Using recapitalization to transfer voting control to younger shareholders.

• Author: Ellentuck, Albert B.
• Position: Case study

Facts: Jane Hamilton and Peter Brown incorporated their software business five years ago as Hambro Systems, Inc. At the time of incorporation, the issuance of 100,000 shares of common stock and 50,000 shares of nonvoting preferred stock was authorized. Jane received 50,000 shares of common stock, and Peter received 30,000 shares of common and 10,000 shares of nonvoting preferred stock in exchange for their respective capital contributions of $50,000 and $40,000 when the business was incorporated. * Jane handles sales and administration and Peter is in charge of new product development. The innovative software Peter has designed has been the major reason for the corporation's success. * Jane, who is much older than Peter, is in poor health. Her will provides that her brother, Ronald, will inherit everything she owns (including her stock in Hambro) when she dies. Ronald is a music teacher; he knows nothing about software and has never been involved in the business. Peter is afraid that Ronald, because of his lack of knowledge of the software industry, will manage the business poorly once he becomes the majority owner of the corporation's common stock. He would like to purchase 25,000 shares of Jane's stock so that he could become the majority shareholder, but he recently suffered some major investment losses and does not have any cash. In any event, Jane is not interested in selling any of her stock. While she agrees that Peter, rather than Ronald, should control the corporation after her death, she does not want to sell her stock to him for several reasons: She does not want to recognize any gain on a transaction that makes Peter the controlling shareholder. Further, she has always provided a portion of Ronald's support, and wants to use her ownership interest to continue to provide for him after her death. * Peter and Jane have consulted their tax adviser for advice about how Peter can become the majority owner of the common stock without purchasing any of Jane's stock. They have provided the adviser with a recent valuation of the stock that shows that the per-share value of the common stock is equal to the per-share value of the preferred stock. Issue: How can Peter become the majority owner of the common stock without purchasing any of Jane's stock?

Analysis

The tax adviser might consider a Type E reorganization (i.e., a recapitalization). Basically, a recapitalization is the restructuring of the ownership of a single corporation. If...