Rev. Rul. 77-238

Advice has been requested concerning the Federal income tax consequences, in the situations described below, upon the conversion of common stock of a corporation into preferred stock of the same corporation and upon the conversion of preferred stock of a corporation into common stock of the same corporation.

Situation 1.

Corporation X is engaged in a manufacturing business and has shares of voting common stock and shares of nonvoting preferred stock outstanding. All the common stock is owned by employees of X. The certificate of incorporation requires that the shareholders of X convert their common stock into preferred stock at a specified exchange rate upon their retirement from X, or have the stock redeemed for cash. The taxpayer, a retiring employee of X, exchanged the X common stock for X preferred stock of equal value pursuant to the conversion privilege. The purpose of the conversion privilege is to eliminate common stock ownership by retiring employees and to reduce the cash expenditures by X that would otherwise result if the common stock of retiring employees were redeemed for cash.

Situation 2.

Corporation Y is engaged in a manufacturing business and has shares of voting common stock and shares of nonvoting preferred stock outstanding. The certificate of incorporation gives the shareholders of Y the right to convert their preferred stock into common stock at a specified exchange rate. The taxpayer, pursuant to the conversion privilege, exchanged preferred stock for Y common stock of equal value. The purpose of the conversion privilege is to encourage the conversion of preferred stock into common stock in order to simplify the capital structure of the corporation by eliminating the preferred stock.

Section 368(a)(1) of the Internal Revenue Code of 1954, in defining the term "reorganization," includes a recapitalization as one of the kinds of transactions so defined.

Section 1.368-2(e) of the Income Tax Regulations provides, in part, that a transaction involving the exchange of common stock for preferred stock of the same corporation and a transaction involving the exchange of preferred stock for common stock are recapitalizations within the meaning of section 368(a)(1)(E) of the Code.

Section 354(a)(1) of the Code provides, in part, that no gain or loss will 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 a corporation a party to the same reorganization.

Section 1.368-1(c) of the regulations provides that the nonrecognition provisions of the Code relating to exchanges pursuant to reorganizations defined in section 368(a)(1) of the Code are not applicable unless the exchanges are in pursuance of a plan of reorganization.

Section 1.368-2(g) of the regulations provides that the transaction embraced in a plan of reorganization must not only come within the specific language of section 368(a) of the Code, but the readjustments involved in the exchange or distributions effected in the consummation thereof must be undertaken for reasons germane to the continuance of the business of a corporation a party to the reorganization.

The conversions of stock in Situation 1 were in furtherance of a corporate business purpose to encourage the conversion of common stock into preferred stock thereby permitting the corporation to use the cash that would otherwise be expended to redeem the common stock for other business purposes, and were pursuant to a continuing plan of reorganization represented by the conversion privilege embodied in the certificate of incorporation. Likewise, the conversions of stock in Situation 2 were in furtherance of a corporate business purpose to simplify the capital structure, and were in pursuance of a plan of reorganization. See Rev. Rul. 56-179, 1956-1 C.B. 187.

Accordingly, the exchanges of stock in Situation 1 and Situation 2 pursuant to the conversion privileges involved are reorganizations within the meaning of section 368(a)(1)(E) of the Code. Under section 354(a)(1), no gain or loss is recognized to the taxpayers involved upon the exchanges of stock pursuant to the conversion privileges.

Compare Rev. Rul. 72-265, 1972-1 C.B. 222, regarding the exercise of the conversion privilege provided for in a corporate debenture.