Revenue Ruling 83-28: Tax-Free Recapitalizations
Learn how Revenue Ruling 83-28 provides a framework for structuring a corporate recapitalization to defer a shareholder's tax on a stock exchange.
Revenue Ruling 83-28 from the Internal Revenue Service (IRS) addresses a scenario where a shareholder exchanges stock for a different type of stock within the same corporation. It clarifies how such a transaction can qualify as a recapitalization, allowing the exchange to occur without creating an immediate tax bill for the shareholder. This guidance helps in structuring these exchanges to defer potential tax liabilities.
Conditions for a Tax-Free Recapitalization
For a stock exchange to receive tax-free treatment, it must qualify as a corporate reorganization defined under Internal Revenue Code Section 368 as a “recapitalization.” A primary condition is that the exchange must be confined to a single corporation, where a shareholder swaps their shares for a new set from that same entity. The transaction must be driven by a legitimate corporate business purpose.
Common examples of a valid business purpose include simplifying a company’s capital structure, perhaps by eliminating a class of stock, or shifting voting control among different shareholder groups. The ruling confirms that an isolated transaction involving a single shareholder can qualify if these conditions are met, as the shareholder is continuing their investment in a modified form.
Tax Consequences for the Shareholder
When a stock exchange qualifies as a tax-free recapitalization, the shareholder does not recognize a taxable gain or a deductible loss at the time of the exchange. This is true even if the fair market value of the new shares received is greater than the cost of the old shares surrendered. This deferral does not eliminate the tax liability indefinitely, as the tax implications are postponed until the new shares are eventually sold.
A concept governing this outcome is the “substituted basis” under IRC Section 358. The shareholder’s original cost basis in the shares they gave up is transferred to the new shares they receive. For example, if an investor’s original shares had a basis of $1,000, the new shares will also have a basis of $1,000. The holding period of the original stock is tacked onto the holding period of the new stock, which is important for determining whether a future sale results in a short-term or long-term capital gain.
Required Tax Return Disclosures
Documenting a tax-free recapitalization is a procedural requirement for both the shareholder and the corporation. Federal tax regulations mandate that a detailed statement be attached to the income tax returns of all parties for the year in which the exchange took place. Failure to include this statement can draw scrutiny and potentially jeopardize the tax-free status of the exchange.
The required statement must contain specific information as outlined in Treasury Regulation 1.368-3. It needs to provide a clear description of the transaction, including the date and parties involved. The shareholder must report the cost basis and fair market value of the stock surrendered, as well as the fair market value of the stock received. Both parties must also include a declaration confirming the exchange qualifies as a tax-free reorganization.