Recapitalizations in general
While a recapitalization is not specifically defined in the Internal Revenue Code, it is listed under section 368(a)(1)(E) as a type of reorganization in which tax-free treatment can apply to both the corporation and its shareholders. A commonly cited definition of a recapitalization is a “reshuffling of a capital structure within the framework of an existing corporation.”1 Several examples are also provided in Treas. Reg. section 1.368-2(e), such as issuing stock to bond holders in cancellation of the existing bonds or the cancellation of 25% of the corporation’s preferred stock in exchange for no par value common stock.
The general rule in a recapitalization qualifying under section 368(a)(1)(E) is that no gain or loss is recognized by the recapitalized corporation.2 For the shareholders involved, similar tax-free treatment usually applies, provided stock or securities are exchanged solely for stock or securities.3 If cash or property (other than stock or securities) is received by a shareholder in the exchange, such amount is treated as boot, and is taxable to the extent of the greater of the total gain realized or boot received.4 Finally, shareholders generally receive a basis in the stock or securities received equal to the basis in the stock or securities exchanged, although there are certain basis adjustments that apply when boot is also received.5
Cancelled stock in a recapitalization
As described above, a transaction qualifying as a recapitalization under section 368(a)(1)(E) generally is tax-free to the corporation and its shareholders. For example, corporation X has three shareholders, A, B and C. Shareholders A and B each hold preferred stock, while C holds common stock. For valid business reasons, A and B exchange their preferred stock for new common stock, and C exchanges his old common stock for new common stock, such that corporation X only has the new common stock outstanding after the transaction. The transaction qualifies as a tax-free recapitalization to both corporation X and the shareholders, assuming all requirements for treatment under section 368(a)(1)(E) are met.
Now, consider the above example, but instead shareholder A holds both common and preferred stock, as well as a long-term note. Corporation X cancels A’s common stock, exchanges A’s existing preferred stock for new common stock, and satisfies the long-term note with new common stock. Despite the transaction still qualifying as a tax-free recapitalization, shareholder A might want a loss deduction for the common stock that was cancelled. However, is it appropriate for shareholder A to claim a loss in such a scenario?
The answer, at least in the past, may have depended on the jurisdiction of the taxpayer. Circuit Courts had differing views on whether losses could be claimed on stock surrenders,6 until the U.S. Supreme Court settled this Circuit Court split in Commissioner v. Fink.7 In Fink, the Court held that a loss deduction was not allowed for surrendered stock where no consideration was received, because the stockholder retained a controlling ownership interest in the corporation.8 Instead, the basis of the surrendered shares was reallocated to the basis of the retained shares.9 Therefore, any loss deduction for surrendered shares is deferred until the stockholder disposes of all of his shares.
The IRS looked at a very similar situation to that of Fink, and released a private letter ruling (PLR) addressing the tax treatment of the transaction.10 In the PLR, a corporation’s shareholders held both preferred and common stock, as well as secured notes. To simplify its capital structure, the corporation cancelled the existing common stock and the existing notes, and exchanged the existing preferred stock for new common stock. The IRS held that the cancellation of the existing common stock and notes was part of the broader recapitalization under section 368(a)(1)(E), and therefore no gain or loss was recognized by the shareholders (or the corporation). The ruling relied on the representation that the fair market value (FMV) of the newly issued common stock was substantially equal to the FMV of both (i) the existing common stock and notes cancelled, and (ii) the preferred stock exchanged to common stock. Additionally, the basis of the new common stock received was the same as the basis of the cancelled common stock, the exchanged preferred stock, and cancelled notes, instead of just the exchanged preferred stock. Since the issued stock took the combined basis of the exchanged and canceled stock and notes, instead of just the exchanged preferred stock, it implies that the new common stock was issued, in part, as consideration for the cancelled common stock, too. Therefore, a claim for a loss deduction for the cancelled stock appears incorrect, as it is likely viewed as surrendered in exchange for the consideration issued in the recapitalization.
Conclusion
While a shareholder may want to claim a loss deduction for cancelled or surrendered stock, in some situations no loss is allowed for stock that is cancelled as part of a larger recapitalization transaction that qualifies under section 368(a)(1)(E). Instead, the basis of the cancelled stock carries over into the basis of the new stock issued, and the overall transaction is generally tax-free to the shareholder.
1 See Helvering v. Sw. Consol. Corp, 315 U.S. 194, 202 (1942).
2 Section 1032(a). However, corporations undergoing recapitalizations can realize cancellation of debt income under various rules in section 108(e).
3 Section 354(a)(1). Note that gain or loss is recognized to the shareholder on the receipt of securities to the extent that the principal amount of the securities received exceeds the principal amount of the securities surrendered. Section 354(a)(2)(A)(i).
4 Section 356(a)(1).
5 Section 358(a).
6 See e.g., Fink v. Comm’r, 789 F.2d 427 (6th Cir. 1986) (adopting the fragmentary view, where each share of stock is considered a separate investment, and a shareholder is entitled to an immediate ordinary loss upon the surrender of some shares); Schleppy v. Comm’r, 601 F.2d 196 (5th Cir. 1979) (adopting the unitary view, where shares are viewed as a single indivisible property unit, and therefore a shareholder cannot recognize gain or loss until the disposition of all of his shares); Frantz v. Comm’r, 784 F.2d 119 (2d Cir. 1986) (adopting the unitary view).
7 483 U.S. 89 (1987).
8 Comm’r v. Fink, 483 U.S. 89, 99 (1987).
9 Id.
10 See PLR 7734053 (May 26, 1977).
