Using recapitalization to transfer voting control to younger shareholders.

Facts: Jane Hamilton and Peter Brown incorporated their software business five years ago as Hambro Systems, Inc. At the time of incorporation, the issuance of 100,000 shares of common stock and 50,000 shares of nonvoting preferred stock was authorized. Jane received 50,000 shares of common stock, and Peter received 30,000 shares of common and 10,000 shares of nonvoting preferred stock in exchange for their respective capital contributions of $50,000 and $40,000 when the business was incorporated. * Jane handles sales and administration and Peter is in charge of new product development. The innovative software Peter has designed has been the major reason for the corporation's success. * Jane, who is much older than Peter, is in poor health. Her will provides that her brother, Ronald, will inherit everything she owns (including her stock in Hambro) when she dies. Ronald is a music teacher; he knows nothing about software and has never been involved in the business. Peter is afraid that Ronald, because of his lack of knowledge of the software industry, will manage the business poorly once he becomes the majority owner of the corporation's common stock. He would like to purchase 25,000 shares of Jane's stock so that he could become the majority shareholder, but he recently suffered some major investment losses and does not have any cash. In any event, Jane is not interested in selling any of her stock. While she agrees that Peter, rather than Ronald, should control the corporation after her death, she does not want to sell her stock to him for several reasons: She does not want to recognize any gain on a transaction that makes Peter the controlling shareholder. Further, she has always provided a portion of Ronald's support, and wants to use her ownership interest to continue to provide for him after her death. * Peter and Jane have consulted their tax adviser for advice about how Peter can become the majority owner of the common stock without purchasing any of Jane's stock. They have provided the adviser with a recent valuation of the stock that shows that the per-share value of the common stock is equal to the per-share value of the preferred stock. Issue: How can Peter become the majority owner of the common stock without purchasing any of Jane's stock?

Analysis

The tax adviser might consider a Type E reorganization (i.e., a recapitalization). Basically, a recapitalization is the restructuring of the ownership of a single corporation. If certain requirements are met, the transaction will be tax-free to both the shareholders and the corporation.

Regs. Sec. 1.368-2(e) lists five examples of transactions that will qualify as recapitalizations:

1. Discharge of bonds outstanding by issuance of preferred shares (rather than cash) to the bondholders.

2. Surrender for cancellation of 25% of a corporation's preferred stock in exchange for no-par-value common stock.

3. Issuance of previously authorized, but unissued, preferred stock for outstanding common stock.

4. Exchange of a corporation's outstanding preferred stock, which has certain priorities as to the amount and timing of payment of dividends and the distribution of the corporate assets on liquidation, for a new issue of the corporation's common stock with no such rights.

5. Exchange of a corporation's outstanding preferred stock with dividends in arrears for other corporate stock.

Jane could exchange 25,000 shares of her common stock for 25,000 shares of the corporation's unissued, but authorized, preferred stock; such a transaction would meet the definition of a recapitalization. The following table illustrates how the ownership of the corporation would be structured after the transaction:

        Common shares   Preferred shares
Jane    25,000          25,000
Peter   30,000          10,000

Peter would own the majority of the common stock, but Jane would retain an ownership interest in the corporation that would provide income for Ronald after her death.

However, reorganizations must meet certain regulatory and judicial requirements to qualify for tax-free status. These requirements include business purpose, continuity of business enterprise, continuity of interest and the step-transaction doctrine. Unlike most other types of reorganizations, a recapitalization does not have to meet the continuity-of-interest and the continuity-of-business-enterprise requirements. This is because a recapitalization, as opposed to other types of reorganizations, involves only one corporation.

However, recapitalizations must meet the business purpose requirement. A transaction designed for the sole purpose of allowing the shareholders to avoid taxation is not considered to have a bona fide business purpose. The following are examples of situations in which a business purpose has been found to exist:

1. Achieving a principal shareholder's estate planning objectives. Tax avoidance by the shareholders is not considered a bona fide business purpose--estate planning is.

2. Simplifying a corporation's capital structure.

3. Eliminating outstanding dividend or interest arrearages.

4. Buying out hostile minority shareholders.

5. Attracting executive talent to a corporation.

6. Distributing a corporation's liquid assets to its shareholders.

7. Strengthening a corporation's financial condition by exchanging outstanding debentures for new debentures with shorter terms and lower interest rates.

8. Transferring voting control from older shareholder/executives to younger shareholder/executives, to prevent voting control front being shifted to inexperienced shareholders (the older shareholder/executives' beneficiaries) when the older shareholder/executives die.

In at least one instance, the courts have ruled that a transaction qualified as a tax-free recapitalization when its purpose was to allow shareholders to pay off their debts. In Survaunt, 5 TC 665 (1945), when two shareholders in a corporation died, the remaining two shareholders bought their stock, paying for it with promissory notes. When a third shareholder died, demand was made on his estate to pay off the notes used to purchase the stock. The corporation was dissolved and the assets transferred to a new corporation for stock and debentures delivered to the estates of the first two shareholders to die and to the other shareholder. This transaction was considered a reorganization even though it served the shareholders' (rather than the corporation's) purposes. In another case revolving this same issue, the court held that no business purpose existed for the recapitalization. In Well-house, 3 TC 363 (1944), the shareholders in a corporation authorized the issuance of preferred stock, exchanged the preferred for some of their common, and used the preferred to pay off their debt.

An exchange by Jane of 25,000 shares of common stock for 25,000 shares of nonvoting preferred stock would satisfy the business purpose requirement. Actually, it would have two acceptable business purposes: it would satisfy Jane's estate planning objectives, while at the same time transfer voting control to an experienced younger shareholder/executive. Thus, the transaction should qualify as tax-free for income tax purposes.

However, even though a recapitalization qualifies as tax-free for income tax purposes, it may not qualify as tax-free for all tax purposes. For example, if the total fair market value (FMV) of property (e.g., stock) received in the exchange is less than the FMV of the property surrendered, the capitalization could be subject to gift tax. If so, the shareholder is considered to have made a taxable gift to the company's other shareholders, to the extent of the difference between the FMV of the stock surrendered and the stock received (unless the exchange is made in the ordinary course of business and lacks donative intent). Alternatively, based on all the facts, the excess could be compensation. Because the per-share FMV of the preferred stock Jane receives is equal to the per-share value of the common stock she surrenders, gift tax or compensation is not an issue.

Conclusion

The tax adviser could recommend that Jane exchange 25,000 shares of her common stock for 25,000 shares of the corporation's previously unissued nonvoting preferred stock. Peter will become the majority owner of the common stock, Ronald will inherit an ownership interest in the corporation when Jane dies, and Jane will not have to recognize any gain on the transaction,

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Closely Held Corporations," 12th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter-Craig, Lewis A. Siegel, Joan Wilson Gray, Richard L. Burris, James A. Keller and Gregory B. McKeen, Published by Practitioners Publishing Company, Fort Worth, Tex., 1999