EXCHANGE OF VOTING COMMON FOR NEW VOTING AND NONVOTING COMMON WILL BE 'E' RECAPITALIZATION IF NOT PART OF PLAN TO INCREASE PROPORTIONATE INTEREST

Rev. Rul. 86-25

Is the transaction described below a reorganization as defined in section 368(a)(1)(E) of the Internal Revenue Code or is it a distribution of property to which section 301 applies by reason of the application of section 305(b)(3)?

FACTS

X, a closely held domestic corporation, had 3,000 shares of $100 par value voting common stock ("old common") outstanding. For valid business reasons, a plan of reorganization was adopted pursuant to which X authorized the issuance of a new class A no par value voting common stock, a new class B no par value nonvoting common stock, and a new class C $100 par value nonvoting, nonparticipating, nonconvertible preferred stock. The only difference between the class A and class B common stock was the voting rights of the class A stock, and the only difference between the class A common stock and the old common stock was the par values. No terms of the old common stock, such as dividend or liquidation rights, are tied to the par value.

The plan of reorganization provided that each outstanding share of old common stock could be exchanged either for one share of class A common stock plus 99 shares of class B common stock, or for one share of class A common stock plus six shares of class C preferred stock. Pursuant to the plan of reorganization, one group of X shareholders surrendered 2,500 shares of X old common stock in exchange for 2,500 shares of class A common stock and 15,000 shares of class C preferred stock. A second group of shareholders surrendered 500 shares of old common stock in exchange for 500 shares of class A common stock and 49,500 shares of class B common stock. The value of the stock received by each shareholder of X was equal to the value of the stock surrendered by such shareholder in the exchange. The exchange of stock was an isolated transaction and not part of a plan to increase periodically the proportionate interest of any shareholder in the assets or earnings and profits of X.

LAW AND ANALYSIS

Section 368(a)(1)(E) of the Code provides that the term "reorganization" includes a recapitalization. In Helvering V. Southwest Consolidated Corp., 315 U.S. 194, 202 (1942). 1942-1 C.B. 218, the Supreme Court of the United States defined a recapitalization under a predecessor of section 368(a)(1)(E) as a "reshuffling of a capital structure within the framework of an existing corporation."

Section 354(a) of the Code states that no gain or loss will be recognized if stock in a corporation that is a party to a reorganization is exchanged solely for stock in such corporation.

Section 305(a) of the Code contains the general rule that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.

Section 305(b)(3) of the Code provides that section 305(a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which section 301 applies if the distribution (or a series of distributions of which such distribution is one) has the result of the receipt of preferred stock by some common shareholders and the receipt of common stock by other common shareholders.

Section 305(c) of the Code provides that a change in redemption price, a difference between redemption price and issue price, a redemption which is treated as a distribution to which section 301 applies, or any transaction (including a recapitalization) having a similar effect on the interest of any shareholder may be treated as a distribution with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change, difference, redemption, or similar transaction.

Section 1.305-7(c)(1) of the Income Tax Regulations provides that a recapitalization (whether or not an isolated transaction) will be deemed to result in a distribution to which section 305(c) of the Code applies if it is pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation.

Section 1.305-7(c)(4) of the regulations provides than an example of the application of section 1.307(c) is example (12) of section 1.305-3(e).

In Example (12) contained in section 1.305-3(e) of the regulations, five shareholders owned 300 shares each and five shareholders owned 100 shares each of Corporation R's 2,000 shares of class A stock outstanding. In preparation for the retirement of the five major shareholders, R, in a single and isolated transaction, had a recapitalization in which each share of class A stock was exchanged either for five share of new class B nonconvertible preferred stock plus 0.4 share of new class C common stock, or for two shares of new class C common stock. As a result of the exchanges, each of the five major shareholders received 1,5000 shares of class B nonconvertible preferred stock and 120 shares of class C common stock, and the remaining shareholders each received 200 shares of class C common stock. The example concludes that none of the exchanges are within the purview of section 305 of the Code.

In the instant case, had X made an outright distribution of the new preferred stock and new class B common stock on the old common stock, the distribution would have been taxable as a distribution of property under section 301 of the Code by reason of the application of section 305(b)(3).

Nevertheless, a transaction that effects a reshuffling of a corporation's capital structure will be respected as a recapitalization exchange to which section 305(b)(3) of the Code does not apply so long as it has a bona fide business purpose and is an isolated transaction and not part of a plan to increase periodically the proportionate interest of any shareholder in the assets or earnings and profits of a corporation. See Example (12) in section 1.305-3(e) of the regulations, discussed above. Compare Bazley v. Commissioner, 331 U.S. 737 (1947), 1947-2 C.B. 79, (the exchange lacked a bona fide business purpose and was therefore not a reorganization) and section 1.301-1(1) of the regulations (a distribution occurring at the same time as a recapitalization is taxable as a dividend if, in substance, it is not part of the recapitalization).

HOLDING

Under the circumstances set forth above, the exchange of old voting common stock for either class A voting common stock plus class C nonvoting preferred stock or class A voting common stock plus class B nonvoting common stock, will qualify as a tax-free recapitalization under section 368(a)(1)(E) and 354(a) of the Code, and will not be treated as distributions of property to which section 301 applies by reason of the application of section 305(b)(3).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 54-192, 1954-1 C.B. 99, and Rev. Rul. 54-482, 1954-2 C.B. 148, are amplified.