Recap risks: Tax traps in swapping preferred for common stock

This article highlights a potential tax pitfall that may occur during an otherwise tax-free recapitalization transaction. Where preferred stock, with dividends in arrears, is exchanged for common stock in a recapitalization, there is potential for the exchanging preferred stockholders to recognize taxable dividend income.

Introduction

Corporate shareholders exchanging one class of stock for another in a corporate recapitalization generally do not recognize taxable gain or loss. However, recapitalizations of preferred stock into common stock may generate taxable dividend income for the shareholders.

Recapitalizations generally

Corporate recapitalizations generally qualifying for tax free treatment in the Code,¹ specifically under section 368(a)(1)(E), are broadly defined as a "reshuffling of a capital structure within the framework of an existing corporation."² Qualifying recapitalizations can include exchanges of preferred stock for common stock, as well as various other exchanges of stock or securities issued by a single corporation.³

Shareholders who participate in a recapitalization typically receive tax-free treatment, provided they exchange their stock or securities for new stock or securities of equivalent value issued by the same corporation.⁴ However, there are important exceptions where gain is recognized:

• Holders of stock or securities will recognize gain or loss if the principal amount of the securities they receive exceeds the principal amount of the securities they surrendered.⁵
• Similarly, if holders of stock or securities receive stock or securities with value that exceeds the value of the stock of securities they exchanged, the excess generally would be treated as having been used for whatever the purpose the facts indicate. For example, the excess may represent compensation for services.⁶
• If holders of stock or securities receive cash or property other than stock and securities in the exchange (i.e., “boot”), their gain realized (if any) is taxable, but the taxable amount cannot exceed the amount of boot received.⁷

In the context of a tax-free recapitalization, shareholders generally maintain the same tax basis in the new stock or securities as they had in the stock or securities they exchanged. However, basis adjustments may be necessary if boot is also received.⁸

Deemed distributions in a preferred stock recapitalization

Recapitalizations can lead to situations where shareholders receive stock that is treated as a distribution with respect to stock—a distribution that may represent a taxable dividend. 

To determine whether distribution treatment is applicable, two of the main factors considered are whether:

• The recapitalization is part of a deliberate plan to periodically increase a shareholder's proportionate interest in the corporation's assets or its earnings and profits; or
• A shareholder who owns preferred stock with dividends in arrears exchanges this stock for other stock, thereby increasing their proportionate interest in the corporation's assets or earnings and profits.⁹

Issuing new stock to shareholders corresponding to accrued dividends (or dividends in arrears) on preferred stock is viewed under the regulations as an increase in shareholders’ proportionate interest giving rise to a deemed distribution.¹⁰

When calculating the amount of distribution attributable to a shareholder whose proportionate interest has increased due to a recapitalization, the regulations specify that the amount is the lesser of two values:

• The excess of the fair market value or liquidation preference of the stock received over the issue price of the preferred stock surrendered, or
• The total amount of dividends in arrears.¹¹

This approach ensures that shareholders cannot bypass the recognition of dividends in arrears by exchanging their preferred stock for new stock that does not pay dividends. Instead, they are treated as receiving a deemed distribution to the extent of the unpaid dividends.

Examples

Consider a shareholder that exchanges in a recapitalization preferred stock originally purchased for $1000 and carrying $200 of accrued dividends (dividends in arrears). If the shareholder receives $1200 worth of new stock, that shareholder has received a deemed distribution of $200 from the corporation. Regulations illustrate this result in an example.¹²

What if other shareholders contemporaneously receive stock so the that the exchanging shareholder own proportionately less of the corporation’s stock when the dust has settled? Would that change the result?   

Consider this scenario: Investor X, the sole shareholder of Corporation D, holds preferred¹³ stock with an issue price of $1,000 and $200 of accrued dividends (dividends in arrears). In a new round of financing, X's preferred shares are converted into new common stock valued at a fair market value (FMV) of $1,200, while new investors purchasing new preferred stock are introduced. Does the introduction of new investors, which seems to dilute X's overall proportionate interest in Corporation D, change the deemed distribution result?

The answer is no; a deemed distribution still results. The key to understanding the tax implications lies in how a shareholder's proportionate interest in the corporation is measured. The regulations explain that an increase in a preferred shareholder's proportionate interest is occurs in any scenario where the FMV or liquidation preference, whichever is greater, of the stock received post-recapitalization exceeds the issue price of the surrendered preferred stock.¹⁴ Following a literal reading of the regulation, this means that despite no increase, or even dilution, in ownership percentage due to recapitalization, a shareholder can still experience an increase in their ‘proportionate interest’ for the purposes of section 305(c) stock distribution.

Are deemed distributions dividends?

Whether dividend income must be recognized by shareholders receiving deemed distributions from a corporation in a recapitalization depends on the corporation’s earnings and profits (E&P). E&P is a federal income tax measure of earnings. A deemed distribution (like corporate distributions generally) is treated as:

• A dividend, to the extent the corporation has made the distribution out of accumulated E&P (prior years’ E&P) or current E&P (current year E&P computed as of the close of the year),
• A return of capital, to the extent the distribution (i) was not made out of the corporation’s E&P and (ii) does not exceed the shareholder’s tax basis in its stock, and
• Gain (generally capital gain), to the extent the distribution (i) was not made out of the corporation’s E&P and (ii) exceeds the shareholder’s tax basis in its stock.¹⁵

Summary

In a recapitalization of preferred stock for new common stock, the existence of accrued dividends can result in a deemed a distribution to the preferred shareholders that may be characterized as a taxable dividend. Companies sometimes look to recapitalize by converting existing preferred stock into new common in a dilutive cram-down. In these situations, it’s important to look at the possibility of section 305(c) distribution treatment.

_{¹ All section references are to the Internal Revenue Code of 1986, as amended (the Code), or to Treasury Regulations.}

_{² Helvering v. Southwest. Consol. Corp, 315 U.S. 194 (1942).}

_{³ Reg. sections. 1.368-2(e)(2); 1.368-2(e)(4).}

_{⁴ Section 354(a)(1).}

_{⁵ Section 354(a)(2)(A)(i).}

_{⁶ See Rev. Rul. 74-269, 1974-1 C.B. 87.}

_{⁷ Section 356(a).}

_{⁸ Section 358(a).}

_{⁹ Reg. section 1.305-7(c).}

_{¹⁰ Reg. section 1.305-5(d), Ex. 1.}

_{¹¹ Reg. section 1.305-7(c)(2).}

_{¹² Reg. section 1.305-5(d), Ex. 1.}

_{¹³ The definition of “preferred stock” for purposes of section 305 is outside the scope of this article.}

_{¹⁴ Reg. section 1.305-7(c)(1)(ii).}

_{¹⁵ Sections 301(c) and 316(a). The deemed distribution amount typically would also be deemed recontributed by the shareholder to the corporation, requiring a corresponding adjustment to the shareholder’s tax basis in the stock. Thus, for example, a deemed distribution amount treated entirely as a return of capital would be treated as deemed distributed and recontributed and the tax basis decrease and increase attributable to the deemed distribution and contribution respectively would offset one another.}