Down Round Recapitalization: Tax on Preferred, Splits and Grants

Is a down round or recapitalization taxable to shareholders?

Usually not. A recapitalization is one of the reorganizations listed in section 368(a)(1)(E), and a holder who exchanges stock solely for other stock of the same company in a reorganization recognizes no gain or loss under section 354. The company itself has no gain when it issues new shares for cash in the round (section 1032).

Where tax does and does not show up:

A case is not simple when holders receive cash or new redeemable preferred, when preferred carries unpaid accumulated dividends, when the recap repeats in a planned pattern, or when the round shifts enough ownership to limit the company's losses. Gather the cap table before and after the recap, the charter amendment, the exchange and conversion ratios, any cash paid per holder, and each holder's purchase dates and basis.

Is a preferred to common conversion tax-free?

Generally yes. The recapitalization regulations give, as an example of a recapitalization, an exchange of a company's preferred stock with dividend and liquidation priorities for a new issue of its common stock without those rights (Treas. Reg. 1.368-2(e)(4)). The IRS describes the holder result plainly: when a company gives you common stock for preferred stock in a recapitalization, you do not recognize gain or loss (Publication 550).

Common for common and preferred for preferred in the same company are also tax-free under section 1036, so an exchange of old preferred for a new series works the same way. For a recapitalization, the continuity of interest and continuity of business enterprise tests do not apply (Treas. Reg. 1.368-1(b)).

The holder keeps the old basis in the new shares, reduced by any cash or other property received and increased by any gain recognized (section 358(a)), and adds the old holding period when the old shares were capital assets (section 1223(1)).

Two traps change the answer:

• New redeemable preferred. Preferred that the holder can put back to the company, that the company must redeem, or that the company is likely to call can be nonqualified preferred stock, which is treated as property other than stock when received for common or ordinary preferred (section 351(g)(2); section 354(a)(2)(C)). Stock with a real and meaningful chance to share in the company's growth is not preferred stock for this rule (section 351(g)(3)(A)), so whether venture-style convertible preferred meets the definition depends on its terms.
• Cash or other property in the exchange. Gain is taxed up to the cash and the value of other property, and loss is not allowed. If the exchange has the effect of a dividend, part of that gain can be a dividend, up to the holder's ratable share of the company's accumulated earnings and profits (section 356).

Can a recapitalization be a deemed dividend under section 305?

It can, but a single, isolated recap usually is not. Section 305(c) lets the IRS treat a change in conversion ratio, or any recapitalization with a similar effect, as a distribution to each holder whose proportionate share of the company's assets or earnings goes up.

The regulations name two cases in which a recapitalization, isolated or not, is a deemed distribution (Treas. Reg. 1.305-7(c)):

1. It is part of a plan to periodically increase a holder's proportionate interest, or
2. A holder of preferred stock with dividends in arrears exchanges it for other stock and ends up with a larger proportionate interest. The deemed distribution is then the lesser of the dividends in arrears and the excess of the new stock's value or liquidation preference, whichever is greater, over the old preferred's issue price.

The regulations' own example of a single, isolated recapitalization that reshuffles classes among holders is outside section 305 (Treas. Reg. 1.305-3(e), Example 12). A conversion price cut made under a bona fide, reasonable antidilution formula is also not a deemed distribution (Treas. Reg. 1.305-7(b)), so a down-round adjustment under such a formula does not by itself create income.

When section 305 does apply, the deemed distribution is taxed like a cash distribution: a dividend to the extent of earnings and profits, then a reduction of basis, then gain (section 301(c)). A loss-making startup may have little or no earnings and profits, but that is a fact to check, not assume. Cumulative dividends left unpaid on preferred, or a recap paired with cash to some holders, are the facts that call for a closer review.

Pay-to-play conversion to common: what is the tax?

A holder who skips the new round and has preferred converted to common is making a preferred-for-common exchange, which is generally a tax-free recapitalization (Treas. Reg. 1.368-2(e)(4)). The holder's basis and holding period move to the common shares, even though the common carries less value than the preferred did.

Holders who do invest buy new shares for cash, which is a purchase, not income. If they also swap old preferred for a new series, that is preferred for preferred (section 1036). Their proportionate interest goes up because others were converted, which is the pattern section 305(c) looks at; a one-time pay-to-play generally falls outside the two cases the regulations name, unless the preferred has dividends in arrears or the terms repeat as a plan. That reading depends on the deal's facts.

The non-participating holder's economic loss is not deductible at conversion, because no loss is recognized in the exchange. It shows up later, through the carried-over basis, when the common is sold or becomes worthless. If the old shares were section 1244 small business stock, new shares received in a recapitalization keep that status, which can make a later loss ordinary (Publication 550).

Is a reverse stock split taxable?

A reverse split on its own is not. Exchanging old common for fewer new common shares is common for common in the same company (section 1036) and is also a recapitalization. Total basis stays the same and is spread over fewer shares, as with any stock split (Publication 550).

Cash paid instead of a fractional share is treated as an amount realized on a sale of the fractional share, reported on Form 8949 (Publication 550, Fractional shares). The holder allocates part of the old basis to the fractional share and reports gain or loss on that piece only. If the cash for fractions is not a mechanical rounding payout but a meaningful payment to some holders, section 356 and the dividend tests need review.

Are new founder and employee grants after the recap taxable as pay?

Yes, when shares are given for work and the person pays less than their value. Under section 83, the value of stock received for services, minus any amount paid, is income when the shares vest. A person can instead elect under section 83(b), no later than 30 days after the transfer, to include the value at grant; later growth is then not pay, and a later forfeiture gives no deduction (Publication 525, Restricted Property).

Shares a founder receives purely in exchange for old shares in the recap are part of the tax-free exchange. If the old shares were still unvested with no 83(b) election, unvested new shares are treated as substituted for them, so pay still arises at vesting (Publication 525); if vested shares are swapped for shares with new vesting, section 83 applies to the new shares. Extra shares, a refresh grant, or new restricted stock given to keep founders and staff after the down round are compensation. The value used is the shares' fair market value at grant or at vesting. For an employee, that pay is wages: the company must withhold on it and is liable for tax it fails to withhold (sections 3401(a) and 3403). The company deducts the same amount in its tax year in which the person's year of inclusion ends; reporting it on time, such as on Form W-2, counts as the person having included it (Treas. Reg. 1.83-6(a)). For how to file the election, see founder shares that vest; for founders asked to re-vest shares they already own, see founder re-vesting at a priced round. For underwater options, see repricing stock options after a down round.

Do QSBS status and holding periods carry over to the new shares?

Generally yes. Stock acquired solely by converting qualified small business stock of the same company keeps its QSBS status and the converted stock's holding period (section 1202(f)). Stock received for QSBS in a section 368 reorganization, which includes a recapitalization, is treated as QSBS acquired on the date the old stock was acquired (section 1202(h)(4)).

Section 1202(h)(4) can cap the exclusion on the new shares at the gain built in at the exchange date, but that cap does not apply when the company is still a qualified small business at the time of the exchange. Cash buybacks that ride along with the recap can taint QSBS for others; see QSBS and company buybacks around a round. Whether a holder's shares qualify at all is covered in QSBS for founders and early employees.

Can the round limit our loss carryforwards?

It can. New money, conversions and recap exchanges that shift ownership among larger holders count toward a section 382 ownership change, which caps how much of the company's past losses it can use each year; see net operating losses for startups.

What must the company report to shareholders about basis?

A company that takes an action affecting the basis of its stock, such as a stock split or a recap that changes per-share basis, generally files Form 8937 with the IRS and gives each holder of record a copy or a written statement (Instructions for Form 8937; Treas. Reg. 1.6045B-1). The rule applies to private companies too.

A startup with individual founders, employees or angels on the cap table usually cannot rely on the exempt-recipient exception, because individuals are not exempt recipients. Whether a given exchange "affects basis" enough to require the form depends on the ratios and any cash, so confirm it before the deadline.

Example

These examples are illustrative and use US dollars.

Pay-to-play conversion

An investor paid $1,000,000 for Series A preferred four years ago and skips the down round. Under the pay-to-play terms, all of its Series A is converted to common, with no cash paid and no unpaid cumulative dividends. The investor recognizes no gain or loss. Its basis in the common is $1,000,000 and its holding period still starts four years ago. If the Series A was QSBS, the common keeps that status and date.

Reverse split 1-for-10

A holder owns 15 common shares with a total basis of $15. After a 1-for-10 reverse split, the holder is entitled to 1.5 new shares, now with a basis of $10 each. The company issues 1 new share and pays $20 for the half share, a plain rounding payout. The holder reports a sale of the half share: $20 received minus $5 of basis, a $15 gain. The 1 whole share keeps a $10 basis and the old holding period.

Founder refresh grant

After the recap, a founder receives 1,000,000 restricted shares vesting over four years, worth $0.05 each, and pays nothing. With an 83(b) election filed within 30 days, the founder reports $50,000 of compensation now and nothing more at vesting; basis is $50,000. Without the election, the value of each tranche when it vests is compensation that year. If 250,000 shares vest after one year at $0.20, that year's pay is $50,000.

Different for you?

• The company also reprices or exchanges underwater options: see repricing stock options after a down round.
• The round may cause an ownership change: see net operating losses for startups.
• Holders are paid cash, or the company buys back shares around the round: see QSBS and company buybacks around a round and get startup tax help.
• A holder needs to know whether shares still qualify for QSBS: see QSBS for founders and early employees.
• Founders get new restricted shares or must re-vest: see founder shares that vest and founder re-vesting at a priced round.
• Convertible notes convert or are forgiven in the same deal: see convertible notes past maturity.
• Foreign investors join or are converted: see foreign investors in a startup round.
• The books must show the new classes: see recording a priced round.
• Preferred carries unpaid cumulative dividends, new preferred is redeemable, or Form 8937 is due: these need the facts mapped before closing; get startup tax help.