Petition — Shimberg v. United States

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In the Supreme Court of the Unde BRERA 8

ee

OCTOBER TERM, 1978

No. 78-698

MANDELL SHIMBERG, JR., and ELAINE F. SHIMBERG,

Petitioners,

V.

UNITED STATES OF AMERICA,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

SHERWIN P. SIMMONS

Post Office Box 1102

Tampa, Florida 33601

Attorney for Petitioners

Haroutp W. MUuLLIs, JR.

WILLIAM KALISH

Davip A, PEARSON

TRENAM, SIMMONS, KEMKER, Gomans.

BARKIN, FRYE & O’NEILL,

PROFESSIONAL ASSOCIATION

Post Office Box 1102

Tampa, Florida 33601

Of Counsel

E. L. MENDENHALL, INc., 926 Cherry Street, Kansas City, Mo. 64106, (816) 421-3030

INDEX

II dis J saireencsieclccpncsivartisonckeagosvenasadas. + -iaSbenons 2

I ia a8 hoo ci cence eeieenitcesenmnnciconsorisumace laden 2

I er cs shondiniosenisoneantanshinbainbabagiacieeelo 2

Statutory Provisions Involved -.......0.22....2.--ccccecccesseeesesseees 3

ea NE MN eee PL 5

Reasons for Granting the Wit 0.0.2.2... .cecscssssseseeeseeees 8

1. The Decision of the Fifth Circuit in This Case

Is in Direct Conflict With Decisions of the Courts

of Appeals for the Second and Eighth Cir-its

BE ee 8

2. The Decision Below Sanctions a Bifurcation of

an Integrated Transaction Contrary to the Step

Transaction Doctrine, Section 356(a)(2) and the

Decision of the Eighth Circuit in Wright v.

NRE shea einen RE SCN DOES Zs 11

ERE et ch an Cee OTE aE EOI CP nO PE AE 13

a ES saphsiikcneintinciiarcarinsien ahs etaccandaponsiotehielabaiasaacuasaslaoansane Al

IE TEE. tn cerdanustacpetscanthiniashannsselgntoeunindiselusdamhaoanscancuoeiele All

I hn ical ila csc seintnaegreedalapneeasiidipienabmenessadsbentaaile Al2

SERIE EC ERENCES RD EE A27

Citations

CASES

Alabama Asphaltic Limestone Co., Helvering v., 315

5 Ry 2). SXetananaaeoranenannane oniabasiiek bast cuaia eyateaenseee 11

Bedford, Estate of, Commissioner v., 325 U.S. 283 (1945)

SE EL BOER DS BY RP SPR ALR EN See RAS EOD SNE TEES ETS. 9, 13, 15

II

Davis, United States v., 397 U.S. 301 (1970) ............ 2, 7, 8, 9,

10, 11, 14

Hawkinson v. Commissioner, 235 F.2d 747 (2d Cir. 1956)

Siac talaadelialioaicrataseasncsasslece alinidtssabeanccehaadhssheanddadianbheinioaunil 8, 11, 13, 14

Idaho Power Co. v. United States, 161 F. Supp. 807

(Ct.Cl. 1958) ....... EAETDD gente LN ROR MERPORD FON Rae RS OO 13

McDonald v. Commissioner, 52 T.C. 82 (1969) 0.00.00... 12

Ross v. United States, 173 F. Supp. 793 (Ct.Cl. 1959),

cert. denied, 361 U.S. 875 (1959) ~....00.00000..... Diaicsende 8, 11, 14

Wright v. United States, 482 F.2d 609 (8th Cir. 1973)

ie hdialadaletaiedinnetheesdeirea lrebaapeabigesi< 1saxeee\abbessainien 7, 8, 9, 10, 11, 12, 14

Zenz Vv. Quinlivan, 213 F.2d 914 (6th Cir. 1954) ............ 12

STATUTES

Internal Revenue Code of 1954 (26 U.S.C.):

BS) REUSE aE pn 2, 3, 8,9, 11, 14

I: Sa a 3, 13

Section 356(a) (2) ............ 2, 4, 7, 8, 9, 10, 11, 12, 13, 14, 15

BOCs BERR) C1) CA) nncnccrceccsnccnsscessesseses a iesiniibononabbeeaoe 6

Revenue Act of 1924, c. 234, 43 Stat. 253:

I on i ecrescaseenaiceenemnenneionneteess 12

REVENUE RULINGS

Revenue Ruling 74-515, 1974-2 C.B. 118 0.0... 9,11,14

Revenue Ruling 74-516, 1974-2 C.B. 121 00... 9,11,14

Revenue Ruling 75-83, 1975-1 C.B. 112 0000000... 9, 11,14

MISCELLANEOUS

B. Bittker & J. Eustice, Federal Income Taxation of

Corporations and Shareholders, § 14.34 at 14-92 (3d

I EN eceesviiccci terns cacehetesconeesavscpeaoniealis cana necetdhnnaiateeousTantsaia 9,14

III

H.R. Rep. No. 179, 68th Cong., Ist Sess. (1924), 1939-1

(Part 2) C.B. 241, 252 ....... ESP P88 ARE ORES POS ASL: OR 12

Levin, Adess and McGaffey, ‘‘Boot Distributions in

Corporate Reorganizations—Determination of Divi-

dend Equivalency,” 30 The Tax Lawyer 287 (1977) 8,14

S. Rep. No. 398, 68th Cong., 1st Sess. (1924), 1939-1

(Part 2) C.B. 266, 277 ......... poicspevasegrumbatightemimasoigeek Ne

Wittenstein, “Boot Distributions and Section 112(c)

(2): A Re-Examination,” 8 Tax. L. Rev. 63 (1952) 14

In the Supreme Court of the United States

OCTOBER TERM, 1978

No.

MANDELL SHIMBERG, JR., and ELAINE F. SHIMBERG,

Petitioners,

V.

UNITED STATES OF AMERICA,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

Petitioners, MANDELL SHIMBERG, JR., and ELAINE

F. SHIMBERG, respectfully pray that a writ of certiorari

issue to review the judgment and opinion of the United

States Court of Appeals for the Fifth Circuit entered in

this proceeding on July 28, 1978.

OPINIONS BELOW

The order of the District Court for the Middle District

of Florida (Appendix A, infra, pp. Al-A10) granting judg-

ment for Petitioners is reported at 415 F. Supp. 832. The

opinion of the United States Court of Appeals for the

Fifth Circuit reversing the judgment of the district court

(Appendix C, infra, pp. Al2-A26) is reported at 577 F.2d

283.

JURISDICTION

The judgment of the Court of Appeals for the Fifth

Circuit (Appendix D, infra, p. A27) was entered on July

28, 1978. This petition for a writ of certiorari was filed

within ninety (90) days of that date. The jurisdiction

of this Court is invoked under 28 U.S.C. 1254(1).

QUESTIONS PRESENTED

1. Whether the meaningful reduction test for deter-

mining dividend equivalence in corporate redemptions un-

der Section 302(b)(1) of the Internal Revenue Code of

1954 (the “Code”), as enunciated by this Court in United

States v. Davis, 397 U.S. 301 (1970), is applicable under

Section 356(a) (2) of the Code to corporate reorganizations

where a stockholder of a merged corporation receives cash

in addition to stock and securities of the continuing cor-

poration.

2. Whether an integrated tax-free merger may be

fragmented into separate steps for the purpose of analyz-

ing under Section 356(a) (2) of the Code a boot distribution

incident to the merger.

STATUTORY PROVISIONS INVOLVED

Sections 302 and 356 of the Internal Revenue Code

of 1954, 26 U.S.C. 302 and 356, provide in pertinent part

as follows:

SEC. 302. DISTRIBUTIONS IN REDEMPTION OF

STOCK.

(a) General Rule—If a corporation redeems its

stock (within the meaning of section 317(b)),

and if paragraph (1), (2), (3), or (4) of sub-

section (b) applies, such redemption shall be

treated as a distribution in part or full pay-

ment in exchange for the stock.

(b) Redemptions Treated as Exchanges.—

(1) Redemptions Not Equivalent to Divi-

dends.—Subsection (a) shall apply if the

redemption is not essentially equivalent

to a dividend.

s * se

SEC. 356. RECEIPT OF ADDITIONAL CONSIDER-

ATION.

(a) Gain on Exchanges.—

(1) Recognition of Gain.—If—

(A) section 354 or 355 would apply to

an exchange but for the fact that

4

(B) the property received in the ex-

change consists not only of property

permitted by section 354 or 355 to

be received without the recognition

of gain but also of other property

or money,

then the gain, if any, to the recipient shall be recog-

nized, but in an amount not in excess of the sum

of such money and the fair market value of such

other property.

(2) Treatment as Dividend.—If an exchange

is described in paragraph (1) but has the effect of

the distribution of a dividend, then there shall be

treated as a dividend to each distributee such an

amount of the gain recognized under paragraph (1)

as is not in excess of his ratable share of the undis-

tributed earnings and profits of the corporation ac-

cumulated after February 28, 1913. The remainder,

if any, of the gain recognized under paragraph (1)

shall be treated as gain from the exchange of property.

STATEMENT OF THE CASE

The facts in this proceeding were fully stipulated and

may be summarized as follows.

Prior to December 9, 1970, LaMonte-Shimberg Corpo-

ration (“LSC”) was a local Florida corporation engaged

primarily in the business of building and selling single

family houses. Petitioner’ was its president, chief execu-

tive officer and majority stockholder, owning directly and

indirectly 68.43% of its 135,521 issued and outstanding

shares of LSC capital stock. The balance of its outstand-

ing LSC stock was owned by 19 unrelated stockholders.

MGIC Investment Corporation (“MGIC”), a “publicly

held” corporation, the stock of which was registered and

traded on the New York Stock Exchange, was a holding

company engaged through its various subsidiaries primar-

ily in the financial guaranty business, insuring lenders

and lessors against credit and rental losses in the real

estate financing business. Immediately prior to the events

of December 9, 1970, a total of 6,204,448 shares of MGIC

common stock were issued and outstanding, being held

by some 5,191 stockholders of record.

MGIC’s financial statement for December 31, 1970, re-

flected ownership of assets having a value of $250,527,729,

liabilities of $170,433,208 and stockholders’ equity of

$80,094,521. By comparison, LSC’s consolidated balance

sheet for October 31, 1970, showed assets of $6,047,122, lia-

bilities of $5,225,126 and stockholders’ equity of $821,996.

1. References to ‘Petitioner’ are to Mandell Shimberg, Jr.

Petitioner Elaine F. Shimberg is involved in this proceeding only

because she filed a joint Federal income tax return with Mandell

Shimberg, Jr. for the calendar year 1970.

The financial conditions of MiGIC and LSC were substan-

tially the same at the time of the merger as they were on

December 31, 1970 and October 31, 1970, respectively.

Pursuant to the terms of a merger agreement executed

on September 18, 1970 and consummated on December

9, 1970, LSC was merged into MGIC in a transaction

which qualified as a reorganization under the provisions

of Section 368(a)(1)(A) of the Internal Revenue Code

of 1954 (the “Code”).” ,

Incident to the merger, the LSC stockholders received

in the aggregate a pro rata distribution of cash in the

amount of $625,000 plus a total of 32,132 shares of MGIC

common stock outstanding and an additional 32,132 MGIC

common shares placed in escrow subject to an earnout.

Petitioner, in exchange for his LSC stock, received

$417,449 in cash plus 21,461 shares of MGIC common stock

and a like number of MGIC common shares in escrow.

After consummation of the merger, Petitioner owned less

than 1% of the issued and outstanding common stock of

MGIC.

On his federal income tax return for 1970, Petitioner

reported the cash received incident to the merger as long-

term gain from the sale of a capital asset. Upon audit,

the Internal Revenue Service determined that the cash

was taxable as a dividend. Petitioner paid the resulting

deficiency under protest, and following denial of his claim

for refund, initiated suit for refund in the district court.

The parties stipulated that the merger of LSC into

MGIC constituted a “reorganization” within the meaning

of Section 368(a)(1)(A) of the Code and that Petitioner

was entitled to capital gain treatment with respect to the

2. All references to section numbers, unless otherwise ex-

pressly indicated, are to the Internal Revenue Code of 1954.

7

cash received unless the payment of the cash had “the

effect of the distribution of a dividend” within the meaning

of Section 356(a) (2) of the Code.

The district court found (Appendix A, infra, pp. A7-

Al0) that the principles enunciated by the Eighth Circuit

in Wright v. United States, 482 F.2d 600 (8th Cir. 1973)

were controlling, and held that the cash received by Peti-

tioner pursuant to the reorganization did not have the

effect of a dividend because there had been a meaningful

reduction in the nature of Petitioner’s interest in the con-

tinuing enterprise. The district court noted (Appendix

A, infra, pp. A8-A9) that Petitioner had been president,

chief executive officer and owner of approximately 66%

of the stock in LSC prior to the merger, and subsequently

held less than 1% of the outstanding stock of MGIC. Be-

cause the district court determined (Appendix A, infra,

p. A9) that the loss in valuable corporate rights resulting

from the reorganization constituted a meaningful reduc-

tion, the district court held in favor of Petitioner.

On Respondent’s appeal to the Court of Appeals for

the Fifth Circuit, that court reversed, holding that the

meaningful reduction test enunciated by this Court in

United States v. Davis, 397 U.S. 301 (1970), and as utilized

in Wright, was not applicable to the facts of the present

case. Instead, the court (Appendix C, infra, p. A22)

deemed the cash received by Petitioner to be part of a

hypothetical pro rata distribution by LSC to its stockhold-

ers. The court found on this analysis that the distribution

had the “effect of the distribution of a dividend” within

the meaning of Section 356(a)(2) and reversed the judg-

ment in favor of Petitioner. ‘Appendix C, infra, pp. A22-

A23, A26).

REASONS FOR GRANTING THE WRIT

1. The Decision of the Fifth Circuit in This Case

Is in Direct Conflict With Decisions of the

Courts ot Appeals for the Second and Eighth

Circuits and the Court of Claims.

In 1970 the Court in United States v. Davis, 397 U.S.

301 (1979), prescribed the meaningful reduction test for

determining dividend equivalence under Section 302(b) (1)

in corporate redemption transactions. No comparable test

has been provided by this Court for determining the divi-

dend effect of boot distributions under Section 356(a) (2).

However, when faced with this precise question, the Eighth

Circuit in Wright v. United States, 482 F.2d 600 (8th Cir.

1973), following the rationale of the Second Circuit in

Hawkinson v. Commissioner, 235 F.2d 747 (2d Cir. 1956)

and the Court of Claims in Ross v. United States, 173

F. Supp. 793 (Ct.Cl. 1959), cert. denied, 361 U.S. 875

(1959), held that Section 302(b) (1) and Section 356(a) (2)

should be read in pari materia and concluded (428 F.2d

at 605) that the appropriate measure to be applied to

Section 356(a)(2) boot distributions was the meaningful

reduction test enunciated by the Court in Davis.*

In explaining its application of the Davis test in the

context of a reorganization, the Eighth Circuit in Wright

stated (482 F.2d at 605):

We read [the ‘meaningful reduction’] language and

Davis as holding that the proper inquiry is the per-

centage change of ownership in the corporation and

the attendant overall results due to that change. Stated

3. See generally Levin, Adess and McGaffey, “Boot Dis-

tributions in Corporate Reorganizations—-Determination of Divi-

dend Equivalency,” 30 The Tax Lawyer 287 (1977).

otherwise, the basic inquiry is whether the distribution

had the ‘net effect’ of a dividend. [Citations omitted. |

We think that if a distribution is not to have

the ‘net effect’ of a dividend, there must have occurred

a meaningful reduction of the redeeming shareholder’s

proportionate interest or in other words a meaningful

change in the relative economic interests or rights of

the shareholder after the redemption... .

... [V]iewing the transaction as a realistic whole,

the taxpayer has reduced his holding in [the preex-

isting corporation] from almost complete ownership

in [that corporation] to 61.7 per cent ownership in

[the surviving corporation]. . . . [Emphasis added. ]

As noted by the Eighth Circuit, the Government in

Wright agreed that Section 302(b)(1) and Section 356(a)

(2) should be read in pari materia.* Thereafter, the In-

ternal Revenue Service published its accord with this statu-

tory construction. Rev. Rul. 75-83, 1975-1 C.B. 112. See

also Rev. Rul. 74-515, 1974-2 C.B. 118; Rev. Rul. 74-516,

1974-2 C.B. 121.

It was the Davis meaningful reduction test and the

Wright analysis of viewing the transaction as a realistic

whole which the district court below applied to find that

the boot received by Petitioner incident to the merger

was taxable as capital gain.

In reversing, the Fifth Circuit refused to apply in

this case either the Wright analysis or the Davis teachings.

Thus, the Fifth Circuit held (Appendix C, infra, p. A19):

4. The Government’s agreement reflected a major shift in

policy from its ‘automatic dividend” position following the

Court’s decision in Commissioner v. Estate of Bedford, 325 U.S.

283 (1945). See B. Bittker & J. Eustice, Federal Income Tazxa-

tion of Corporations and Shareholders, { 14.34 at 14-92 (3d Ed.

1971).

10

The ‘meaningful reduction’ test cannot be indis-

criminately applied in the reorganization context. The

Davis case illustrates its proper application in a re-

demption under § 302, as does the recently decided

case of Morris v. United states, 441 F.Supp. 76 (N.D.

Tex.1977), while Wright indicates that it also is ap-

propriate when a reorganization can be realistically

treated as a redemption. Even assuming that Wright

is correctly decided—a point on which, we express

no opinion—the instant case presents radically differ-

ent facts and calls for correspondingly different anal-

ysis. We agree with the government that ‘the undif-

ferentiating invocation of stock redemption principles

in a reorganization case’ such as this one is erroneous,

and we decline to apply on a wholesale basis the

‘meaningful reduction’ test in cases arising under

§$ 356(a)(2). [Footnote omitted. ]

In explaining its refusal to follow Wright and Davis,

the Fifth Circuit said (Appendix C, infra, p. A20) that

the application of Section 302 principles “would render

§ 356(a)(2) virtually meaningless when a large corpora-

tion swallows a small one in a reorganization, for there

will always be a marked decrease in control by the small

corporation’s shareholders, unless the same shareholders

control both corporations.”

Indeed, according to the Fifth Circuit (Appendix C,

infra, p. A22):

... § 356(a)(2) requires a determination of whether

the distribution would have been taxed as a dividend if

made prior to the reorganization or if no reorganiza-

tion had occurred. This inquiry is essentially a com-

parison of the effect of actual distribution and the

effect of a hypothetical one. | Emphasis added. |

11

Certainly the courts must recognize the factual differ-

ences inherent in redemptions and corporate reorganiza-

tions. However, Petitioner submits that the legal guide-

lines for determining dividend effect under Section 356 (a)

(2) should be the same as those used in determining divi-

dend equivalence under Section 302(b)(1). Indeed, the

Internal Revenue Service and the courts which have con-

sidered the statutory construction issue, with the exception

of the Fifth Circuit in this case, are in agreement that

Section 302(b)(1) and Section 356(a)(2) are to be read

in pari materia®

The uncertainty in the law resulting from the Fifth

Circuit’s failure to follow the Wright analysis and the

Davis guideline concerning boot distributions in tax-free

corporate reorganizations will seriously undermine the

planning of such transactions in the future, and the ad-

ministration of the Internal Revenue Code with respect

thereto.

2. The Decision Below Sanctions a Bifurcation of

an Integrated Transaction Contrary to the Step

Transaction Doctrine, Section 356(a)(2) and

the Decision of the Eighth Circuit in Wright v.

United States.

The step transaction doctrine requires that all parts

of an integrated multi-step exchange or reorganization be

grouped together to determine the appropriate tax treat-

ment for the entire transaction. Helvering v. Alabama

Asphaltic Limestone Co., 315 U.S. 179 (1942). The Eighth

5. Wright v. United States, 482 F.2d 600 (8th Cir. 1973);

Hawkinson v. Commissioner, 235 F.2d 747, 751 (2d Cir. 1956);

Ross v. United States, 173 F. Supp. 793, 797 (Ct.Cl. 1959), cert.

denied, 361 U.S. 875 (1959); Rev. Rul. 74-515, 1974-2 C.B.

118; Rev. Rul. 74-516, 1974-2 C.B. 121; Rev. Rul. 75-83, 1975-1

C.B. 112.

12

Circuit’s analysis of the facis in Wright v. United States

was in accord with the step transaction doctrine.

Although the Fifth Circuit recognized the existence

and validity of the step transaction doctrine (Appendix

C, infra, p. A24), it reasoned that this doctrine was not

a bar to the fragmenting of the merger between LSC

and MGIC into parts and the consideration of a nypotheti-

cal pre-merger pro rata distribution. The Fifth Circuit

explained (Appendix C, infra, p. A24) that it was not

treating the hypothetical boot distribution as a separate

step in an overall transaction but rather “analyzing the

distribution in accordance with the requirements of § 356

(a) (2).”

Neither the language of Section 356 (a) (2), its legisla-

tive history, nor business reality supports the conclusion

that a statutory merger can be fragmented or a portion

of the operative facts disregarded. There is nothing on

the face of the statute which remotely suggests that, in

making the critical determination, less than all the facts

of the transaction are to be considered or that some of

the facts are to be taken out of context and viewed in

isolation. Moreover, the legislative history of Section 203

(D) (2), of the Revenue Act of 1924, the predecessor of

Section 356(a)(2), does not suggest that the appropriate

inquiry by a reviewing court is the fragmenting of the

transaction and the disregarding of a portion of the facts.

See Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954), and

McDonald v. Commissioner, 52 T.C. 82 (1969). Lastly,

the “fragment and disregard” approach of the Fifth Circuit

in making Section 356(a)(2) analyses creates uncertainty

as to the circumstances in which the step transaction

6. H.R. Rep. No. 179, 68th Cong., Ist Sess. (1924), 1939-1

(Part 2) C.B. 241, 252; S. Rep. No. 398, 68th Cong., Ist Sess.

(1924), 1939-1 (Part 2) C.B. 266, 277.

13

doctrine will be applied and is contrary to the economic

and business realities of most reorganizations.

The effect of the Fifth Circuit’s opinion in this case

is to disregard the step transaction doctrine. As a result,

the future application of that doctrine to integrated trans-

actions is unclear.

CONCLUSION

The tax consequences of common commercial transac-

tions can be fairly and predictably determined only where

there is a uniform administration of the tax laws. It

is important to taxpayers and the Government alike that

whenever possible there be certainty as to the meaning

of complicated tax provisions.

For many years, it was unclear whether all boot re-

ceived in a reorganization automatically had the effect

of a dividend to the extent of earnings and profits or

whether leeway existed for capital gain treatment. Fol-

lowing the decision in Commissioner v. Estate of Bedford,

325 U.S. 283 (1945), the Internal Revenue Service took

the position that, in situations where a taxpayer continued

as a stockholder after the exchange, Section 356(a) (2)

automatically converted gain recognized pursuant to Sec-

tion 356(a) (1) into dividend income to the extent of earn-

ings and profits.

However, this so-called “automatic dividend” position

was strongly and effectively criticized by commentators,

and the cases decided in later years retreated from that

view.”

7. Hawkinson vy. Commissioner, 235 F.2d 747 (2d Cir. 1956);

Idaho Power Co. v. United States, 161 F. Supp. 807 (Ct.Cl. 1958);

(Continued on following page)

14

Finally, in 1974, following its agreement in Wright

as to the applicability of Section 302 standards to Section

356 (a) (2) determinations, the Service abandoned its “auto-

matic dividend” position and accepted the reasoning that,

in determining whether boot has the effect of the distribu-

tion of a dividend for purposes of Section 356(a) (2), the

standards of ‘‘essential dividend equivalence” under Sec-

tion 302 should be applied.*

As the result of the decisions of the Second and Eighth

Circuits in Hawkinson and Wright, respectively, and the

Court of Claims in Ross, and the agreement of the Service

regarding the proper statutory construction, taxpayers had

every reason to believe that at long last some certainty

had come into the law as to the appropriate test to be

applied in determining dividend effect under Section 356

(a)(2). This belief was reinforced by the existence of

the Davis guideline for determining dividend equivalence

under Section 302(b) (1).

The refusal of the Fifth Circuit in this case to apply

Section 302 standards and the Davis test to boot distribu-

tions under Section 356(a)(2) and its disregard of the

step transaction doctrine reintroduces into the law a high

degree of uncertainty. Indeed, the Fifth Circuit’s decision

to adopt a “limited automatic dividend” rule is a throwback

Footnote continued—

Ross v. United States, 173 F. Supp. 793 (Ct.Cl. 1959), cert. denied,

361 U.S. 875 (1959); Wright v. United States, 482 F.2d 600 (8th

Cir. 1973). See B. Bittker & J. Eustice, Federal Income Taxation

of Corporations and Shareholders, { 14.34 at 14-92 (3d ed. 1971);

Wittenstein, “Boot Distributions and Section 112(c)(2): A Re-

Examination,” 8 Tax. L. Rev. 63 (1952). See also Levin, Adess

and McGaffey, “Boot Distributions in Corporate Reorganizations—

— of Dividend Equivalency,” 30 The Tax Lawyer 287

8. Rev. Rul. 74-515, 1974-2 C.B. 118; Rev. Rul. 74-516,

1974-2 C.B. 121; Rev. Rul. 75-83, 1975-1 C.B. 112.

15

to the Bedford case, the point of beginning more than

33 years ago.

Only a definitive pronouncement by this Court as

to the proper guidelines for determining dividend effect

under Section 356(a) (2) will reconcile the conflicts among

the courts and bring certainty to the law.

For the reasons set forth above, the petition for a writ

of certiorari should be granted.

Respectfully submitted,

SHERWIN P, SIMMONS

Post Office Box 1102

Tampa, Florida 33601

Attorney for Petitioners

Haroitp W, MUuLLIs, JR.

WILLIAM KALISH

Davin A, PEARSON

TRENAM, SUMMONS, KEMKER, SCHARF,

BaRKIN, Frye & O'NEILL,

PROFESSIONAL ASSOCIATION

Post Office Box 1102

Tampa, Florida 33601

(813) 223-7474

Of Counsel

October 24, 1978

APPENDIX .

Al

APPENDIX

APPENDIX A

UNITED STATES DISTRICT COURT

MIDDLE DISTRICT OF FLORIDA

TAMPA DIVISION

No, 74-440-Civ-T-H

MANDELL SHIMBERG, JR. and ELAINE F. SHIMBERG,

Plaintiffs,

VS.

UNITED STATES OF AMERICA,

Defendant.

ORDER

(Filed July 1, 1976)

The sole issue for determination in this proceeding

is whether cash in the amount of $417,449 received by

the Plaintiff, Mandell Shimberg, Jr.,{ on December 9, 1970

in connection with the merger of Lamonte-Shimberg Cor-

poration into MGIC Investment Corporation is taxable as

proceeds from ihe sale of a capital asset, entitled to long-

term capital gain treatment for federal income tax pur-

poses, as contended by the Plaintiffs; or, whether the cash

proceeds are taxable as a dividend or ordinary income

as contended by the Defendant.

1, The Plaintiff, Elaine F. Shimberg, is involved in this pro-

ceeding only because she filed a joint federal income tax return

with Mandell Shimberg, Jr. for the calendar year 1970, Unless

otherwise expressly indicated, all references herein to the “Plain-

tiff” shall refer solely to Mandell Shimberg, Jr.

A2

The issue has been submiited to the Court for determi-

nation upon stipulated facts contained in the parties’ pre-

trial stipulation. The following is a summary of the facts:

(a) LaMonte-Shimberg Corporation (“LSC”)

was incorporated under the laws of the State of Florida

on September 28, 1959. LSC was, at all material times,

engaged primarily in the business of building and

selling single family homes. The Plaintiff was its

president and chief executive officer. :

(b) The Plaintiff was the majority stockholder

of LSC, owning, directly or indirectly, approximately

90,517 shares or sixty-six per cent (66%) of its 135,521

issued and outstanding shares of common stock. The

remainder of the stock of LSC was owned by nineteen

unrelated stockholders.

(c) MGIC Investment Corporation (“MGIC”) is

a corporation organized and existing under the laws

of the State of Delaware, having been incorporated

in that state in 1968. MGIC was, at all material times,

a “publicly held’ corporation, the stock of which was

traded on the New York Stock Exchange, engaged

through its various subsidiaries primarily in the finan-

cial guaranty business, insuring lenders and lessors

against credit and rental losses in the business of real

estate financing.

(d) On November 9, 1970, 6,204,448 shares of

MGIC common stock were issued and outstanding,

being held at that time by 5,191 stockholders of record.

The stock ownership of MGIC did not materially

change during the period from November 9, 1970

through December 9, 1970.

(e) On September 18, 1970, MGIC and LSC exe-

cuted a Plan and Agreement of Merger (the “Agree-

A3

ment”), pursuant to which LSC was to be merged

into MGIC in a transaction meeting the requirements

of the applicable provisions of the Delaware General

Corporation Law and the Florida Corporation Law.

The Agreement contemplated that LSC would be

merged into MGIC in a transaction qualifying as a

“reorganization” under the provisions of Section

368(a)(1)(A) of the Internal Revenue Code of 1954,

as amended, 26 USC §368.

(f) On December 9, 1970, LSC was merged into

MGIC, the surviving corporation, and the separate

existence of LSC was terminated. The merger was

consummated in accordance with the applicable laws

of the states of Florida and Delaware.

(g) In connection with the merger, the stock-

holders of LSC received ratably, in exchange for all

of their LSC stock, 32,132 shares of MGIC common

stock outright, 32,132 shares of MGIC common stock

in escrow, and cash in the total amount of $625,000.

Specifically, the Plaintiff received in exchange for his

LSC stock, 21,461 shares of MGIC common stock out-

right, 21,461 shares of MGIC common stock in escrow,

and cash in the amount of $417,449. The undistributed

earnings and profits of both corporations, immediately

prior to December 9, 1970, was in excess of $625,000

each.

(h) On their joint federal income tax return for

1970, the Plaintiffs reported the cash received in con-

nection with the merger as long-term capital gain.

Upon audit and examination of the return, the Internal

Revenue Service determined that the cash received

by the Plaintiff in connection with the merger was

taxable as a dividend or ordinary income. The Com-

missioner of Internal Revenue assessed a federal

A4

income tax deficiency against the Plaintiffs in the

amount of $125,883. The amount of the deficiency,

and interest in the amount of $15,664.67, was timely

paid by the Plaintiffs on June 19, 1973. Additional

interest in the amount of $505.26 was paid by the

Plaintiffs on August 17, 1973.

(i) On January 4, 1974, the Plaintiffs timely filed

a claim for refund with respect to the amount of

the deficiency and interest paid. On May 8, 1974,

the Plaintiffs were notified by the Commissioner of

Internal Revenue that their claim for refund was disal-

lowed in full.

(j) This suit for recovery of the amount of the

deficiency, and all interest paid, was commenced on

August 8, 1974.

Section 354 of the Code, 26 USC §354, provides that

no gain or loss shall be recognized for tax purposes if,

pursuant to a plan of reorganization, stock and securities

in a corporation are exchanged solely for stock or securities

in another corporation which is a party to the reorganiza-

tion. Section 368(a)(1)(A) of the code, 26 USC §368(a)

(1)(A), defines the term “reorganization” to include a

“statutory merger,” that is, a merger effected pursuant

to the laws of one or more states. Accordingly, the In-

ternal Revenue Code permits a stockholder to dispose

of stock owned by him in a statutory merger free of

federal income tax consequences so long as he receives

as consideration only stock or securities of the other cor-

poration participating in the merger.

However, most state laws, including those of Florida

and Delaware,’ permit consideration other than stock or

2. Sections 608.20 and 608.21, Florida Statutes; Section 252,

Delaware General Corporation Law.

A5

securities to be utilized in effecting a statutory merger.

The additional consideration, commonly referred to as

“boot,” may consist of cash or any property other than

the stock or securities of the acquiring corporation.

The receipt of “boot” in connection with a statutory

merger does not make the transaction completely taxable;

rather, it has the effect of making the ordinarily tax-

free transaction partially taxable. Section 356(a) of the

Code, 26 USC §356 (a), provides:

$356. Receipt of Additional Consideration

(a) Gain on Exchanges.—

(1) Recognition of Gain.—If

(A) section 354... would apply to an ex-

change but for the fact that

(B) the property received in the exchange

consists not only of property permitted by Section

354... to be received without the recognition —

of gain but also of other property or money,

then the gain, if any, to the recipient shall be recog-

nized, but in an amount not in excess of the sum

of such money and the fair market value of such

other property.

(2) Treatment as Dividend—If an exchange is

described in paragraph (1) but has the effect

of the distribution of a dividend, then there

shall be treated as a dividend to each dis-

tributee such an amount of the gain recog-

nized under paragraph (1) as is not in excess

of his ratable share of the undistributed earn-

ings and profits of the corporation accumu-

lated after February 28, 1913. The remainder,

A6

if any of the gain recognized under paragraph

(1) shall be treated as gain from the exchange

of property.” [Emphasis added. ]

Accordingly, in statutory mergers involving the receipt

of “boot,” the recipients are required to recognize gain

to the extent of the value of the “boot.” The question

is whether it is taxable as proceeds from the sale of the

capital asset or is taxable as a dividend, and the answer

turns on whether the payment and receipt of the “boot”

“... has the effect of the distribution of a dividend .. .”

within the meaning of Section 356(a) (2). That, of course,

is the ultimate issue in this case.

Based upon the Supreme Court decision in Commis-

sioner v. Bedford’s Esicte, 65 S.Ct. 1157, 325 U.S. 283

(1945), the Internal Revenue Service took the position

for many years that, in situations where the taxpayer

continued as a stockholder after a reorganization exchange,

Section 356(a)(2) “automatically” treated “boot” recog-

nized pursuant to Section 356(a)(1) as dividend income

to the extent of the distributing corporation’s earnings

and profits. See, Rev. Rul. 56-220, 1956-1 C.B. 191. The

so-called “automatic dividend” rule was criticized by the

commentators, however, and the more recent cases*® tended

to abandon the rigidity of that approach in favor of a

more flexible analysis similar to that employed under Sec-

tion 302(b)(1) (relating to dividend equivalence incident -

to a stock redemption. )

Accordingly, following the decision in Wright v. United

States, 482 F.2d 600 (8th Cir. 1973), the Internal Revenue

3. King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct.

Cl. 1969); Hawkinson v. Commissioner, 253 F.2d 747 (2d Cir.

1956); Ross v. United States, 173 F.Supp. 793 (Ct. Cl. 1959);

Idaho Power Co. v. United States, 161 F.Supp. 807 (Ct. Cl. 1958).

A7

Service has apparently abandoned the “automatic divi-

dend’ application of Bedford and has accepted the reason-

ing that, in determining whether “boot” has the effect

of a distribution of a dividend for purposes of Section

356 (a) (2), the standard of “essential dividend equivalency”

under Section 302(b)(1) should be applied. (See Rev.

Rul. 74-515, LR.B. No. 1974-43, p. 7; Rev. Rul. 74-516,

I.R.B. No. 1974-43, p. 9).*

In United States v. Duvis, 397 U.S. 301, 90 S.Ct. 1041

(1970), the leading authority interpreting and applying

Section 302(b) (1), the Supreme Court held that in decid-

ing whether a payment in redemption of stock “is not

essentially equivalent to a dividend,” within the meaning

of that section, the inquiry should be “whether the redemp-

tion could be characterized as a sale’ (397 U.S. at 311;

90 S.Ct. at_ 1047); and the answer to that question, in

turn, should not be sought by examining the business

motives underlying the transaction, but by ascertaining

whether the redemption resulted “in a meaningful reduc-

tion of the shareholder’s proportionate interest in the cor-

poration” (397 U.S. at 313; 90 S.Ct. at 1048).

Thus, in Wright v. United States, supra, the Eighth

Circuit applied the Davis “meaningful reduction” standard

in resolving the same issue of law presented by this case

under Section 356(a) (2), concentrating in particular upon

the taxpayer’s reduction in voting power in the surviving

corporation and concluding that the “boot” he received

in addition to a stock-for-stock exchange arising out of

4. “The question whether a distribution in redemption of

stock of a shareholder is not essentially equivalent to a dividend

under Section 302(b)(1) depends upon the facts and circum-

stances of each case.” Tres. Reg. §$1.302-2(b). [Emphasis sup-

plied]

A8

a corporate consolidation did not have “the effect of a

distribution of a dividend” under Section 356(a) (2).°

In the final analysis, therefore, the issue in this case

under Section 356(a) (2), as to whether the payment of

the “boot” had the “effect of the distribution of a dividend,”

must be treated as an ultimate issue of fact to be resolved

by an examination of the total transaction and its result-

ing effect upon the interests of the taxpayer as a stock-

holder. Stated more precisely the factual -question is

whether sale or dividend characteristics predominate in

the transaction, regardless of the underlying motives of

the parties; and the test to be applied in answering that

question is whether the transaction resulted “in a meaning-

ful reduction of the shareholder’s proportionate interest

in the corporation.”

Prior to the merger in this case, Plaintiff was

the president, chief executive officer and owner (directly

or indirectly) of approximately 66% of the stock of LSC.

As a result, under Florida law he could effectively control

the corporation. Subsequent to the merger the Plaintiff

5. In resolving the sale-or-dividend issue under Section

356(a)(2) the Court in Wright first devoted considerable space in

its opinion to an analysis of the reorganization under the so-called

“safe harbor” or “substantially disproportionate redemption” pro-

visions of Section 302(b)(2). In so doing the Court viewed the

transaction involved as one in which only stock was issued, fol-

lowed by a fictional redemption by the acquiring corporation of

a portion of its newly issued stock for the “boot.” The Court

concluded, nevertheless, that the “boot” would not qualify as the

proceeds of a “redemption” under the mathematical limitations of

Section 302(b)(2), and then turned its attention to the general,

dividend equivalence test of Section 302(b)(1) to resolve the

parallel issue presented under Section 356(a)(2). Thus, to the

extent the opinion might suggest application of Section 302(b) (2)

in a reorganization context governed by Section 356(a)(2), it is a

dubious dictum and need not be pursued here despite Plaintiff's

contention that his resulting stock position in MGIC would meet

the requirements of Section 302(b)(2) should that analysis be

made in this case.

AQ

owned (directly and indirectly) less than 1% of the out-

standing common stock of MGIC, a large publicy-held

corporation whose stock was traded on the New York

Stock Exchange and was held by approximately 5,200

shareholders. His former rights to direct the affairs of

LSC were extinguished. His interest in MGIC afforded

him no control whatsoever over the destiny of the large

national corporation. No longer was he the major “owner”

of a successful local company operating in several Florida

counties. He was then the holder of a miniscule percentage

of the outstanding stock of a huge, publicly-held corpora-

tion. It is clear that the merger resulted in a radical

change and meaningfui reduction in the nature of the

Plaintiff’s interest in the continuing business. The net

effect of the transaction was a sale by the Plaintiff and

the other LSC stockholders of their LSC stock to MGIC

for cash and marketable securities in a publicly owned

corporation.®

The Court concludes that the cash or “boot” received

by the Plaintiff on December 9, 1970, in connection with

the merger of LSC into MGIC did not have “the effect

of the distribution of a dividend” within the meaning of

6. The Defendant, in apparent reliance upon that portion of

the Wright opinion discussed in the preceding footnote, contends

that the scope of the inquiry should be a narrow one, i.e., that the

“meaningful reduction” test should not be applied on a before and

after basis, but should be restricted to a post merger comparison

between what the taxpaper’s interest in the resulting consolidated

corporation would have been with and without the boot payment.

Wright does not support such a myopic view of the consequences

of the transaction in determining Section 302(b)(1) “dividend

equivalence” in resolving the parallel issue presented under Sec-

tion 356(a)(2). The other authorities cited by the Defendant,

namely King Enterprises, Inc. vs. United States, 418 F.2d 511 (Ct.

Cl. 1969), and Ross vs. United States, 173 F.Supp. 793 (Ct. Cl.

1959), cert. denied, 361 U.S. 873 (1959), are inapposite on their

facts, involved minority shareholders, and did not have the bene-

fit of the teachings of Davis.

Al0

Section 356(a)(2) and is taxable as proceeds from the

sale of a capital asset. It follows that the Plaintiffs are

entitled to recover and the parties are directed, pursuant

to paragraph 6(t) of the pre-trial stipulation, to submit

an agreed form of judgment within forty days from the

date hereof.

The foregoing shall constitute the Court’s findings of

fact and conclusions of law pursuant to Rule 52, F.R.Civ.P.

DONE and ORDERED at Tampa, Florida, this Ist day

of July, 1976.

/s/ W. Terrell Hodges

United States District Judge

All

APPENDIX B

IN THE

UNITED STATES DISTRICT COURT FOR THE

MIDDLE DISTRICT OF FLORIDA

TAMPA DIVISION

CIVIL ACTION NO. 74-440-Civ-T-H

MANDEL SHIMBERG, JR. and ELAINE F, SHIMBERG,

Plaintiffs

Vv.

UNITED STATES OF AMERICA,

Defendant

JUDGMENT

(Filed August 2, 1976)

Pursuant to the findings of fact and conclusions of law

by the Court in its order, entered in this cause on July 1,

1976, it is hereby

ORDERED and ADJUDGED that plaintiffs recover

from the defendant income taxes and assessed interest paid

by them for the year 1970 in the amounts of $125,240.00

and $16,087.34, respectively, together with statutory inter-

est on the total amount of $141,327.34 pursuant to law, and

the plaintiffs are awarded their costs.

DONE and ORDERED this 2nd day of August, 1976,

at Tampa, Florida.

/s/ W. Terrell Hodges

United States District Judge

Approved as to form:

/s/ Harold W. Mullis, Jr.

Attorney for Plaintiffs

/s/ Rodger M. Moore

Attorney for Defendant

Al2

APPENDIX C

Mandell SHIMBERG, Jr. and Elaine F. Shimberg,

Plaintiffs-Appeilees,

Vv.

UNITED STATES of America,

Defendant-Appellant.

No. 76-3749.

United States Court of Appeals,

Fifth Circuit.

July 28, 1978.

* 2 >

Appeal from the United States District Court for the

Middle District of Florida.

Before BROWN, Chief Judge, and THORNBERRY

and CLARK, Circuit Judges.

THORNBERRY, Circuit Judge:

If Justice Holmes was correct that “[t]axes are what

we pay for civilized society,” then the question in this case

is how much civilization the taxpayer will be required to

purchase.

More precisely, we are asked to decide the proper tax

treatment of a pro rata distribution of cash to shareholders

in the course of a corporate reorganization. The taxpayer

contends that this “boot” should be taxed as a long-term

capital gain, while the government argues that it has “the

1. Compania General de Tabacos de Filipinas v. Collector of

Internal Revenue, 275 U.S. 87, 100, 48 S.Ct. 100, 105, 72 L.Ed. 177

(1927) (Holmes, J., dissenting).

Al3

effect of the distribution of a dividend” within the mean-

ing of 26 U.S.C, § 356(a)(2) and should thus be taxed as

ordinary income, The district court agreed with the tax-

payer and awarded him a substantial refund.” For the rea-

sons stated below, we reverse,

The facts are fully stipulated. LaMonte-Shimberg

Corp, (LSC), a Florida corporation engaged in home con-

struction and sales, was controlled by taxpayer Mandell

Shimberg, Jr., who owned 66.8 per cent of the stock, His

wife* owned an additional 1.6 per cent for the benefit of

their children, and nineteen other unrelated persons held

the remaining shares, MGIC Investment Corp, (MGIC) is

a holding company incorporated under the laws of Dela-

ware that is primarily engaged, through various subsidiar-

ies, in the financial guaranty business, In September 1970,

MGIC and LSC executed a merger agreement, pursuant to

which LSC was to be merged into MGIC in a transaction

qualifying for statutory merger treatment under 26 U.S.C,

§ 368(a)(1)(A), To so qualify, the merger must satisfy

applicable state laws regarding such reorganizations,‘

Thus, MGIC would be the surviving corporation, and the

separate corporate existence of LSC would cease, Under

the agreement, LSC shareholders were to receive, pro rata,

$625,000 in cash and 32,132 shares of MGIC common stock,

plus another 32,132 shares in escrow to be delivered in five

years if the conditions of the agreement were met,

2. Shimberg v. United States, 415 F.Supp. 832 (M.D.Fla.

1976),

3. Mrs, Shimberg is involved in this case only because she

filed a joint income tax return with her husband for 1970, the

year in question,

4. See Del.Code Ann,, tit, 8, § 252 (Supp.1977); Fla.Stat.Ann,

§ 607,234 (1977). Section 368(a)(1) (A) also applies to consolida-

tions, and transactions under this section are commonly known as

“A” reorganizations,

Al4

The merger was consummated on December 9, 1970,

and taxpayer in exchange for his LSC stock received $417,-

449, plus 21,461 shares of MGIC commori stock and a like

number in escrow, Immediately prior to the merger, the

undistributed earnings and profits of both corporations

were in excess of $625,000 each.°

On his federal income tax return for 1970, taxpayer

reported the cash received in connection with the merger

as a long-term capital gain, Upon audit and examination

of the return, the Internal Revenue Service determined

that the cash received was taxable as a dividend, that is,

as ordinary income, Accordingly, the IRS assessed a tax

deficiency against taxpayer in the amount of $125,883,

That amount, plus interest totalling $16,169.93, was paid,

and taxpayer then filed for a refund, The IRS disallowed

the refund claim in full, and taxpayer commenced this suit.

Under 26 U.S.C, § 368(a)(1), six types of corporate

transactions are defined as “reorganizations,” among them

a “statutory merger” pursuant to state law.’ If the cor-

porate transaction meets one or more of these definitions

and thus qualifies as a reorganization, favorable tax treat-

ment is available under § 354(a) (1), which provides that no

gain or loss shall be recognized if, pursuant to a reorgani-

zation plan, stock or securities of one corporation are ex-

changed solely for stock or securities of another corpora-

tion that is a party to the reorganization. Accordingly,

such transactions are generally characterized as “tax-free”

reorganizations,

5. As of October 31, 1970, LSC’s consolidated balance sheet

showed retained earnings of $724,559, while on December 31, 1970,

MGIC had retained earnings of $34,012,746.

6. Section 368(a)(1)‘A). See generally 1 Fox & Fox, Cor-

porate Acquisitions & Mergers, 13.03, 4.02 (1977); Comment, 60

Nw.L. Rev, 655 (1965).

Al5

However, § 354(a) (1) makes clear that not all reorga-

nizations will be entirely tax free, for it applies so long as

a shareholder of one corporation receives as consideration

only stock or securities of another corporation participat-

ing in the reorganization, Under some reorganizations—

including the statutory merger—the transaction is not a

stock-for-stock exchange but may involve additional con-

sideration such as cash or property other than stock, In

these circumstances, this additional consideration—com-

monly known as “boot’—does not qualify for tax-free

treatment, 26 U.S.C, § 356(a)(1).". Thus, the reorganiza-

tion is only partially tax-free,

Most state laws, including the Florida and Delaware

statutes applicable here,’ permit other consideration in ad-

dition to stock to be utilized in a statutory merger, In the

instant case the “boot” was a pro rata distribution of

$625,000 to the LSC shareholders, The question in this

case is not whether the “boot” is to be taxed—for § 356 (a)

(1) makes clear that it is—but whether it is to be taxed

as proceeds from the sale of a capital asset, i, e., as a capital

gain, or as a dividend, i, e., as ordinary income,

7, Section 356(a) (1) provides:

Gain on exchanges.—

(1) Recognition of gain,—-If——

(A) section 354 or 355 would apply to an exchange but

for the fact that

(B) the property received in the exchange consists not

only of property permitted by section 354 or 355 to be

received without the recognition of gain but also of other

property or money,

then the gain, if any, to the recipient shall be recognized, but

in an amount not in excess of the sum of such money and the

fair market value of such other property,

8, Del.Code Ann,, tit, 8, § 252 (Supp.1977); Fla.Stat.Ann,

§§ 607,214, 607,234 (1977).

Al6

The answer turns on whether the payment and receipt

of the “boot” has “the effect of the distribution of a divi-

dend” within the meaning of § 356(a) (2), which provides:

Treatment as dividend.—If an exchange is described

in paragraph (1) but has the effect of the distribution

of a dividend, then there shall be treated as a dividend

to each distributee such an amount of the gain recog-

nized under paragraph (1) as is not in excess of his

ratable share of the undistributed earnings and profits

of the corporation accumulated after February 28, 1913.

The remainder, if any, of the gain recognized under

paragraph (1) shall be treated as gain from the ex-

change of property.

The district court, 415 F.Supp. 832, held that the test

to be applied in determining whether the exchange had

“the effect of the distribution of a dividend” is whether

the transaction resulted in a “meaningful reduction” of

the taxpayer’s proportionate interest in the corporation,

relying on United States v. Davis, 397 U.S. 301, 90 S.Ct.

1041, 25 L.Ed.2d 323 (1970), and Wright v. United States,

482 F.2d 600 (8 Cir. 1973). The court then compared

the taxpayer's interest in the merged corporation (LSC)

with his interest in the surviving corporation (MGIC).

Because taxpayer held a controlling interest—68 per cent

of the stock—in LSC prior to the merger and owned less

than one per cent of MGIC’s stock after the merger, the

court concluded that the merger resulted in “a radical

change and meaningful reduction” in taxpayer’s interest

in the continuing business and thus did not have the effect

of the distribution of a dividend under § 356(a)(2). Ac-

cordingly, the court held that the “boot” was taxable as

a capital gain. Unfortunately, this approach is too sim-

plistic.

AlT7

In United States v. Davis, supra, the Supreme Court

was faced with interpreting 26 U.S.C. § 302,” under which

a stock redemption is treated as a distribution in payment

in exchange for the stock and ths qualifies for capi-

tal gain treatment under certain circumstances. Under

§ 302(b) (1), capital gain treatment is available if the re-

demption is “not essentially equivalent to a dividend.”

However, if the redemption has dividend equivalency, it

is taxed as ordinary income. Although the Court was

primarily faced with two other issues,’ it followed a

long line of prior decisions'' in holding that to qualify

under § 302(b) (1), a redemption must result in a “mean-

ingful reduction of the shareholder’s proportionate interest

in the corporation.” 397 U.S. at 313, 90 S.Ct. at 1048.

If the redemption does not result in such a reduction,

it is considered essentially equivalent to a dividend and

is taxed as ordinary income. The taxpayer in Davis was

9. Section 302 provides, in nertinent part:

(a) General Rule.—If a corporation redeems its stock (with-

in the meaning of section 317(b)), and if paragraph (1), (2),

(3), or (4) of subsection (b) applies, such redemption shall

be treated as a distribution in part or full payment in ex-

change for the stock.

(b) Redemptions treated as exchanges.—

(1) Redemptions not equivalent to dividends.—Subsec-

tion (a) shall apply if the redemption is not essentially

equivalent to a dividend.

10. In resolving these questions, the Court held that the rules

of attribution of stock ownership in § 318(a) apply to § 302(b) (1)

and that “business purpose” was irrelevant in determining whether

a redemption is equivalent to a dividend.

ll. E. g., Levin v. Commissioner of Internal Revenue, 385

F.2d 521 (2 Cir. 1967); Bradbury v. Commissioner of Internal

Revenue, 298 F.2d 111 (1 Cir. 1962); Keefe v. Cote, 213 F.2d 651

(1 Cir. 1954); Commissioner of Internal Revenue v. Roberts, 203

F.2d 304 (4 Cir. 1953); Flanagan v. Helvering, 73 App.D.C. 46, 116

F.2d 937 (1940). See also 1 J. MERTENS, LAW OF FEDERAL

INCOME TAXATION, § 90.100 (1974); B. BITTKER & J. EUS-

TICE, FEDERAL INCOME TAXATION OF CORPORATIONS &

SHAREHOLDERS, 9-24—9-27 (3d ed. 1971).

Als

the sole shareholder in a corporation both before and after

he redeemed a certain amount of his stock and thus did

not meet the meaningful reduction test. Obviously, his

relationship with other shareholders in the corporation

did not change and he suffered no loss of voting power

or control.

In Wright v. United States, supra, the Eighth Circuit

applied the ‘meaningful reduction” analysis to a corporate

reorganization. There three corporations were owned and

controlled by the same shareholders but in different pro-

portions. The principal shareholders wanted to consolidate

two of the corporations into a single entity in which their

ownership would be approximately the same proportion

as in the other corporation. This goal could not be ac-

complished through a simple merger because one corpora-

tion was worth about twice as much as the other. Ac-

cordingly, the reorganization required payment of a “boot”

to the taxpayer to reflect his greater entitlement and to

result in a new corporation with the desired ownership

percentages. Even though a formal redemption did not

occur, the court viewed the “‘boot” from the reorganization

as having been paid to the taxpayer by the newly formed

corporation when he redeemed his stock in that corporation

—stock which never had been issued and which the tax-

payer had never owned. The court thus treated the trans-

action as if there had been only one corporation all along

and as if one shareholder had redeemed his stock. Because

this hypothetical redemption resulted in a 23 per cent

reduction in the taxpayer’s ownership,’ the court con-

cluded that the “redemption” had caused a “meaningful

reduction” under Davis. Thus, the court concluded that

12. Before the reorganization, the taxpayer owned 85 per

cent of the two corporations. After the reorganization, he owned

62 per cent of the new corporation.

Alg

the “boot” was “not essentially equivalent to a dividend”

under § 302(b)(1) and therefore did not have “the effect

of the distribution of a dividend” under § 356 (a) (2).

Application of the “meaningful reduction” test in

Wright was not illogical, given the court’s recasting of

the transaction, since a single shareholder was treated

as having redeemed his stock in a single corporation. In

the instant case, however, the reorganization involves two

different corporations of different sizes and with different

shareholders. There is no commonality of ownership as

in Wright, and, accordingly, no opportunity for reshaping

the transaction as a redemption. Moreover, there was

not a single “boot” distribution to a single shareholder,

as in Wright, but a pro rata distribution to all LSC share-

holders.

The “meaningful reduction” test cannot be indis-

criminately applied in the reorganization context. The

Davis case illustrates its proper application in a redemp-

tion under § 302, as does the recently decided case of

Morris v. United States, 441 F.Supp. 76 (N.D.Tex.1977),

while Wright indicates that it also is appropriate when

a reorganization can be realistically treated as a redemp-

tion. Even assuming that Wright is correctly decided—

a point on which we express no opinion—the instant case

presents radically different facts and calls for correspond-

ingly different analysis. We agree with the government

that “the undifferentiating invocation of stock redemption

principles in a reorganization case” such as this one is

erroneous, and we decline to apply on a wholesale basis

the “meaningful reduction” test in cases arising under

§ 356(a)(2).%° Accordingly, we hold that the district

13. We are not unaware of several cases indicating that

Sections 356(a) (2) and 302(b)(1) are to be read in pari materia,

(Continued on following page)

A20

court erred in utilizing “meaningful reduction” analysis

in this case. A contrary holding would render § 356 (a) (2)

virtually meaningless when a large corporation swallows

a small one in a reorganization, for there will always

be a marked decrease in control by the small corporation’s

shareholders, unless the same shareholders control both

corporations. And, even in that situation, disproportionate

ownership—as in Wright—could result in a meaningful

reduction.

Section 356(a) (2) requires that a “boot” be taxed as

a dividend if it “has the effect of the distribution of a

dividend.” The focal point of our analysis, then, is the

effect of the “boot” in the instant case, and we must

examine all of the facts and circumstances surrounding

its distribution in light of basic tax principles pertaining

to dividends and reorganizations.

Under 26 U.S.C. § 316(a), “dividend” is defined as

“any distribution of property made by a corporation

to its shareholders ... out of its earnings and profits,”

either current or accumulated. Thus, a dividend is the

severance of profits from the corporation and the distribu-

tion of those profits to the shareholders. United States

v. Phellis, 257 U.S. 156, 170, 42 S.Ct. 63, 66 L.Ed. 180 (1921).

Footnote continued—

despite the absence of an express statutory relationship between

them. E. g., Hawkinson v. Commissioner of Internal Revenue, 235

F.2d 747, 751 (2 Cir. 1956); Ross v. United States, 173 F.Supp. 793,

797, 146 Ct.Cl. 223, cert. denied, 361 U.S. 875, 80 S.Ct. 138, 4

L.Ed.2d 113 (1959). This is correct in that both provisions are

usually triggered by pro rata distributions. - However, the facts of

th? instant case illustrate why principles developed in § 302(b)

(1) cases cannot be haphazardly applied in the context of a § 356

(a)(2) reorganization. The Internal Revenue Service has stated

that tests developed for § 302 may “in appropriate cases” serve as

“useful guidelines for purposes of applying § 356(a)(2).” Rev.

Rul. 74-516, 1974-2 Cum.Bull. 121. We agree with the govern-

ment that the instant case is not among those “appropriate cases,”

A21

Section 301(c) provides that a dividend is to be included

in the taxpayer’s gross income.

The theory behind tax-free corporate reorganizations

is that the transaction is merely “a continuance of the

proprietary interests in the continuing enterprise under

modified corporate form.” Lewis v. Commissioner of In-

ternal Revenue, 176 F.2d 646, 648 (1 Cir. 1949); Treas.Reg.

§ 1.368-1(b). See generally Cohen, Conglomerate Mergers

and Taxation, 55 A.B.A.J. 40 (1969). Indeed, if the trans-

action does not involve the exchange of sufficient stock

or securities, the judicially-created “continuity of proprie-

tary interest” test destroys the transaction’s treatment as

a reorganization."

If a pro rata distribution of profits from a continu-

ing corporation is a dividend, and a corporate reerganiza-

tion is a “continuance of the proprietary interests in the

continuing enterprise under modified corporate form,” it

follows that the pro rata distribution of “boot” to share-

holders of one of the participating corporations must cer-

tainly have the “effect of the distribution of a dividend”

within the meaning of § 356(a)(2). King Enterprises,

Inc. v. United States, 418 F.2d 511, 189 Ct.Cl. 466 (1969);

Hawkinson v. Commissioner of Internal Revenue, 235 F.2d

747 (2 Cir. 1956); Ross v. United States, 163 F.Supp. 793,

146 Ct.Cl. 223, cert. denied, 361 U.S. 875 (1959); Love v.

14. The purpose of the test is to ensure that the shareholders

of the corporations involved in a reorganization retain a signifi-

cant continuing equity interest in the reorganized business. See

Le Tulle v. Scofield, 308 U.S. 415, 60 S.Ct. 313, 84 L.Ed. 355

(1940); Helvering v. Minnesota Tea Co., 296 U.S. 378, 56 S.Ct. 269,

80 L.Ed. 284 (1935); Pinellas Ice & Cold Storage Co. v. Commis-

sioner of Internal Revenue, 287 U.S. 462, 53 S.Ct. 257, 77 L.Ed. 428

(1933); Southwest Natural Gas Co. v. Commissioner of Internal

Revenue, 189 F.2d 332 (5 Cir.), cert. denied, 342 U.S. 860, 72 S.Ct.

88, 96 L.Ed. 647 (1951). See generally Sapienza, Tax Considera-

tions in Corporate Reorganizations and Mergers, 60 Nw.L.Rev. 765

(1966); Fox & Fox, supra, n. 6, 1 4.02[5][a].

A22

Commissioner of Internal Revenue, 113 F.2d 236 (3 Cir.

1940); Rose v. Little Inv. Co., 86 F.2d 50 (5 Cir. 1936); Com-

missioner of Internal Revenue v. Owens, 69 F.2d 597 (5 Cir.

1934). Moreover, the legislative history of § 356(a) (2)’s

predecessor statute makes clear that a distribution that

would have been a dividend if made prior to the reorga-

nization is subject to the same treatment when made as

part of the transaction. H.Rep. No. 179, 68th Cong., Ist

Sess., 14-15 (1924) [1939-1 Cum.Bull. (Part 2), 241, 252];

S.Rep. No. 398, 68th Cong., 1st Sess., 15-16 (1924)

[1939-1 Cum.Bull. (Part 2), 266, 277].

Accordingly, § 356(a)(2) requires a determination

of whether the distribution would have been taxed

as a dividend if made prior to the reorganization or if

no reorganization had occurred. This inquiry is essentially

a comparison of the effect of actual distribution and the

effect of a hypothetical one. Prior to the mergef in the

instant case, LSC had retained earnings of approximately

$725,000. In the course of the merger, LSC shareholders

received a pro rata distribution of $625,000 as “boot”. If

no reorganization had taken place and LSC had made

such a pro rata distribution, or if LSC had taken such

action prior to the merger, there is no doubt that this

would have been a dividend taxable as ordinary income.

The same result should obtain where, as here, the LSC

shareholders received a pro rata “boot” of $625,000.

15. The “boot” is to be treated as having been distributed

by the acquired corporation—here LSC—rather than by the ac-

quiring corporation. See Commissioner of Internal Revenue v.

Owens, supra; Ross v. United States, supra; James Armour, Inc.,

43 T.C, 295 (1964). Our decision in Davant v. Commissioner of

internal Revenue, 366 F.2d 874 (5 Cir. 1966), cert. denied, 386

U.S. 1022, 87 S.Ct. 1370, 18 L.Ed.2d 460 (1967), is not to the con-

trary. There we recognized the general rule stated above, but

looked to the acquired and acquiring corporations since both had

the same shareholders. As we pointed out, the two corporations

ye but different pockets in the same pair of trousers.” 366

.2d at 889.

A23

Indeed, the legislative history of the predecessor to

$ 356(a) (2) offers virtually the same fact situation as an

example of a transaction having the effect of a dividend

distribution.’” The taxpayer should not be able to reap the

benefits of capital gain treatment simply because he re-

ceived his share of the distribution after the merger in the

form of a “boot” rather than before the merger in the form

of a dividend.

Taxpayer argues that we ignore economic reality by

hypothesizing that LSC could have declared a dividend

prior to the merger, since the corporation had only $147,000

in cash on hand when the merger took place. Taxpayer

thus asks us to erase approximately $725,000 in retained

earnings from the corporation’s pre-merger balance sheet

and pretend that these profits were never made. This

we refuse to do. It is apparent that taxpayer, who con-

trolled LSC made a considered decision to utilize the

corporation’s retained earnings for purposes other than

16. The House Report states:

The necessity for this provision may best be shown by an

example: Corporation A has capital stock of $100,000, and

earnings and profits accumulated since March 1, 1913, of

$50,000. If it distributes the $50,000 as a dividend to its

stockholders, the amount distributed will be taxed at the full

surtax rates. On the other hand, corporation A may organize

corporation B, to which it transfers all its assets, the consid-

eration for the transfer being the insurance by B of all its

stock and $50,000 in cash to the stockholders of corporation A

in exchange for their stock in corporation A. Under the

existing law, the $50,000 distributed with the stock of cor-

poration B would be taxed, not as a dividend, but as a capital

gain, subject only to the 12% per cent rate. The effect of

such a distribution is obviously the same as if the corporation

had declared out as a dividend its $50,000 earnings and profits.

If dividends are to be subject to the full surtax rates, then

such an amount so distributed should also be subject to the

surtax rates and not to the 12% per cent rate on capital gain.

Here again this provision prevents evasions.

House Report No. 179, supra at 14-15. Senate Report No. 398,

supra at 15-16, gives the same example.

£

+ eR OF ower —_—_

A24

payment of a dividend. It cannot be said that LSC was

unable to pay a dividend; rather, for reasons not revealed

in the record, it chose not to do so. Moreover, despite

taxpayer’s protestations to the contrary, it seems clear

that the merger operated as a device for “bailing out”

LSC’s retained earnings, which were evidently tied up

in certain aspects of the business’ operation.

Taxpayer also contends that our analysis in this case

constitutes abrogation of the “step transaction” doctrine.

We disagree. Under the doctrine, which has application

in a variety of tax situations, all parts of a multi-step

exchange or reorganization are grouped together to deter-

mine the appropriate tax treatment for the entire transac-

tion, if the several steps are an essential and integral

part of the overall plan. See Helvering v. Alabama As-

phaltic Limestone Co., 315 U.S. 179, 62 S.Ct. 540, 86 L.Ed.

775 (1942); Kanawha Gas & Utilities Co. v. Commissioner

of Internal Revenue, 214 F.2d 685 (5 Cir. 1954). However,

the doctrine is certainly no bar to our comparing the

“boot” distribution in the instant case with a hypothetical

situation in which the pro rata distribution of LSC’s re-

tained earnings would obviously have becn a dividend.

If the doctrine forbids such an examination of the “boot”

portion of the reorganization scheme, it would be impos-

sible to determine whether the “boot” distribution had

the effect of the distribution of a dividend. We are not

treating the “boot” distribution as a separate step in the

overall transaction but are rather analyzing the distribu-

tion in accordance with the requirements of § 356(a) (2).!7

17. The doctrine’s place in the reorganization context is

plain, for when cash is received in a series of transactions in

connection with a general reorganization plan, the taxable result

may vary considerably depending upon whether the transactions

are to be considered separately or as a whole and whether the

(Continued on following page)

A25

Moreover, taxpayer’s reliance on the step transaction

doctrine seems bottomed on his view that the meaningful

reduction test applies here and that the appropriate focus

is control of the corporation.'* We again reject this ap-

proach, for, as we have previously pointed out, a majority

shareholder in a small corporation will always become

a minority shareholder in a large corporation that acquires

the small one, so long as there is no commonality of owner-

ship. Further, although taxpayer and the other LSC share-

holders relinquished their control of LSC, they certainly

did not part with their interests in the continuing corporate

entity under the reorganization, i. e., MGIC. Taxpayer’s

approach also fails to address the effect of the “boot”

distribution itself, an inquiry mandated by the plain lan-

guage of § 356(a) (2).

Finally, we are compelled to note that our decision

today does not signal a return to the now-discredited “auto-

matic dividend” rule." We are concerned in this case

Footnote continued—

cash constitutes “boot” or the sole consideration in connection

with a single step in the transaction. See 3 J. MERTENS, LAW

OF FEDERAL INCOME TAXATION, §§ 20.161 et seq. (1972).

There is no doubt in the instant case that the “boot” was dis-

tributed pursuant to an overall plan of corporate reorganization.

18. Taxpayer cites and discusses various § 302 redemption

cases. E. g., Zenz v. Quinlivan, 213 F.2d 914 (6 Cir. 1954); Arthur

D. McDonald, 52 T.C. 82 (1969). As we have previously indi-

cated, we will not haphazardly apply § 302 principles in § 356

cases. Moreover, the cases relied on by taxpayer only peripherally

involve the step transaction doctrine and simply stand for the

proposition that either the complete termination of a taxpayer’s

interest in a corporation or the substantial reduction of that inter-

est does not result in dividend equivalency. The Supreme Court

reaffirmed this principle in Davis.

19. This rule stemmed from language in Commissioner of

internal Revenue v. Estate of Bedford, 325 U.S. 283, 65 S.Ct. 1157,

89 L.Ed. 1611 (1945). The opinion was widely criticized, how-

ever, because it appeared to encompass all distributions, regardless

(Continued on following page)

A26

with the effect of a pro rata “boot” distribution, not with

the effect of a distribution on a non-pro rata basis. Ob-

viously, the latter variety does not bear the earmarks

of a classic dividend. Further, we do not totally reject

the relevance of principles developed in § 302 redemption

cases in the context of a corporate reorganization implicat-

ing § 356. However, such a blind application of those

principles would be somewhat akin to hunting ducks with

a deer rifle, since there are fundamental differences be-

tween the redemption of stock in a single corporation

and the reorganization of two or more corporations that

results in a “boot”.

Accordingly, we hold that the district court erred in

concluding that the meaningful reduction test of Davis was

applicable here and that the “boot” received by the t-x-

payer was to be taxed as a capital gain. Because the

distribution of the “boot” had the cffect of the distribution

of a dividend, § 356(a)(2) requires that it be taxed as

ordinary income.”

REVERSED.

Footnote continued—

of whether they were made on a pro rata basis. Accordingly, a

string of lower court decisions have retreated from the rule and

have examined, as we have done here, the facts and circumstances

of each case in order to determine the effect of the distribution.

E. g., Hawkinson v. Commissioner of Internal Revenue, supra;

Ross v. United States, supra.

20. This case is obviously a complex one, and the court was

aided by the excellent briefs and argument of both parties. We

thus cannot say that this tax puzzle is one that “cometh not out

save by fasting and by prayer,” Houston Textile Co. v. Commis-

sioner of Internal Revenue, 173 F.2d 464 (5 Cir. 1949) (Hutcheson,

J.), although we certainly do not disparage either of those

activities.

ee

A27

APPENDIX D

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 76-3749

D. C. Docket No. 74-440-Civ-T-H

MANDELL SHIMBERG, JR. and

ELAINE F. SHIMBERG,

Plaintiffs-Appellees,

versus

UNITED STATES OF AMERICA,

Defendant-Appellant.

Appeal from the United States District Court for the

Middle District of Florida

Before BROWN, Chief Judge, and

THORNBERRY and CLARK, Circuit Judges.

JUDGMENT

This cause came on to be heard on the transcript

of the record from the United States District Court for

the Middle District of Florida, and was argued by counsel;

ON CONSIDERATION WHEREOF, It is now here

ordered and adjudged by this Court that the judgment

of the said District Court in this cause be, and the same

is hereby, reversed;

It is further ordered that plaintiffs-appellees pay to

defendant-appellant, the costs on appeal to be taxed by

the Clerk of this Court.

July 28, 1978

Issued As Mandate: