What is a recapitalization?
Recapitalization occurs when a corporation reorganizes its ownership structure. For instance, it may divide its stock into two classes: preferred stock and common stock. Preferred stock provides certain advantages and priorities over common stock, which may include a higher dividend rate, preference in the payment of dividends, liquidation preference, and voting rights. After recapitalization, common stock can be made available to investors, while the owner(s) of the corporation retain(s) control of the company by keeping the preferred stock. A recapitalization can basically be described as a reshuffling or rearranging of a corporation's capital structure. While the total value of the company is not affected by recapitalization, the value of each individual share will likely change.
Example(s): Jack and Jane each own 50 of the 100 outstanding shares of Acme Corporation, which has a total value of $100,000. Thus, each share is worth $1,000. Jack and Jane decide to recapitalize Acme, creating two classes of stock. The recapitalization will create 1,000 shares of common stock with a total value of $50,000 (or $50 per share) and 100 shares of preferred stock with a total value of $50,000 (or $500 per share). Jack and Jane will keep the preferred stock and make the common stock available for purchase.
What are the advantages of recapitalization?
Raise capital through the sale of common stock
Recapitalization allows you to raise capital without taking on debt. You will give up partial ownership of your company through the sale of stock, however.
Owner(s) retain control of business
A recapitalization can allow the business owner to retain control of the business while simultaneously raising capital. In a recapitalization, you create two classes of stock: preferred stock and common stock. Preferred stock typically has voting rights, dividend rights, and/or preferential liquidation rights, which are spelled out in your articles of organization. You would keep the preferred stock, which allows you to continue running the company, and make the common stock available for purchase.
Recapitalization considered a tax-free reorganization by the IRS
A recapitalization is an exchange of a corporation's stock for other stock in the same corporation. Typically, the owner of common stock exchanges the common stock for a combination of common and preferred stock. Most recapitalizations are recognized under the Internal Revenue Code as tax-free exchanges. The owner of the common shares does not incur a tax liability when the recapitalization takes place. To qualify as a tax-free exchange, the recapitalization must have a valid business purpose. In general, as long as a corporate purpose for the recapitalization is identified, the transaction should qualify as a tax-free exchange.
What are the disadvantages of recapitalization?
Recapitalization is an extremely complex and expensive process
Recapitalizations have become extraordinarily complex and technical, thanks, in part, to the IRS. To structure and document a recapitalization, you need to hire attorneys, tax advisors, valuation experts, and other professionals to guide you through the statutory maze. Unfortunately, none of these professionals work cheaply.
Adverse tax consequences may result
Distribution of preferred stock through recapitalization may cause adverse tax consequences under Sections 305 and 306 of the Internal Revenue Code. Section 305 deals with the tax treatment of distributions by a corporation of its own stock, which may be taxable as a dividend. Section 306 applies to stock that has been distributed as a tax-free dividend to existing stockholders. Only a competent tax attorney should attempt to analyze the tax impact of recapitalization. In addition, you should be aware that an ordinary loss deduction is available only for common stock. Thus, a loss that occurs on the sale or transfer of preferred stock cannot be claimed as an ordinary loss.
Preferred stock dividends may drain the company of needed cash
In a typical recapitalization, a large, cumulative dividend has to be paid on the preferred stock to boost the value of this class of stock. For many corporations, the payment of these dividends every year may severely drain the company of needed cash. In many instances, it may not make business sense to put the future health of the company at risk just to raise capital. Furthermore, dividends payable to the preferred shareholders are not deductible by the company. Therefore, the money used to pay the dividends will be taxed twice, once at the corporate level and then when the individual receives the dividends.
S corporations may not do a recapitalization
If your business is classified as an S corporation, you cannot do a recapitalization because S corporations are prohibited from having more than one class of stock. For many companies, loss of S corporation tax treatment (which allows the shareholders to be taxed as if the company were a partnership) could be a very large disadvantage, especially since individual tax rates are lower than corporate tax rates.
How is recapitalization done?
Don't try this at home
Recapitalizations have become extremely complex and technical. There are numerous legal, tax, and valuation issues that must be addressed before, during, and after a recapitalization. Failure to follow all of the requirements can have disastrous income, gift, and estate tax consequences. Therefore, you should hire a team of experts to guide you through the entire process.
Hire competent, experienced legal counsel
You should hire a competent and experienced attorney to structure and document the recapitalization. Any attorney you hire should have extensive experience with securities and general corporate law issues. Among the other tasks in a recapitalization, new securities will have to be issued, stock certificates will have to be transferred, votes of the board of directors will have to be taken, and new shareholders will be created. All of these tasks require the assistance of an attorney.
You may have to hire a separate tax advisor
In addition to an attorney to draft all the documents needed to set up the recapitalization, a separate tax attorney or tax accountant may have to be hired to give tax advice before, during, and after the recapitalization. The tax laws governing recapitalizations are also very complex, so only an accountant or attorney who specializes in this area should be hired to give tax advice.
You may need an appraiser to value stock and other assets of company
You may also have to hire an appraiser to value the stock and assets of the company that you will recapitalize. In many cases, this appraisal can be very difficult. There is usually not a publicly traded market for closely held companies, so it may be difficult to find other similar types of companies to do a comparison appraisal. For this reason, you should use a professional appraiser experienced in corporate valuations.