Rev. Rul. 77-479

Advice has been requested whether the recapitalization described below qualifies as a reorganization under section 368(a)(1)(E) of the Internal Revenue Code of 1954 when part of the stock received in the recapitalization is sold pursuant to a prearranged plan.

Individuals A and B each owned one half of each class of the outstanding stock of Z corporation, which consisted of 50,000 shares of voting common stock and 50,000 shares of nonvoting preferred stock. Under a plan to offer some of the Z stock to the public, A and B made arrangements with an investment broker for a secondary offering of 80 percent of their stock. To facilitate the sale by making the stock a more attractive investment, the broker suggested that the existing common and preferred stock be converted into one new class of common stock. Thus, Z effected a recapitalization in which all of its outstanding shares of common and preferred stock were exchanged by A and B for shares of one new class of voting common stock of Z on a share-for-share basis. A and B each then sold 40,000 shares of the new voting common stock to the public through the broker.

Section 368(a)(1)(E) of the Code provides that a "recapitalization" is a "reorganization". For this purpose a recapitalization has been defined as a "reshuffling of a capital structure within the framework of an existing corporation". Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942), 1942-1 C.B. 218.

Section 354(a)(1) of the Code provides, in part, that no gain or loss will be recognized if stock in a corporation a party to the reorganization is, in pursuance of the plan of reorganization, exchanged solely for stock in such corporation.

Section 1.368-1(b) of the Income Tax Regulations provides, in general, that requisite to a reorganization is a continuity of interest in the business enterprise on the part of those persons who were the owners of the enterprise prior to the reorganization.

The exchange by A and B of their common and preferred stock for new common stock meets the definition of a reorganization under section 368(a)(1)(E) of the Code. However, when a shareholder receives stock in a reorganization described in section 368(a)(1) and any of the stock received is disposed of pursuant to a prearranged plan, a question arises whether the continuity of interest requirement for a recorganization is satisfied. See Rev. Rul. 66-23, 1966-1 C.B. 67.

In Rev. Rul. 77-415, 1977-2 C.B. 311, a shareholder who owned only preferred stock in a corporation exchanged all of this stock for bonds of the corporation pursuant to a plan of recapitalization. Rev. Rul. 77-415, states, consistent with several court decisions, that the continuity of interest requirement need not be applied to a recapitalization under section 368(a)(1)(E) of the Code because the considerations that make the continuity of interest requirement necessary in acquisitive reorganizations are not present in recapitalizations involving a single corporation. Thus, Rev. Rul. 77-415 concludes that the transaction was a recapitalization under section 368(a)(1)(E) even though the shareholder did not retain a proprietary interest in the corporation.

Accordingly, since continuity of interest is not required for the recapitalization of Z to qualify as a reorganization described in section 368(a)(1)(E) of the Code, the subsequent sale by A and B of the stock received by them as a result of the recapitalization does not affect the qualification of the transaction as a reorganization under section 368(a)(1)(E). Therefore, no gain or loss is recognized to A or B on the exchange of their common and preferred Z stock for new Z common stock pursuant to section 354(a). The basis to A and B of the new common stock is the same as the basis of the Z common and preferred stock exchanged therefor pursuant to section 358(a). Any gain realized or loss sustained by A or B upon the sale of the new Z stock to the public is recognized to them pursuant to section 1001.