An E reorganization is a recapitalization – a “reshuffling of a capital structure within the framework of an existing corporation.” Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942). Recapitalizations are useful for passing control to the next generation while retaining an income interest, or for restructuring debt.
The regulations give examples of recapitalizations: exchanging preferred for bonds, common for preferred, preferred for common, or exchanging preferred with dividends in arrears for other stock. Reg. § 1.368‑2(e).
But if the recapitalization is used as a device to distribute E&P, the stock may be Section 306 stock or the exchange may be taxable under § 305. Rev. Rul. 86‑25, 1986‑1 C.B. 202, held that a recapitalization where shareholders could choose between common + preferred or common + more common was a tax‑free E reorganization, not a taxable stock dividend, because it had a bona fide business purpose and was an isolated transaction.
The ruling contrasted Example (12) of Reg. § 1.305‑3(e) (which was a non‑taxable recapitalization) with Bazley v. Commissioner, 331 U.S. 737 (1947), where the exchange lacked a business purpose and was therefore taxable.
So if you’re planning a recapitalization, make sure you have a corporate business purpose, and keep it as an isolated transaction – not part of a plan to periodically increase any shareholder’s proportionate interest.
Also, be aware of Section 306. If you receive preferred stock in a recapitalization, it may be Section 306 stock, meaning a later sale or redemption will be taxed as ordinary income. But common stock received in exchange for Section 306 stock is not Section 306 stock. Reg. § 1.306‑3(d).
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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