Rev. Rul. 56-586

Advice has been requested as to the tax effect of an exchange by certain majority shareholders of outstanding preferred stock and accrued dividends in arrears thereon for new preferred stock under the circumstances describe below.

A certain corporation had preferred and common stock outstanding All of the common stock was held equally by two brothers; namely C and D . Of the outstanding preferred stock, C and D , and their wives and children, owned 83 percent; a third brother and his children owned 7 percent; and the remaining ten percent stock interest was owned by members of the general public.

The preferred stock had a redemption or liquidation value of 45 X dollars per share. Such stock was entitled to cumulative dividends at the rate of 2 x dollars a share per year, and to equal voting rights with the holders of the common stock. No dividends had been paid on the preferred stock since it was issued in 1946. Dividend arrearages amounted to 20 x dollars per share. The corporation was unable to redeem all of the outstanding preferred shares for cash since it needed working capital and funds to continue its expansion. Further, it has outstanding a long-term debt of $2,300 x dollars owed to a bank under an agreement prohibiting the payment of any dividends without the bank's consent. The corporation operated under a line of credit with such bank for 3,000 x dollars to cover its short-term needs. The corporation's balance sheet reflected total current assets of $10,000 x dollars and earned surplus of 3,800 x dollars.

Pursuant to a plan, the shares of outstanding preferred stock held by C and D and members of their immediate families were exchanged for new subordinated preferred shares. The remaining preferred shares were redeemed for cash. In the exchange, C and D and the members of their immediate families had the option to exchange their preferred shares with accrued dividends therein for an equal number of new preferred shares of either of the following classes:

Class A: Nonvoting redeemable preferred stock having a 65 x par value and redemption and liquidation price, and being entitled to cumulate dividends from the date of the exchange at the rate of 2 x dollars per annum.

Class B: Nonvoting subordinated redeemable preferred stock having a par value of 65 x dollars, a redemption and liquidated price of 75 x dollars, and being entitled to non-cumulative dividends from the date of exchange at the rate of 3 x dollars per annum.

C and D and their wives elected to receive Class B shares and their children elected to receive Class A shares. The Class A shares were put on a current dividend basis, and there was no present intention of redeeming any portion of either of the two classes of new preferred stock.

The reason for issuing the new subordinated shares was that under a statute of the state of incorporation, it would have been necessary to redeem the old preferred stock in the entirety, by lot, or pro rata. The reason that two new classes of preferred shares were desired was to permit the corporation to pay currently all dividends on shares entitled to cumulative dividends without seriously impairing the working capital of the corporation or the ability to meet its obligations as they become due. Also, the management of the corporation had been advised and believed that it would be improper to issue non-cumulative preferred to the children of C and D . These children received their shares by gift from their parents, extending over the past ten years, and had no common stock interest in the corporation.

In view of the foregoing, the Internal Revenue Service holds that the exchanges of the old preferred stock and accrued dividends thereon for the new nonvoting Class A or Class B preferred stock constitute a recapitalization and, accordingly, a reorganization as defined in section 368(a)(1)(E) of the Internal Revenue Code of 1954 in which no gain or loss is recognized from the exchanges under section 354(a)(1) of the Code. Under section 358(a)(1) of the Code, the basis of the preferred stock received is the same as the basis of the preferred stock exchanged therefor. Such exchanges do not diminish the corporation's earnings and profits available for dividends within the meaning of section 316(a) of the Code. The new preferred stock will be treated as `section 306 stock,' as defined in section 306(c) of the Code, to the extent that cash, if received in lieu of such stock, would have been treated as a distribution to which section 301 of the Code applies by reason of the provisions of section 356(a)(2) of the Code.

The amount received by the minority preferred shareholders in redemption of their preferred stock in each instance is treated as in full payment in exchange for the stock, in accordance with the provisions of section 302(a) of the Code, to the extent that the amount received in exchange for the stock is not in excess of its fair market value as of the date of redemption. Under section 1001 of the Code, gain or loss is recognized upon the exchanges, measured by the difference between the amount received for the stock and the cost or other basis of the stock, to the extent that the amount received for the stock is not greater than its fair market value as of the date of redemption. Such gain or loss constitutes a capital gain or loss subject to the provisions and limitations of Part III of Subchapter P of the Code.