Rev. Rul. 83-119

ISSUE

In a recapitalization where a corporation issues preferred stock that must be redeemed on the holder's death at the price in excess of one hundred and ten percent of the issue price, is the amount of the excess redemption premium treated, by reason of section 305(c) of the Internal Revenue Code, as a distribution with respect to preferred stock within the meaning of section 305(b)(4)? If so, when is this distribution deemed to be received?

FACTS

A domestic corporation, X, had outstanding 100 shares of common stock. A owned 80 shares of the X common stock and B, A's child owned the other 20 shares. A was actively engaged in X's business as its president, and B was a key employee. A retired from the business and resigned as a director, officer, and employee of X with no intention to take part in the future activities of X. Pursuant to a plan of recapitalization for the purpose of transferring control and ownership of the common stock to B in conjunction with A's retirement, a single class of nonvoting, dividend paying preferred stock (as defined in section 1.305-5(a) of the Income Tax Regulations) was authorized. There are no redemption provisions with regard to the preferred stock, except that on the death of a shareholder of the preferred stock, X is required to redeem the preferred stock from the shareholder's estate or beneficiaries at its par value of 1,000x dollars per share. On January 1, 1981, A had a life expectancy of 24 years determined by using the actuarial tables provided in section 1.72-9 of the regulations. On January 1, 1981, A exchanged 80 shares of common stock for 80 shares of preferred stock. Following this exchange, A held all of the preferred stock, and B held all of the common stock that X then had outstanding.

On the date of the exchange the X common stock surrendered had a fair market value of $1,000x dollars per share, and the X preferred stock had a par value of $1,000x dollars per share. The one-for-one exchange ratio resulted because the par value of the preferred stock was presumed to represent its fair market value. However, the fair market value of the preferred stock was only 600x dollars per share. See Rev. Rul. 83-120, page 170, this Bulletin, for factors taken into account in valuing common and preferred stock. Thus, A surrendered X common stock with a fair market value of 80,000x dollars (80 x 1,000x dollars) in exchange for X preferred stock with a fair market value of 48,000x dollars (80 x 600x dollars).

The exchange of all of A's X common stock for X preferred stock is a recapitalization within the meaning of section 368(a)(1)(E) of the Code. Under section 354, no gain or loss will be recognized to A with regard to the receipt of the preferred stock to the extent of its 48,000X dollars fair market value. However, the 32,000x dollars excess in the fair market value of the X common stock surrendered by A as compared to the fair market value of the preferred stock A received will be treated as having been used to make a gift, pay compensation.

Satisfy obligations of any kind, foul or for whatever purposes the facts indicate. Section 356(f) of the Code and Rev. Rul. 74-269, 1974- 1 C.B. 87.

LAW AND ANALYSIS

Section 305(a) of the Code provides generally that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock except as otherwise provided in section 305(b) or (c).

Section 305(b)(4) of the Code provides, in part, that section 305(a) will not apply to a distribution by a corporation of its stock, and the distribution will be treated as a distribution of property to which section 301 applies, if the distribution is with respect to preferred stock.

Section 305(c) of the Code provides, in part, that the Secretary shall prescribe regulations under which a difference between issue price and redemption price will be treated as a distribution with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by the transaction. Section 1.305-7(a) of the regulations provides, under the authority of section 305(c), that an unreasonable redemption premium on preferred stock will be treated in accordance with section 1.305-5.

Section 1.305-5(b)(1) of the regulations provides that if a corporation issues preferred stock which may be redeemed after a specific period of time at a price higher than the issue price, the difference will be considered under the authority of section 305(c) of the Code to be distribution of additional stock on preferred stock (section 305(b)(4)) constructively received by the shareholder over the period of time during which the preferred stock cannot be called for redemption. However, section 1.305-5(b)(2) states that section 1.305-5(b)(1) will not apply to the extent that the difference between issue price and redemption price is a reasonable redemption premium, and that a redemption premium will be considered reasonable if it is in the nature of a penalty for the premature redemption of the preferred stock and if such premium does not exceed the amount the corporation would be required to pay for the right to make such premature redemption under market conditions existing at the time of issuance. Section 1.305-5(b)(2) also states that a redemption premium not in excess of 10 percent of the issue price on stock which is not redeemable for five years from the date of issuance shall be considered reasonable.

Section 1.305-7(a) of the regulations provides, in part, that a change in conversion ratio, a change in redemption price, a difference between redemption price and issue price, a redemption which is treated as a distribution to which section 301 applies, or any transaction (including a recapitalization) having a similar effect on the interest of any shareholder will be treated as a distribution to which sections 305(b) and 301 apply if (1) the proportionate interest of any shareholder in the earnings and profits or assets of the corporation deemed to have made such distribution is increased by such transaction, and (2) such distribution has the result described in paragraph (2), (3), (4), or (5) of section 305(b).

Section 1.305-3(e), Example (12), of the regulations illustrates a situation where section 305 does not apply to exchanges of stock in a recapitalization that is a "single and isolated transaction". However, section 1.305-7(c)(1) of the regulations provides that a recapitalization, whether or not an isolated transaction, will be deemed to result in a distribution to which section 305(c) of the Code and section 1.305-7 of the regulations apply, if, among other things, it is pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation.

One element which is necessary to taxability under sections 305(b) and (c) is that there must be a distribution. Regarding this requirement, section 305(b) deals with actual distributions, and section 305(c) deems certain transactions which are not actual distributions to be distributions for section 305 purposes. Certain recapitalizations, even if isolated, are treated as distributions under regulations section 1.305-7(c). That is, an actual exchange of stock, even though clearly isolated, can be treated as a distribution if the exchange is pursuant to a larger plan to periodically increase a shareholder's proportionate interest. Section 1.305-5(c) of the regulations provides, "For rules for applying sections 305(b)(4) and 305(c) to recapitalizations, see section 1.305-7(c)". This means that section 1.305-7(c) of the regulations is the rule used to impose section 305(b)(4) and (c) of the Code on an exchange of stock which qualifies as a recapitalization. However, it does not mean that section 1.305-7(c) must be found to be applicable to a transaction in order for any deemed distribution which may result from the transaction to be subject to section 305(b)(4) and (c) and the regulations thereunder.

Although an exchange of stock in an isolated recapitalization would not in itself result in section 305(b) and (c) applicability, the terms of the preferred stock used in the exchange may result in this applicability. The difference between issue price and redemption price (section 1.305-7(a) of the regulations) and the fact that the stock cannot be called for redemption for a specific period of time (section 1.305-5(b) of the regulations) are the factors which combine to produce a deemed distribution. The imposition of tax results from the deemed distribution of additional preferred stock over the period the stock cannot be called or presented for redemption.

Section 1.305-5(d), Example (7), of the regulations describes the proper treatment of preferred stock issued pro rata to the holders of a corporation's common stock. The fair market value of the preferred stock immediately after its issuance was 50x dollars. The preferred stock is redeemable at the end of five years for 105x dollars per share. There is no evidence that a call premium in excess of 5x dollars per share is reasonable. The 50x dollars excess of the call premium (55x dollars) minus the deemed reasonable premium (5x dollars) is considered to be a distribution of additional stock on preferred stock to which sections 305(b)(4) and 301 of the Code apply. This 50x dollar excess is considered to be distributed to the shareholders ratably over the five year period.

In the present situation, X common stock was exchanged by A for X preferred stock. Since the exchange was not part of a plan to periodically increase a shareholder's proportionate interest, the recapitalization itself did not result in a deemed distribution. However, the preferred stock will be redeemed by X on the death of a shareholder at a price of 1,000x dollars per share. Since the preferred stock had a fair market value of 600x dollars per share on the date of issuance, the preferred stock has a redemption premium of 40 dollars per share. There is no evidence that a call premium in excess of 60x dollars was reasonable. Because (1) the X stock is closely held, (2) no public offerings are planned, (3) the X stock is held by members of a family group within the meaning of section 318(a), and (4) the stock is not readily marketable, it is presumed that, at the time of the exchange, the shareholders intended that A would not transfer the preferred stock, and, therefore, redemption would occur upon A's death. Although the exact duration of A's life is not yet known, A's life is "a specified period of time" within the meaning of section 1.305-5(b)(1) of the regulations. Because A has a life expectancy of 24 years, the 400x dollar redemption premium on the X preferred stock has substantially the same effect as a 400x dollar redemption premium payable at the end of a fixed term of 24 years.

HOLDING

The recapitalization in which X issues X preferred stock that must be redeemed on the shareholder's death at a price (1,000x dollars) which exceeds the issue price (600x dollars) results in the recipient, A, being deemed to receive a distribution of additional stock with respect to preferred stock, within the meaning of section 305(b)(4) of the Code, by reason of section 305(c), in the amount of 340x dollars (400x dollars less a deemed reasonable redemption premium of 60x dollars) on each share of preferred stock. This amount will be constructively received ratably (14.16x dollars per share per year) over A's life expectancy of 24 years, and will be treated as a distribution to which section 301 applies. If A should die earlier, any part of the 340x dollars per share not yet constructively received by A would be deemed received at the time of A's death.