LBO Primer: Recapitalizations

By Joseph W. Bartlett, Of Counsel, Sullivan & Worcester LLP

Recapitalizations accomplish several of the purposes of a leveraged buyout except for an entire change in ownership. Thus, existing shareholders retain a share of the value inherent in the leveraging process the upside potential when, as and if acquisition debt is paid down from post-closing cash flows and asset sales. Since the proceeds of leverage are distributed to existing shareholders, the most common tax issues have to do with the nature of those distributions as dividends taxable as ordinary income without recovery of the shareholder's basis^[1] versus a payment in redemption and, therefore, a capital transaction with basis taken into account. A payment purportedly redeeming out existing shareholders is not reclassified as a dividend under § 302(b) if the shareholder becomes or remains a minority holder after the redemption and reduces his percentage of ownership to less than 80% of what it was prior to the redemption.^[2] A recapitalization in which the Target shareholders are to be essentially cashed out, retaining only so-called "stub" securities, can obviously be structured so that each shareholder actually exchanges stock and reduces his interest by the required percentage. (Note that a 50% reduction in interest will usually limit the future availability of NOLs under § 382.)

A recapitalization may entertain ambitions to qualify as an E-type reorganization under § 368(a)(1)(E), entailing an exchange of stock for stock which is tax postponed under § 354. A recapitalization can be a good E-type without reference to the "continuity of interest" and "continuity of business enterprise" rules, since only one corporation is involved.^[3] However, there is often not much hanging (under today's rules) on the difference between an LBO-type recapitalization which is taxable and one that is not. The boot cash and/or notes will be taxable to the Target shareholders in either event (although taxation of the notes may be deferred). Nonetheless, there can be advantages to paying tax under § 356 versus § 302 in that § 356 taxes the lesser of the selling shareholder's realized gain or the value of the boot while § 302 taxes realized gain. There are, in addition, very sophisticated techniques (beyond the scope of the Text) for utilizing E-type (sometimes combined with F-type) reorganizations in tax minimization schemes, prompted by the fact that the breadth of § 368(a)(1)(E) is still unclear to this day.

^[1] If the issuer has no earnings and profits, basis is recovered under § 301 (c)(2).

^[2]§ 302(b)(2)(C).

^[3] Rev. Rul. 82-34, 1982-1 C.B. 59; Rev. Rul. 77-415,1977-2 C.B. 311.