Rev. Rul. 56-654

Advice has been requested as to the effect, for Federal income tax purposes, of an amendment by a corporation of its articles of incorporation to change the provisions of its preferred stock, as indicated below.

The corporation had outstanding 20 x shares of $10 par value preferred stock and 100 x shares of $1 par value common stock at the time the transaction in question was carried out. The outstanding stock was owned by three individuals, each shareholder's proportionate ownership of the preferred shares being equal to his proportionate ownership of the common shares. As of a specified date a few months preceding the charter amendment, the accumulated earnings and profits of the corporation amounted to approximately 6,600 x dollars, and the excess of the value of the corporation's properties over the adjusted basis of such properties was about 2,350 x dollars.

In order to reduce the value of its common stock to a figure approximating its par value, the corporation amended its articles of incorporation to provide that, in the event of the redemption of the preferred stock or upon liquidation, the amount per share which the holders of the preferred stock would be entitled to receive would be an amount which, in the aggregate, would equal the net worth of the corporation (including the appreciation in the value of the assets) as of the specified date referred to above. No additional shares were issued in connection with the amendment.

The change in the provisions of the preferred stock was made in order that a ten percent interest in the common stock could be sold by the shareholders to one of the corporation's officers at a price he could afford to pay. The change also eliminated any possibility of the new shareholder participating in the accumulated profits of the business or the appreciation in the value of the corporation's assets prior to the time he became a stockholder.

Under the circumstances here presented, the change in the outstanding stock is so substantial as to constitute, in substance, an exchange of the preferred stock and a portion of the common stock for new preferred stock in a recapitalization of the corporation. The portion of the common stock deemed to be exchanged is considered to be based on the relative values of the common stock before and after the transaction. The charter amendment is deemed as effective to accomplish this recapitalization as the actual issuance of new certificates in exchange for the outstanding certificates. The recapitalization constitutes a reorganization under section 368(a)(1)(E) of the Internal Revenue Code of 1954. No gain or loss is recognized to the shareholders on the exchange in view of section 354(a)(1) of the Code, which provides as follows:

(a) GENERAL RULE.-

(1) IN GENERAL.-No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

The amendment does not affect the amount of earnings and profits of the corporation available for the distribution of subsequent dividends. Upon the redemption or other disposition of the preferred stock, reference should be made to sections 302 and 306 of the Code.