Corporate recapitalizations and tax-free exchanges (IRC § 351 and § 368)

Reshaping a corporation’s capital structure can move debt to equity, realign voting power, or inject new funding without triggering immediate tax, provided the exchange meets specific continuity, control, and business-purpose requirements.

Recapitalizations under § 368(a)(1)(E) swap securities while preserving entity identity.

A corporation may convert preferred into common, common into preferred, or debt into equity without recognition of gain or loss, so long as the transaction represents a mere change in capital structure not a sale.

Shareholders receiving stock for stock or securities for securities take a carryover basis and tack holding periods. Exchanging securities for stock or vice versa counts as boot: holders recognize gain equal to the lesser of realized gain or boot value. A corporation can count its own notes as “securities” if maturity exceeds five years and issue size represents a material part of the capital stack; short-term notes act as boot.

Section 351 shelters asset transfers to controlled corporations.

No gain or loss arises when one or more transferors contribute property solely for stock and, immediately after, control the transferee (80 percent vote and value).

Liabilities assumed by the corporation do not count as boot unless they exceed aggregate basis, triggering gain under § 357(c). Stock received gains a substituted basis: contributor’s asset basis less any liabilities relieved plus gain recognized. Corporate basis equals contributor’s asset basis, preserving built-in gain for future dispositions.

Journal entry — forming subsidiary via § 351

Dr Machinery $12 000 000

Dr Patent $8 000 000

Cr Subsidiary Stock $20 000 000

No goodwill arises for tax. Book goodwill appears if fair value exceeds basis, yielding deferred-tax liability for the difference.

Boot recognition and § 361 mitigation in divisive exchanges.

In an E-recapitalization, shareholders receiving cash or short-term notes along with stock recognize gain up to boot value. The corporation may distribute boot from earnings and profits, turning part of the gain into dividend income for individuals. Re-capital formations that include parent-level assets (e.g., spin-offs) invoke § 361; the parent avoids gain if assets move solely for stock or securities and distributed property represents reorganization consideration.

Basis adjustments maintain post-deal integrity.

When shareholders surrender stock with differing bases, exchanged shares carry over basis proportionally. Debt-for-stock swaps treating debt as retired for tax record gain for the corporation to the extent principal discharged exceeds basis of its own debt. The shareholder’s basis in new stock equals basis of old debt instruments.

Example — debt-equity recap

• Bond face $5 million, adjusted basis $4 million

• Exchange for preferred shares worth $5 million

• Corporation recognizes $1 million discharge-of-indebtedness income; shareholder’s basis in preferred equals $4 million.

“Old and cold” debt avoids equity-for-debt boot.

Long-standing bona fide debt converted to stock within a recapitalization may escape § 1001 exchange gain if issue price equals adjusted issue price, yet accrued OID recognizes as interest before exchange. Treasury views debt issued within two years of recap as suspect; booking it as equity from inception prevents disallowance.

Section 304 and step-transaction doctrines guard against surplus extraction.

A recapitalization combined with intra-group sale of stock for cash may re-characterize proceeds as a dividend under § 304. Boards sequence restructurings carefully, separating true capital infusions from disguised redemptions. Multi-step deals collapsing into an overall sale will fail § 368 continuity tests, forcing gain recognition on appreciated assets.

Financial-statement impacts under ASC 470 and ASC 805.

Debt-for-equity exchanges derecognize liabilities at carrying amount; any difference to fair value reflects gain in other income, not operating profit. Equity-for-equity trades leave total equity unchanged but shift par and additional paid-in capital. Deferred-tax accounting follows basis differences between book and tax; recapitalizations themselves usually create no current tax but may reset deferred-tax balances on convertible instruments.

State-law compliance and shareholder-approval thresholds influence timing.

Some states require two-thirds vote for class-altering recapitalizations; failure can push cash settlement to dissenters, creating boot. Drafting the plan to provide solely stock or long-term notes to dissenters preserves tax-free status while meeting statutory appraisal-rights cash obligations.

Precise matching of continuity, control, and liability thresholds—along with disciplined boot management—lets corporations restructure capital efficiently under § 351 and § 368 without unplanned tax on shareholders or the entity.

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