A recapitalization is an exchange between one corporation and its shareholders or security shareholders. It has been described as a “reshuffling of a capital structure within the framework of an existing corporation,” and it is one of the most common forms of reorganization encountered in the case of a closely-held business. Simple examples include the exchange of voting common stock for both voting and nonvoting common stock, and the exchange of common stock for preferred stock.
Recapitalizations as Tax-Free Reorganizations
In general, recapitalizations are treated as tax-free reorganizations: the gain realized in the exchange is not recognized and taxed because the substance and value of the corporation has not changed. Generally speaking, however, in order to qualify for this treatment, the fair market value of the stock received in the exchange must equal the fair market value of the stock given up. In an arm’s-length transaction, it is assumed that the parties will exchange property of approximate equal value.
Reorganizations Involving Related Parties
In the case of a reorganization transaction in which related parties exchange property of differing values, the IRS will give tax effect to the substance of the transaction by recasting it as a “value for value” exchange, accounting for any difference in value by characterizing that difference as a taxable transaction. Thus, depending upon the particular facts and circumstances, if an exchanging taxpayer receives new stock having a fair market value in excess of the fair market value of the stock surrendered, the amount of the excess may be treated as compensation, a gift, a payment to satisfy an obligation, or something else supported by the facts; the excess amount will not be eligible for nonrecognition treatment.
A recent IRS Field Attorney Advice illustrated the application of these rules. A corporation had two shareholders, with the majority owner also serving as the CEO. As part of a recapitalization, the corporation converted its debt into two new classes: (A) a new class of common stock, and (B) a class of non-voting preferred stock. The existing common was exchanged for new common and for class B preferred, and the majority shareholder thereby gave up his controlling interest.
The IRS analyzed the fair market value of the corporation before the recapitalization. It concluded that because the corporation’s shareholders had given up stock that was less valuable than the stock that they had received in the exchange, the exchange did not entirely qualify for tax-free treatment. Based on the facts, the IRS determined that the excess amount was paid to the majority shareholder to convince him to give up his majority interest; i.e. income paid as an inducement for agreeing to the transaction. The excess amount therefore needed to be treated separately from the exchange according to its character.
The foregoing highlights how important it is for a closely-held business to examine the potential tax consequences of even seemingly innocuous reorganization transactions, including the recapitalization of a corporation’s own equity. It also underscores the importance of valuation. This is especially so for the family-owned business, reorganizations of which are likely to attract closer scrutiny by the IRS. The failure to consider the reorganization structure from a tax perspective may easily result in taxable income (including a dividend or compensation) or a taxable gift, depending upon the facts and circumstances of the particular corporation and transaction.