 provides, in effect, that upon the sale or exchange of property, the entire amount of the gain or loss resulting shall be recognized, unless the results of such exchanges are expressly exempted by the provisions of section 112(b) of such Code. Among the exchanges, the results of which are exempted, is an exchange in connection with a recapitalization (reorganization).

Section 112(b)(3) provides:

(b) EXCHANGES SOLELY IN KIND.-

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(3) STOCK FOR STOCK ON REORGANIZATION.-No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

Section 39.112(g)-1(b) of Regulations 118 provides 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 such readjustments of corporate structures, made in one of the particular ways specified in the Code, as are required by business exigencies, and which effect only a readjustment of continuing interests in property under modified corporate forms. The same subsection also provides that 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 interprise prior to the transaction, are requisite to a reorganization under the Code.

Section 39.112(e) of Regulations 118 provides that a recapitalization and therefore a reorganization, takes place if, for example; a corporation issues preferred stock, previously authorized but unissued, for outstanding common stock.

Accordingly, the described transaction is a recapitalization as defined by section 112(g)(1)(E) of the Internal Revenue Code of 1939 preferred stock. The basis of the or loss is recognized to the stockholders upon the exchanges by them of their common stock for new preferred stock. He basis of the preferred stock received by each shareholder is the same as the cost or other basis of the common stock surrendered by him. The exchanges of common stock for preferred stock have no effect upon the accumulated earnings and profits of M Corporation available for the distribution of dividends