Petition for Writ of Certiorari — Commissioner v. Clark

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In the Supreme Court of the Ani

OCTOBER TERM, 1987

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

DONALD E. CLARK AND PEGGY S. CLARK

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

DONALD B. AYER

Acting Solic:tor General

WILLIAM 38. ROSE, JR.

Assistani Atiorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

ALAN I. HOROWITZ

Assistant to the Solicitor General

ERNEST J. BROWN

Altorney

Departmer: of Justice

Washingtor D.C. 20530

(202) 633-2217

QUESTION PRESENTED

In this case, a relatively small corporation was merged

into a subsidiary of a large publicly-owned corporation,

and the sole shareholder of the acquired corporation

received in exchange for his shares both cash and shares of

the stock of the publicly-owned corporation. The question

presented is whether that payment of cash had the “effect

of the distribution of a dividend” within the meaning of

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

(1)

TABLE OF CONTENTS

Page

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Reasons for granting the petition ......................... 6

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TABLE OF AUTHORITIES

Cases:

Baker v. United States, 460 F.2d 827 (8th Cir. 1972)... .. 22

Campbell v. Commissioner, 144 F.2d 177 (3d Cir.

MC ACh Cece: 6 ou wire h ebmee 6b Oss eee 6s. . 8, 15, 16

Commissioner v. Estate of Bedford, 325 U.S. 283 (1945) . 16, 17

Commissioner v. Forhan Realty Corp., 75 F.2d 268 (2d

RN a ee Te i elcek eee bebe 15

Commissioner v. Gordon, 391 U.S. 83 (1968)... 0000... 12

Commissioner Vv. Munter, 331 U.S. 210 (1947) 2000000... 11

Commissioner v. National Alfalfa Dehvdrating & Milling

Ne ce vaceeeceeuces 20

Commissioner v. Owens, 69 F.2d 597 (Sth Cir. 1934) .... 14, 16

Commissioner Vv. Phipps, 336 U.S. 410 (1949) 200... 1]

DeGroff v. Commissioner, 444 F.2d 1385 (Oth Cir.

I ea 1S

Don E. Williams Co. v. Commissioner, 429 U.S. 569

EE ee ee

Estate of Uris v. Commissioner, 605 &.2d 1258 (2d Cir.

SS oe ee ee pean : 22

Foster vy. United States, 303 U.S. 118 (1938) ae, li, 22

General Housewares Corp. v. United States, 615 &.2d

va Le 5 iia il, 16

Hawkinson v. Commissioner, 235 &.2d 747 (2d Cir.

ee ew kas i; ewes us 8, 15,17

(111)

BEST AVAILABLE COPY

IV y

Cases-Continued: Page Statutes and regulation-Continued Page

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

Cl.), cert. denied, 358 U.S. 832 (1958) ............-.- 16 — . ; aor Partie el a1. 8, ae .

Kine Sescnpeiees, Onc. v. eed ees, MORIN i a

RE Ba 8, 15, 17 Revenue Act of 1921, ch. 136, 42 Stat. 227............, 12

Lewis v. Commissioner, 176 F.2d 646 (Ist Cir. 1949) .. 13, 15-16 § 202(c{2), 42 Stat. 230 ........... eee eee, 13

Liddon v. Commissioner, 230 F.2d 304 (6th Cir.), cert, § 202(d)(1), 42 Stat. 230... 0... eee eee, 13

ao ee 15 Revenue Act of 1924, ch. 234, § 203(d), 43 Stat. 257... .. 13

Love v. Commissioner, 113 F.2d 236 (3d Cir. 1940) ...... 16 ee tae: 13

Pridemark, Inc. v. Commissioner, 345 F.2d 35 (4th Cir.

DEED -cneSssboepecsaveccanan «06 6eesk buns see e4ess 16 Miscellaneous:

Rose v. Little Investment Co., 86 F.2d 50 (Sth Cir. 1936) .. 15

Ross v. United States, 173 F. Supp. 793 (Ct. C1.), cert. Darrell, The Scope of Commissioner vy. Bedford Estate,

denied, 361 U.S. 875 (1959) ...........00.00005: 15, 16, 17 eR See ee 17

Sheldon v. Commissioner, 6 T.C. 510 (1946) . 2.0... 5... 15 H.R. Rep. 179, 68th Cong., Ist Sess. (1924) ............ 13

Shimberg v. United States, 577 F.2d 283 (Sth Cir. 1978), H.R. Rep. 99-841, 99th Cong., 2d Sess. Pt. I (1986)... y

cert. denied, 439 U.S. 1115 (1979) .... 4, 6, 7, 8, 16, 17, 18, 19

United States v. Davis, 397 U.S. 301 (1970) . 2... 2... ee. 19 Rev. Rul. 74-515, 1974-2C.B. 118 ........... 0 eee 7

woadward v. Commissioner: Rev. Rul. 74-516, 1974-2C.B. 121 .................... 17, 20

ee one a a cena kh dkmaee oh 15, 16 S. Rep. 275, 67th Cong., Ist Sess. (1921)... 00002... 13

30 B.T.A. 1216 (1934) . pla beeing tettee eee 15 S. Rep. 398, 68th Cong., Ist Sess. (1924) ....0.00.00.... 13

Wright v. United States, 482 F.2d 600 (8th Cir. 1973) .. 4, 17, 18 Shoulson, Boot Taxation: The Blunt Toe vf the Auto-

matic Rule, 20 Tax L. Rev. 573 (1965)... 0.2.0.6... 17

Statutes and regulation:

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

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Jn the Supreme Court of the United States

OCTOBER TERM, 1987

No.

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

DONALD E. CLARK AND PEGGy S. CLARK

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

The Solicitor General, on behalf of the Commissioner

of Internal Revenue, petitions for a writ of certiorari to

review the judgment of the United States Court of Appeals

for the Fourth Circuit in this case.

OPINIONS BELOW

The opinion of the court of appeals (App., infra,

la-14a) is reported at 828 F.2d 221. The opinion of the

Tax Court (App., infra, 15a-39a) is reported at 86 T.C.

138.

JURISDICTION

The judgment of the court of appeals (App., infra, 40a)

was entered on September 4, 1987. On November 24,

1987, the Chief Justice extended the time for filing a peti-

tion for a writ of certiorari to and including January 2,

1988. On December 17, 1987, the Chief Justice further ex-

tended the time for filing a petition for a writ of certiorari

to and including January 11, 1988. The jurisdiction of this

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

(1)

STATUTE INVOLVED

The relevant portions of Sections 302, 316, 317, 354,

and 356 of the Internal Revenue Code (26 U.S.C.) are set

forth in a statuiory appendix (App., infra, 41a-45a).

STATEMENT

For some time prior to April 1979, respondent Donald

E. Clark! was the president of Basin Surveys, Inc., a West

Virginia corporation that furnished radiation, nuclear,

and electronic open-hole logging services to the petroleum

industry, and he owned all of its outstanding 58 shares of

stock. N.L. Industries, Inc. (NL) was then a publicly-held

New Jersey corporation engaged in manufacturing and

supplying petroleum equipment and services, chemicals,

and metals. NL had outstanding approximately

32,533,000 shares of a single class of common stock and

500,000 shares of preferred stock. That stock was publicly

traded on the New York and Pacific Stock Exchanges.

N.L. Acquisition Corp. (NLAC) was a wholly owned sub-

sidiary of NL. App., infra, 16a.

In 1978, NL had initiated discussions with respondent

concerning the possible acquisition of Basin. After several

months of negotiations, NL offered respondent alter-

native terms for the acquisition of Basin: (1) 425,000

shares of NL common stock without cash; or (2) 300,000

shares of common stock and $3,250,000 in cash. Respond-

ent decided in favor of the latter alternative. App., i/ra,

l6a.?

' Respondent Peggy S. Clark is a party herein only because she filed

a joint federal income tax return for the calendar year 1979 with her

husband, respondent Donald E. Clark. References to “respondent” in

the singular will be to Donald E. Clark.

>In the Tax Court, respondent’s attorney testified (and it was

agreed that, if called, respondent would tesitfy to the same ettect)

that, after receiving NL’s alternative offers, respondent had requesied

On April 3, 1979, an agreement and plan of merger was

executed by Basin, NLAC, NL, and respondent. The plan

provided that, on April 18, 1979, Basin would merge with

and into NLAC, which would change its name to Basin

Surveys, Inc., and that respondent would receive, with

respect to each of the 58 shares of Basin that he owned,

5,172.4137 shares of NL common stock and $56,034.482

in cash. The merger took place as planned. Respondent

received 300,000 shares of NL common stock and

$3,250,000 in cash, and ne entered into an employment

agreement with Basin Surveys, Inc., for three years and an

agreement not to compete for five years. The parties

stipulated that the merger of Basin into NLAC was ef-

fected pursuant to, and qualified as a reorganization

under, Section 368(a)(1)(A) and (a)(2)(D) of the Internal

Revenue Code.? App., infra, 16a-17a.

2. Section 356(a)(1) of the Code provides that, if cash

or other property is received in the course of what would

otherwise be a tax-free, stock-for-stock reorganization,

the recipient must recognize his gain on the transaction up

to the value of that other property received. Accordingly,

in their joint federal income tax return for 1979,

respondents reported the cash received in the merger, com-

the NL representatives to leave the room, so that the two of them

could discuss the matter. In that discussion, the factors that led to a

tentative choice of the latter alternative were that respondent’s “whole

livelihood was tied up in his company,” and that an all-stock deal

would involve the risk of serious loss if something happened to NL.

Moreover, the stock of NL that was to be received would not be

registered stock, but would be restricted letter stock, which would

mean, under SEC rules, that respondent would have to hold the stock

tor a couple of years if he wanted to sell it and receive full value. And,

in view of respondent’s complete involvement with his company, that,

in turn, would have meant that he could not pay his outstanding bills.

C.A. App. 48-53.

* Unless otherwise noted, all statutory references are to the Internal

Revenue Code (26 U.S.C.), as amended (the Code or 1.R.C.).

monly known as “boot,” as taxable gain.* They

characterized this amount as long-term capital gain. Sec-

tion 356(a)(2) of the Code, however, requires that, if the

exchange “has the effect of a distribution of a dividend,”

the recipient must treat the property received as a dividend

to the extent of his ratable share of the undistributed earn-

ings and profits of the corporation accumulated after

February 28, 1913. Under this Section, the Commissioner

determined that $2,319,611 of the reported gain (i.e., the

amount of the accumulated earnings and profits of Basin

at the time of the merger) should be treated as a dividend

and therefore taxable as ordinary income rather than as

capital gain. This determination resulted in an asserted

deficiency of $972,504.74 in federal income taxes for 1979.

3. Respondents petitioned for review in the [ax

Court, which ruled in their favor in a reviewed decision

(App., infra, 15a-39a). The court viewed the question

whether respondents’ receipt of cash in the merger had the

effect of the distribution of a dividend as turning on a

choice between two “judicially articulated tests” set forth

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

and Shimberg v. United States, 577 F.2¢ 283 (Sth Cir.

1978), cert. denied, 439 U.S. 1115 (1979) (App., i/ra,

18a). According to the Tax Court, the Shimberg test

would treat the cash distribuiion as if it constituted a

distribution by the acquired corporation prior to the

merger, and the Wrighs test would treat the cash payment

as if it constituted “a distribution by the acquiring corpora-

tion (NL) in a hypothetical redemption of the shares of NL

stock that would have been received if petitioner had ac-

+The figure reported by respondents on their return Was

$3,195,294. In their later computation for entry of decision by the Tax

Court, respondents acknowledged that the amount of gain recognized

and reported should have been $3,250,000.

cepted stock in lieu of the cash consideration” (App., in-

fra, 18a (emphasis in original)).

The Tax Court then concluded that it should follow

Wright and treat the cash payment as part of a post-

merger hypothetical redemption of the 125,000 shares of

NL stock that respondent declined to accept as payment.

The court stated that this approach was necessary if the

cash payment is to “be viewed and tested within the con-

text of the entire reorganization” (App., infra, 33a).

Because such a hypothetical redemption would have

reduced respondent’s holdings in NL from 425,000 to

300,000, it would nui have been essentially equivalent to a

dividend under the redemption provisions of the Code (see

Section 302(b)(2)).° Under the Tax Court’s approach, this

conclusion meant that the cash received by respondents

should not be viewed as a dividend in the reorganization

context either, and therefore respondents were entitled to

capital gain treatment upon the reported gain. App., in-

Sra, 34a-35a.

4. The court of appeals affirmed (App., infra,

la-14a). Like the Tax Court, the court of appeals ap-

proached the case as requiring it to choose between Wright

and Shimberg (see App., infra, 8a). The court first con-

cluded that the dividend determination was to be made by

importing into the reorganization context the principles

applicable to redemptions under Section 302 of the Code

(App., infra, 3a-6a). The court then concluded that the

tests of Section 302 should be applied as if there had been

a hypothetical redemption after the reorganization was

; Under the “safe harbor” provisions of Section 302(b)(2), cash

received upon a “subtantially disproportionate redemption” will not

be treated as a dividend. The statute defines such a redemption as one

in which the shareholder’s percentage interest in voting stock in the

corporation following the redemption is less than 80% of what it was

before the redemption and he retains less than 50% of the voting

power in the corporation following the redempiion.

completed, and hence that whether the cash payment was

a dividend turned on the extent of the reduction in

respondent’s interest in NL occasioned by the hypothetical

redemption (App., infra, 7a-1la). The court criticized the

Shimberg approach of treating the cash payment as being

made by the acquired corporation (App., infra, 10a-14a),

stating, inter alia, that it failed adequately to consider “the

corporate control he retained after the reorganization was

completed” (/d. at 10a-11a).

REASONS FOR GRANTING THE PETITION

The court of appeals’ decision in this case has created a

clear conflict in the circuits with respect to the treatment

under Section 356(a)(2) of the Code of cash or other prop-

erty received in a reorganization. This conflict, if allowed

to persist, will create severe administrative problems for

the Internal Revenue Service. Depending on their situa-

tion, different types of shareholders have different

preferences for the treatment of the cash that they receive

in a reorganization. Accordingly, regardless of which of

the court of appeals decisions that it follows, the IRS can

expect some taxpayers to challenge its treatment. Unless

the conflict is resolved, therefore, the issue presented here

is destined to remain a continual source of dispute and

litigation. Moreover, the decision below unjustifiably

departs from a long line of contrary authority on a recur-

ring issue on which there are frequently large sums of

money at stake. For these reasons, it is appropriate for this

Court to grant certiorari to resolve the conflict.

1. There can be no doubt that the decision below

directly conflicts with Shimberg v. United States, 577 F.2d

283 (Sth Cir. 1978), cert. denied, 439 U.S. 1115 (1979). As

the Tax Court noted (App., infra, 27a), Shimberg in-

volved “a factual set of circumstances similar to the instant

case,” and there is no principled basis for reaching a dif-

ferent result in the two cases. In Shimberg a smaller cor-

Rr nme eR

poration was merged into a larger one, and the

shareholders of the acquired corporation received shares

in the acquiring corporation, plus $625,000 in cash, to be

allocated among the shareholders on a pro rata basis.

Shimberg, who owned a majority of the shares of stock in

the acquired corporation, reported his share of the cash

received as long-term captial gain, but the Commissioner

determined that it should be taxed as a dividend.

The court of appeals in Shimberg rejected the taxpayer’s

contention that redemption principles— namely, whether

receipt of the cash in a hypothetical redemption of his

shares in the acquiring corporation would have resulted in

a meaningful reduction of his interest in that corpora-

tion — should be applied to determine whether the cash was

equivalent to a dividend. The court stated (577 F.2d at 287

(footnote omitted)): “We agree with the government that

‘the undifferentiating invocation of stock redemption

principles in a reorganization case’ such as this one is er-

roneous, and we decline to apply on a wholesale basis the

‘meaningful reduction’ test in cases arising under

§356(a)(2).” Rather, the court explained, a “dividend” is

generally defined by Section 316(a) of the Code as “any

distribution of property made by a corporation to its

shareholders * * * out of its earnings and profits.” Ac-

cordingly, “[iJf a pro rata distribution of profits from a

continuing corporation is a dividend, and a corporate

reorganization is a ‘continuance of the proprietary in-

terests in the continuing enterprise under modified cor-

porate form,’ it follows that the pro rata distribution of

‘boot’ to shareholders of one of the participating corpora-

tions must certainly have the ‘effect of the distribution of a

dividend’ within the meaning of § 356(a)(2).” The court

concluded that “§ 356(a)(2) requires a determination of

whether the distribution would have been taxed as a divi-

dend if made prior to the reorganization or if no

reorganization had occurred.” 577 F.2d at 288.

It is evident that the holding of Shimberg is precisely the

contention that was rejected here, and, as the court of ap-

peals apparently recognized (see App., infra, 7a-8a,

13a-14a), the two decisions are irreconcilable. Moreover,

the decision below also conflicts with the decisions of

other courts of appeals relied upon in Shimberg (see 577

F.2d at 288) that recognized the appropriateness of divi-

dend treatment in situations parallel to that presented

here. See, e.g., King Enterprises, Inc. v. United States, 418

F.2d 511, 521 (Ct. Cl. 1969); Hawkinson v. Commis-

sioner, 235 F.2d 747, 751 (2d Cir. 1956); Campbell v.

Commissioner, 144 F.2d 177, 181-182 (3d Cir. 1944); see

pages 14-16, infra. Thus, unless the Court grants certiorari

here, different taxpayers will receive disparate tax treat-

ment on the same transaction depending upon the circuit

in which their case arises.

2. The conflict in the circuits created by the decision

below will create substantial administrative problems for

the IRS unless it is resolved. The issue presented here is

one on which the respective interests of individual

shareholders and corporate sharehclders have long been

sharply divergent. At least since 1936, because of the tax

advantages of capital gains as opposed to ordinary in-

come, it has been in the interest of individual

shareholders, like respondents, not to have dividend treat-

ment for gain recognized on boot received on a

reorganization. On the other hand, corporate shareholdeis

participating in the same or similar transactions have

preferred to have such gain treated as a dividend, because

of the deduction for intercorporate dividends allowed by

Section 243 of the Code (generally 85% under present

law). Thus, even if the Commissioner were to abandon his

longstanding position on this issue and were to adopt the

approach taken by the court below, that would not put an

end to the controversy over the treatment of boot. It can

reasonably be anticipated that corporate shareholders,

ewe

relying on Shimberg and the cases cited therein, would

challenge the Commissioner’s new position and argue for

dividend treatment. Thus, the only way to end the con-

troversy over the issue presented in this case is by means of

a definitive resolution of the conflict in the circuits.

In the wake of the Tax Reform Act of 1986, which

eliminated the differential tax rates between capital gains

and ordinary income, one can expect a significant diminu-

tion in the number of individual shareholders whose in-

terests will be adversely affected by dividend treatment of

boot.® There will, however, remain shareholders in this

category; individuals who have, or can carry forward,

capital losses on other transactions will want their gain in a

reorganization to be classified as capital gain, rather than

as a dividend, so that they will be able to take a full deduc-

tion for the capital losses (see I.R.C. § 1211(b)). The 1986

Act will not affect the interests of corporate shareholders.

Because of the intercorporate dividend deduction, they re-

tain the same interest in contesting any effort by the Com-

missioner to deny dividend treatment to gain recognized

on boot received in a reorganization.

Moreover, quite apart from the question of the char-

acterization of the gain recognized by the shareholders of

the acquired corporation, the conflict in the circuits injects

considerable uncertainty into the treatment of other im-

portant tax accounts. The court below has held that “the

boot should be characterized as a post-reorganization

stock redemption by N.L.” (App., infra, 7a). If that

characterization is followed, it would necessitate several

* Congress, however, apparently viewed the elimination of the dil-

ferential tax rates tor capital gain and ordinary income, which had

been part of the revenue laws since 1921, as something of an experi-

ment. Congress stated that it Was retaining the existing statutory siruc-

ture for capital gains in the Code in order “to facilitate reinstatement

of a capital gains rate differential if there is a future tax rate increase.”

H.R. Rep. 99-841, 99th Cong., 2d Sess. Pt. Il, at 106 (1986).

adjustments because, as discussed in detail infra (at

21-22), the receipt of additional stock that is subsequently

redeemed has different collateral consequences from the

receipt of boot. The receipt of additional shares in the

transaction, which has the effect of spreading thinner the

total basis transferred from the surrendered shares, means

that the basis of each individual share retained after the

merger would be smaller than if the boot were character-

ized as a dividend. And because the gain recognized on a

redemption is reduced by the basis of the redeemed shares,

the gain recognized in the merger will be different depen-

ding on whether the boot is characterized as a post-

reorganization redemption. See pages 21-22, infra.

The disparities created by the conflict are even more

pronounced in connection with the earnings and profits

accounts. Under Section 356(a)(2) dividend treatment, the

accumulated earnings and profits of the acquired corpora-

tion would be depleted by the amount of the dividend, and

those earnings and profits would not be available for

future dividends issued by the reorganized entity. On the

other hand, if the boot is treated as coming from a

hypothetical post-reorganization redemption, the earnings

and profits of the acquired corporation ought to survive in

the reorganized entity. Instead, the redemption

presumably would draw upon the earnings and profits of

the corporation whose stock was being redeemed; on the

facts of this case, for example, that would lead to a

substantially different post-reorganization earnings and

profits structure (see pages 21-22, infra).’ Thus, the dif-

’ Moreover, if the transaction is truly to be treated as a redemption,

there would be additional differences because a redemption may draw

upon capital and upon both accumulated earnings and profits and

also those for the taxable year, whereas a Section 356(a)(2) dividend

draws only upon accumulated earnings and profits. See page 22, in/ra.

RR ee

ference between treating the boot as a dividend issued by

the acquired corporation, on the one hand, and as a

hypothetical post-reorganization redemption, on _ the

other, may be reflected in continuing accounts, like basis

and earnings and profits, that will have tax effects —and

may lead to disputes — many years after the reorganization

is complete.* Accordingly, it is of considerable importance

for the Commissioner to know at the outset how to treat

these transactions and to be able to apply a uniform rule

nationwide. In sum, the 1986 Act does not eliminate the

need to resolve the conflict in the circuits in order to per-

mit the Commissioner to avoid an administrative quan-

dary.

Moreover, while it is possible that litigation in this area

will increase now that the Fourth Circuit has flatly rejected

a published IRS position that has been accepted by several

courts, it must be emphasized that the administrative dif-

ficulties caused by this conflict would not be restricted to

the litigation arena. The area of corporate reorganizations

is One that involves considerable planning and often in-

cludes a request for a private letter ruling from the IRS.

The IRS reports that it has issued 190 letter rulings since

1982 on reorganizations involving boot; 110 of these con-

tained explicit rulings on treatment of boot under Section

356(a)(2). Each ruling for a particular reorganization will

be applicable to an undisclosed, often large, number of

shareholders. And a single reorganization may involve

both corporate and individual shareholders, whose in-

terests will likely be at odds, and shareholders who reside

in different circuits, where the precedent governing the

treatment of boot is irreconcilable. It is essential for the

IRS to have a uniform rule to apply in issuing these

rulings.

* See, e.g., Commissioner v. Phipps, 336 U.S. 410 (1949); Commis-

sioner v. Munter, 331 U.S. 210 (1947); Foster v. United States, 303

U.S. 118 (1938).

3. The court of appeals erred in refusing to treat the

boot received by respondents as a dividend. Section 316 of

the Code provides that “the term ‘dividend’ means any

distribution of property made by a corporation to its

shareholders (1) out of its earnings and profits accumu-

lated after February 28, 1913, or (2) out of its earnings and

profits of the taxable year * * *.” It further provides that

“fe]xcept as otherwise provided in this subtitle, every

distribution is made out of earnings and profits to the ex-

tent thereof * * *.” Section 317 in turn defines “property”

for these purposes as “money, securities, and any other

property.” The Court summarized the effect of these pro-

visions as follows (Comsnissioner v. Gordon, 391 U.S. 83.

88-89 (1968) (footnote omitted)):

Under §§ 301 and 316 of the Code, and subject to the

specific exceptions and qualifications provided in the

Code, any distribution of property by a corporation

to its Shareholders out of accumulated earnings and

profits is a dividend taxable to the shareholders as or-

dinary income. Every distribution of corporate prop-

erty, again except as otherwise specifically provided,

“is made out of earnings and profits to the extent

thereof.”

The reorganization provisions of the Code have their

origin in the Revenue Act of 1921, ch. 136, 42 Stat. 227. In

order to “permit business to go forward with the readjust-

ments required by existing conditions without the im-

mediate imposition of taxes” (S. Rep. 275, 67th Cong., Ist

Sess. 11 (1921)), Section 202(c)(2) of that Act (42 Stat.

230) provided that no gain or loss should be recognized

upon an exchange of stock or securities in One corporation

that is a party to the reorganization for stock or securities

in another corporation that is a party to the reorganiza-

tion. Section 202(d)(1) (42 Stat. 230) instead provides that

the stock or securities received on the exchange should

take the same basis in the hands of the taxpayer as ihe sur-

rendered stock or securities. This statutory structure (now

codified in I.R.C. §§ 354, 358 and 368) embodies the prin-

ciple that such a stock-for-stock reorganization is “a con-

tinuance of the proprietary interests in the continuing

enterprise under modified corporate form” (Lewis v.

Commissioner, 176 F.2d 646, 648 (1st Cir. 1949)). See also

Treas. Reg. § 1.368-1(b).

In 1924, Congress refined the reorganization provisions

that it had enacted three vears earlier by addressing the

treatment of a payment of cash, in addition to the stock or

securities received tax-free, to the shareholders of one of

the reorganizing corporations. It enacted the predecessor

to Section 356(a) of the Code, Section 203(d) of the

Revenue Act of 1924, ch. 234, 43 Stat. 257, which provid-

ed that (1) if, in addition to eligible stock or securities,

money or other property was received on a reorganization

exchange, gain should be recognized to the extent of that

money or other property, but (2) if such a distribution

“has the effect of the distribution of a taxable dividend,

then there shall be taxed as a dividend to each distributee”

the amount of the gain that does not exceed his share of

undistributed earnings and profits. Congress indicated

that this provision was necessary to account accurately for

distributions in the context of a reorganization that had

the same effect “as if the corporation had declared out [the

cash] as a dividend” directly without the reorganization.

See H.R. Rep. 179, 68th Cong., Ist Sess. 15-16 (1924); S.

Rep. 398, 68th Cong., Ist Sess. 15-16 (1924).

The logical import of all of these provisions is that boot

in a reorganization that is distributed pro raia to the share-

holders of one of the corporations should be treated as a

dividend. A pro rata distribution of cash from a corpora-

tion to its shareholders is the classical form of dividend.

And the reorganization provisions are designed to reflect

the fact that the new corporation is a continuation of the

Same enterprise of the acquired corporation. Accordingly,

the pro rata “distribution of property” made in the course

of the reorganization to the shareholders of one of the cor-

porations almost falls within the specific terms of the

definition of “dividend” in Section 316 and should be

viewed as “essentially equivalent to a dividend” within the

meaning of Section 356(a)(2).

In this vein, a long line of court of appeals’ decisions in

the wake of the 1924 Act recognized that, where two cor-

porations not previously under common control are uni-

fied either by statutory merger or consolidation (I1.R.C.

§ 368(a)(1)(A)) or by the transfer of substantially all of the

assets Of one to the other in exchange for voting stock of

the latter (1.R.C. § 368(a)(1)(C)), and the shareholders of

one or both corporations receive a pro rata payment of

cash, that payment has the effect of a dividend and is to be

taxed as such. The first case in this line is Commissioner v.

Owens, 69 F.2d 597 (Sth Cir. 1934), where two banks

merged and the shareholders of the smaller bank received

pro rata both stock in the new bank and cash. The court

held that “so much of [the cash] as might before consoli-

dating have been declared by their corpevation as an or-

dinary dividend out of its profits is by [the predecessor of

Section 356(a)(2)] to be so taxed” (69 F.2d at 598). The

court specifically noted (/bid.): “It is true that the money

was not distributed by the [acquired bank] and thus was

not literally a dividend of that bank. But the statute speaks

of a distribution which ‘has the effect of the distribution of

a dividend.’ This pro rata payment to all stockholders of

the [acquired bank] * * * certainly has that effect.”

Subsequent to Owens, several other courts of appeals

reached the same conclusion regarding boot received on a

pro rata basis. See King Enterprises, Inc. v. United States,

418 F.2d at 521 (“The distribution on a pro rata basis, en-

tailing no substantially disproportionate change in the

continuing equity interests of the Tenco stockholders, con-

stitutes a classic example of a transaction having the effect

sm eee

of the distribution of a dividend.”)% Hawkinson v. Corm-

missioner, 235 F.2d at 751 (“the distribution had all the

earmarks of a taxable dividend, i.e., a pro rata disiribu-

tion out of corporate earnings and profits”); Campbell v.

Commissioner, 144 F.2d at 182 (“We [previously] held

that when cash was distributed in a reorganization to the

stock holders of the predecessor company that part of the

amount thus distributed which equalled the accumulated

earnings of the predecessor corporation had the effect of a

taxable dividend and was accordingly taxable as such.”);

see also Ross v. United States, 173 F. Supp. 793, 798 (Ct.

Cl.), cert. denied, 361 U.S. 875 (1959); Rose v. Little In-

vestment Co., 86 F.2d 50 (Sth Cir. 1936); Commissioner v.

Forhan Realty Corp., 75 F.2d 268 (2d Cir. 1935); Sheldon

v. Commissioner, 6 T.C. 510 (1946); Woodsaeard v. Coim-

missioner, 30 B.T.A. 1216, 1229-1230 (1934); Woodward

v. Commissioner, 23 B.T.A. 1259 (1931).? On the other

hand, where the cash payment was not pro rata to the

shareholders of one of the corporations, but rather was

made only to holders of preferred stock who did not own

any common stock in order to call and retire that preferred

stock, the payment was held not to have the effect of a

¥ All of these cases, like the present one, involve “A” or “C”

reorganizations of corporations not under common control. There are

many more cases requiring dividend treatment tor boot received in a

“D” reorganization (“a transfer by a corporation of all or a pari of ils

assets to another corporation if immediately after the transter the

transferor, or one or more of its shareholders * * * is in control of the

corporation to which the assets are transterred,” I.R.C. § 368

(aX(l)(D)). See, e.g., DeGroff v. Commissioner, 444 F.2d 1385 (Own

Cir. 1971); Liddon v. Commissioner, 230 F.2d 304 (6th Cir.), cert.

denied, 352 U.S. 824 (1956); Lewis v. Commissioner, 176 F.2d 646

(Ist Cir. 1949); Love v. Commissioner, 113 b.2d 236 (3d Cir. 1940);

cf. Pridemark, Inc. v. Commissioner, 345 '.2d 35 (4th Cir. 1965).

dividend. /Jdaho Power Co. v. United States, 161 F. Supp.

807 (Ct. Cl.), cert. denied, 358 U.S. 832 (1958). This line

of authority was capped by Shimberg v. United States,

supra, which rejected the precise contention accepted by

the court below (see pages 6-8, supra). See also General

Housewares Corp. v. United States, 615 F.2d 1056, 1066

(Sth Cir. 1980).'°

Indeed, the existence of this established line of authority

was noted approvingly by this Court in Commissioner v.

Estate of Bedford, 325 U.S. 283 (1945). That case dealt

with a factual situation somewhat different from the one

here. The estate in Bedford was a shareholder of a cor-

poration that engaged in a recapitalization or “E” re-

organization. In exchange for 3,000 shares of preferred

stock, the estate received 3,500 shares of a lesser preferred,

1,500 shares of common stock, and $45,240 in cash. The

Court held thai the cash came out of the corporation’s ac-

cumulated earnings and hence had the effect of a dividend

and was taxable at ordinary, rather than capital, gain

rates. The court referred with approval to several of the

cases cited above requiring dividend treatment in the case

of reorganizations involving two corporations, and it

Stated (id. at 291): “We cannot distinguish the two situa-

tions and find no implication in the statute restricting [the

predecessor of Section 356(a)(2)] to taxation as a dividend

'’ These cases uniformly recognize that dividend treatment does not

turn upon which corporation physically pays out the cash to the

shareholders. Whether the immediate scurce of the cash is the acquir-

ing corporation, the acquired corporation, or the new corporation, a

pro rata distribution to the shareholders of one corporaiion is a divi-

dend to the extent of the accumulated earnings and profits of that lat-

ier corporation. See Shimberg v. United States, 577 F.2d at 289; Ross

v. United States, 173 F. Supp. at 798; Campbell v. Commissioner, 144

F.2d at 182; Commissioner v. Owens, 69 F.2d at 598; Woodward v.

Commissioner, 23 B.T.A. at 1362.

only in the case of an exchange of stock and assets of two

corporatins.” !!

Agains:. this uniform body of decisional law, the court

below erroneously relied upon Wright v. United States,

482 F.2d 600 (8th Cir. 1973), which arose in a very dif-

ferent factual context. Wright was the principal share-

holder in three different corporations engaged in construc-

tion and equipment leasing. Wright owned 71.5% of the

stock of the construction company, and his field

superintendent owned 27.9%. They wanted to merge the

other two companies and create a new company (Omni)

that would have a stock ownership ratio similar to that of

the construction company. A simple stock-for-stock

reorganization, however, would have given Wright a

greater share of Omni than he desired. Therefore, the

merger plan provided that, in addition to the exchange of

'! In the course of rejecting an alternative argument made by the

estate, the Court made the statement that “a distribution, pursuant to

a reorganization, of earnings and profits ‘has the effect of a distribu-

tion of a taxable dividend’ ” (325 U.S. at 292). This statement was

read by some as establishing an “automatic dividend” rule that would

accord dividend treatment to any cash received on a reorganization,

whether pro rata or »0t. This “automatic dividend” rule was heavily

criticized by the commentators (see, e.g., Shoulson, Boot Taxation:

The Blunt Toe of the Automatic Rule, 20 Tax L. Rev. 573 (1965); Dar-

rell, The Scope of Commissioner v. Bedford Estate, 24 Taxes 266,

268-276 (1946)). The post-Bedford cases in this area, however, have

rejected this broad reading and have concluded that this Court was

not attempting to establish a rule that would extend to cases not in-

volving a pro rata distribution, which was not what was involved in

Bedford. See Shimberg v. United States, 577 F.2d at 290 & n.19; King

Enterprises, Inc. v. United States, 418 F.2d at 520; Hawkinson vy.

Commissioner, 235 F.2d at 750-751; Ross v. United States, 173 F.

Supp. at 797. The IRS has also rejected this broad reading of Bedford.

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

121. Because the present case involves a pro rata distribution of boot,

the court of appeals erred in suggesting (App., infra, 1la-12a) that the

government’s contention here seeks to “resurrect{ |] the abandoned

automatic dividend rule of Bedford.”

stock in the two old companies for stock in Omni, the

superintendent would purchase additional shares of Omni

and Omni would issue a promissory note to Wright. This

promissory note was boot, and the court of appeals re-

jected the Commissioner’s contention that it had the effect

of a dividend. The court noted that “[t]he corporations in-

volved did not exist separately but were owned and con-

trolled by the same shareholders but in different propor-

tions” (id. at 607). On that basis, the court concluded that

“the note was issued by Omni in exchange for a portion of

Omni stock that the taxpayer would have received if he

had taken Omni stock entirely instead of receiving Omni

stock and a note issued to him by Omni” (ibid.). The court

then applied the provisions of Section 302 to measure the

effect of this hypothetical redemption on Wright’s interest

in Omni and concluded that there was a meaningful reduc-

tion in his percentage interest that precluded dividend

treatment.

The Fifth Circuit in Shimberg recognized that Wright

was distinguishable because the commonality of owner-

ship of the merging corporations appeared to . > the basis

upon which the Eighth Circuit had concluded that the

distribution of boot should be treated like a redemption of

shares in a single corporation. The Fifth Circuit therefore

remarked (577 F.2d at 287): “Even assuming that Wright is

correctly decided —a point on which we express no opin-

ion —the instant case presents radically different facts and

calls for correspondingly different analysis.” That obser-

vation is equally applicable here. For this reason, the court

of appeals below clearly erred in applying the

“hypothetical redemption” approach of Wright to this

case, rather than the long line of authority requiring divi-

dend treatment for boot distributed to the shareholders of

One corporation On a pro rata basis.

4. Inthe words of the Fifth Circuit in Shimberg, it was

error for the court below to embrace “the undifferenti-

ating invocation of stock redemption principles in a re-

Organization case such as this one” (577 F.2d at 287). To

be sure, there is considerable similarity between the

redemption provisions and Section 356(a)(2) -awe=eke

reuemptten-<eenten; both involve an inquiry into whether

a particular non-dividend distribution is sufficiently akin

to a dividend that it should be treated as one for tax pur-

poses. At the same time, there are significant differences

between the two contexts to which these provisions ap-

ply —for example, the difference between a transaction in-

volving a shareholder and a single corporation as opposed

to a consolidation involving two, often unrelated, cor-

porations. These differences are substantial enough to

counsel against the incorporation of every nuance and

detail of Section 302 into the inquiry needed under Section

356(a)(2).

In any event, in the context presented here, there is no

tension between the principles of Section 302 and the prin-

ciples that should be applied under Section 356(a)(2). As

discussed above, a pro rata payment of boot should be

treated as a dividend. A distribution toa sole shareholder,

as in this case, is necessarily pro rata. By the same token, a

pro rata redemption of stock, including the redemption of

some of the shares of a sole stockholder, is essentially

equivalent to a dividénd and therefore taxable as a divi-

dend under Section 302(d). See United States v. Davis, 397

U.S. 301 (1970). In short, a pro rata payment of cash is the

prototype transaction calling for dividend treatment in

both the reorganization and redemption contexts. This

case, therefore, presents no occasicn to consider to what

extent the detailed formulations of Section 302 should be

applicable in the case of boot that is not distributed on a

pro rata basis or whether, in such circumstances, a differ-

ent result could obtain under Section 356(a)(2) from what

would be indicated by Section 302.'?

'2 The court in Shimberg noted that it did not totally reject the rele-

vance of redemption principles in the context of a reorganization (577

The court below concluded that the application of

redemption principles in the post-reorganization setting

yielded capital gain treatment of boot distributed to a sole

shareholder. It could reach this conclusion only by assum-

ing, contrary to fact, that respondent had elected the

choice that he consciously rejected, namely, receiving,

425,000 shares of NL stock and no cash. The court then

applied Section 302 to the hypothetical redemption of

125,000 of those shares and concluded that the diminution

in respondent’s interest in NL was sufficiently substantial

to make the redemption (and hence the receipt of boot)

not equivalent to a dividend.

This approach is seriously flawed. First, it is generally

true that, “while a taxpayer is free to organize his affairs as

he chooses, nevertheless, once having done so, he must ac-

cept the tax consequences of his choice,” not of the alter-

native that he did not choose. Commissioner v. Namonal

Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149

(1974). See also Don E. Williams Co. v. Commissioner,

429 U.S. 569, 579-580 (1977). In addition, the approach of

the court below creates substantial practical difficulties be-

cause it requires a determination of how many shares the

taxpayer would have received instead of the boot if the

transaction had been a stock-for-stock reorganization

followed by a redemption. That determination happened

to be easy in this case because of the fortuity that re-

spondent had been offered two alternatives. In cases that

lack this unusual aspect, and that involve difficult-to-

F.2d at 290). By the same token, the Commissioner has stated that the

principles developed under Section 302 for determining dividend

equivalency may “in appropriate cases” serve as “useful guidelines for

purposes of applying § 356(a)(2).” Rev. Rul. 74-516, 1974-2 C.B. 121.

But these principles come into piay only in the context of a non-pro-

rata distribution; otherwise, the payment is clearly a dividend. Thus,

they have no application here. For this reason, the example of a non-

pro-rata distribution that the court of appeals put forth as demon-

Strating a flaw in the Commissioner’s position (see App., infra, 12a)

was quite irrelevant.

value close corporations, it will be quite difficult to con-

struct the hypothetical redemption required by the court

of appeals. ,

Moreover, the decision below is flawed because it seeks

to equate two transactions that differ in a number of im-

portant respects. If respondent had actually elected to

receive all of the consideration in the form of NL stock

and then redeem a portion of it, the basic accounting

figures generated by the transaction would not have been

the same. The total basis of the stock received by respond-

ent in the merger, which derives from the basis in the old

stock he exchanged, must be allocated over the total

number of shares received. Thus, the basis of each in-

dividual share obviously is going to be different depending

upon whether the total basis is allocated over the 300,000

shares actually received in the merger or over the 425,000

shares that would have been received in the transaction

assumed by the court of appeals. And, because the gain

recognized on a redemption is reduced by the basis of the

redeemed shares, the gain recognized if respondent had

chosen the “no cash option” would have been different

from the gain recognized on the actual transaction involv-

ing boot. ;

Another difference between the two transactions is the

effect on the earnings and profits accounts. In the actual

transaction, the earnings and profits available for distribu-

tion as a dividend were Basin’s $2,319,611 in accumulated

earnings and profits. If respondent had chosen the

redemption option, however, the earnings and profits

would have been those of NL (a figure that is not in the

record here and that, in any event, bears no relation to

Basin’s or respondent’s history).'} And the effect on earn-

ings and profits is not the same under Section 356(a)(2) as

'3 Because Basin did not merge into NL, but rather into its sub-

sidiary, NLAC, Basin’s earnings and profits would not be involved in

the redemption of NL stock.

it is in the case of redemptions. In the former case, the

Statute specifically provides that the available account is

limited to accumulated earnings and profits. In the case of

a redemption, the earnings and profits of the taxable year

are also available (see Estate of Uris v. Commissioner, 605

F.2d 1258 (2d Cir. 1979); Baker v. United States, 460 F.2d

827, 832-835 (8th Cir. 1972)), and a portion of the redemp-

tion would have drawn upon a share of NL’s capital (see

Foster v. United States, 303 U.S. 118 (1938)). These

significant differences cast considerable doubt upon the

validity of a doctrine that assumes that the two trans-

actions are equivalent.

In sum, respondent presumably acted prudently and ac-

cording to his best judgment in choosing to take cash and

stock upon the merger of his corporation into NLAC,

rather than committing substantially all of his resources to

a large corporation in which he would be a minority share-

holder (see note 2, supra). The court below erred in reliev-

ing him of the tax consequences of that choice and instead

giving him the tax consequences of the option that he de-

clined. The court should have followed established prece-

dent and treated the boot actually received as a dividend to

the extent of Basin’s earnings and profits.

Se -

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted.

DONALD B. AYER

Acting Solicitor General*

WILLIAM S. ROSE, JR.

Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

ALAN I. HOROWITZ

Assistant to the Solicitor General

ERNEST J. BROWN

Attorney

JANUARY 1988

* The Solicitor General is disqualified in this case.

APPENDIX A

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

No. 86-1736

DONALD E. CLARK; PEGGY S. CLARK, PLAINTIFF-APPELLEE

Vv.

COMMISSIONER OF INTERNAL REVENUE,

DEFENDANT-APPELLANT

Appeal from the United States Tax Court. Judge

Tannenwald, Tax Court Judge. (Tax Ct. No. 9428-83)

Argued: June 3, 1987

Decided: September 4, 1987

Before: HALL and WILKINSON, Circuit Judges, and

SMALKIN, United States District Judge for the District of

Maryland, sitting by designation.

WILKINSON, Circuit Judge:

In April 1979, Donald Clark sold his company to N.L.

Industries for 300,000 shares of N.L. stock and $3,250,000

in a transaction that qualified as a reorganization. The

issue in this case is whether the cash payment, commonly

called boot, should be taxed as a capital gain or as or-

dinary income. The Commissioner treated the boot as or-

dinary income, characterizing it as a dividend paid by

Clark’s company immediately before the reorganization.

This characterization, however, fails to recognize that the

(la)

cash was an integral part of the reorganization. Rather

than artifically separating the stock and the cash portions

of the reorganization, we must examine the transaction in

its entirety. We regard the boot as a cash payment by N.L.

in return for Clark’s relinquishment of a portion of his in-

terest in the newly reorganized corporation. Because Clark

surrendered more than 20% of his interest in N.L., he is

entitled to capital gain treatment.

Clark was the sole shareholder of Basin, a West Virginia

corporation that supplied electronic, radiation, and

nuclear Open-hole logging services to the petroleum in-

dustry. In 1978, N.L. Industries, a public company listed

on the New York Stock Exchange, initiated negotiations

with Clark over the possible acquisition of Basin. N.L.

eventually offered to buy Clark’s stock for either 425,000

shares of N.L. or 300,000 shares and $3,250,000. Clark ac-

cepted the combination offer.

In April 1979, Clark and N.L. finalized the deal by sign-

ing an agreement in which Basin was merged with NLAC,

a subsidiary of N.L. created for acquisition purposes.

Because Clark and the Commissioner have stipulated that

the transaction qualified as a reorganization under 26

U.S.C. § 368(a)(1)(A) and § 368(a)(2)(D), Clark did not

have to report any gain on the exchange of his Basin stock

for N.L. stock. Section 356(a), however, requires Clark to

pay tax on the $3,250,000 cash payment to the extent of

his gain in the transaction.

Clark and the Commissioner disagree on whether the

cash payment should be taxed as a capital gain or ordinary

income. Clark reported the boot as capital gain, but the

Commissioner found that the cash payment had the effect

of a dividend and should be taxed as ordinary income

to the extent of Clark’s ratable share in Basin’s earnings

and profits. After the Service assessed a deficiency of

$972,504.74, Clark filed a petition with the Tax Court. In

a unanimous reviewed opinion, the Tax Court held that

the corporate boot should be treated as a capital gain.

Clark v. Commissioner, 86 T.C. 138 (1986). The Commis-

sioner appeals.

According to § 356(a)(2), cash received during a

reorganization is considered ordinary income if it has the

effect of a dividend. In determining when corporate boot

has the effect of a dividend, most courts have relied on the

principle of § 302, which provides in part that a corporate

distribution is a dividend unless the shareholder relin-

quished more than 20% of his corporate control and was

less than a 50% shareholder after the transaction. Al-

though the Commissioner notes several differences be-

tween § 302 and § 356, we believe that § 302 continues to

provide the appropriate test for determining whether boot

is ordinary income or a capital gain. Thus, if Clark sur-

rendered more than 20% of his corporate interest in return

for the cash payment, he is entitled to capital gain treat-

ment.

Under § 356(a)(2), Clark must recognize the boot as or-

dinary income if it had the “effect of the distribution of a

dividend.” Section 356 does not define when a payment

has the effect of a dividend. In Commissioner v. Estate of

Bedford, 325 U.S. 283 (1945), the Supreme Court initially

suggested that any cash payment made during a reorgan-

ization would be treated as a dividend under § 356. This

automatic dividend rule, however, was severely criticized

by the commentators. See, e.g., Darrel, The Scope of

Commissioner v. Estate of Bedford, 24 Taxes 266 (1946);

Shoulson, Boot Taxation: The Blunt Toe of the

Automatic Rule, 20 Tax L. Rev. 573 (1965). The lower

courts retreated from this absolute approach, see, e.g.,

Hawkins v. Commissioner, 235 F.2d 747, 750-51 (2d Cir.

1956); King Enterprises, Inc. v. United States, 418 F.2d

511, 520 (Ct. Cl. 1969); Idaho Power Co. v. United

States, 161 F. Supp. 807 (Ct. Cl. 1958), and the Commis-

sioner eventually abandoned the Bedford approach in

several revenue rulings. See, e.g., Rev. Rul. 515, 1974-2

C.B. 118; Rev. Rul. 83, 1975-1 C.B. 112. In place of this

automatic dividend rule, most courts have approached the

corporate boot problem by focusing on the underlying

principle of § 302.

Although § 302 deals with stock redemptions by a single

corporation, the section does draw a fundamental distinc-

tion between a capital gain and ordinary income. The

basic principle of § 302 is that a shareholder who receives

cash in a pro rata corporate distribution must pay an or-

dinary income tax, but if the shareholder relinquishes a

sufficient portion of his corporate control in return for the

cash, he will receive capital gain treatment. See 11 U.S.C.

§ 302 (1982); See also United States v. Davis, 397 U.S. 301

(1970) (requiring capital gain treatment if the redemption

caused a “meaningful reduction” in the shareholder’s cor-

porate control).

When a shareholder surrenders some corporate control

in return for a cash distribution, he is entitled to capital

gain rates because the transaction is essentially an ex-

change of his corporate control, rather than a simple pro

rata distribution of corporate earnings and profits. Be-

cause it is difficult to determine when a shareholder has

yielded a sufficient percentage of control, § 302(b) con-

tains a safe harbor provision, which treats a redemption as

a capital gain if the taxpayer surrendered more than 20%

of his corporate interest and was not a majority share-

holder, after the redemption. If the principle of § 302 ap-

plies in this case, the boot would be a capital gain only if

Clark yielded a sufficient portion of his corporate control.

Section 302 does not explicitly apply in the reorganiza-

tion context, but there are several persuasive reasons why

§ 302 should be used in determining whether boot is taxed

as ordinary income. Sections 302 and 356 contain virtually

identical language, with § 302 providing for ordinary in-

come treatment if the redemption is “essentially equivalent

to a dividend”, while § 356 treats boot as ordinary income

if it “has the effect of a distribution of a dividend.” Based

on this similarity, the courts have consistently held that the

sections should be read in pari materia. See, e.g., Wright

v. United States, 482 F.2d 600, 605 (8th Cir. 1973);

Hawkins, 235 F.2d at 750; Ross v. United States, 173 F.

Supp 793, 797 (Ct. Cl. 1959). See also Shimberg v. United

States, 577 F.2d 283, 287 n.13 (Sth Cir. 1978) (stating that

§ 302 applies in “appropriate cases.”) Moreover, in

discussing the Deficit Reduction Act of 1984, the House

and Senate conference committee noted that the “prin-

ciples of section 302 are applicable in testing for dividend

equivalence under section 356.” H. Rep. 861, 98th Cong.,

2d Sess. 757, 845, reprinted in 1984 U.S. Code Cong. &

Ad. News 1445, 1532. Most importantly, § 302 and § 356

address the same issue: when should a corporate distribu-

tion ve treated as a dividend? Note, Reorganization and

Capital Gains — A Forgotten Concept?, 41 U. Pitt. L. Rev.

291 (1980); Note, Determining Dividend Equivalence of

“Boot” Received in a Corporate Reorganization, 32 Tax

Lawyer 834 (1979).

Until this case, the Commissioner has apparently

adopted the prevailing view that § 302 applies in the

reorganization setting. See, e.g., Wright, 482 F.2d at 605;

Rev. Rul. 515, 1974-2 C.B. 118; Rev. Rul. 83, 1975-1 C.B.

112. The Commissioner, however, has discovered several

differences between the two sections and now argues that

§ 302 does not apply. For example, the Commissioner notes

that all cash received in a stock redemption is ultimately

taxed at either capital gain or ordinary income rates, but

the boot received in a reorganization is taxed only to the ex-

tent of the taxpayer’s gain on the transaction, regardless of

the size of the boot payment. In addition, if a redemption is

a dividend under § 302, the shareholder must pay ordinary

income to the full extent of the corporation’s earnings and

profits (E&P), but if the boot is a dividend, § 356 only re-

quires the shareholder to pay ordinary income to the extent

of his ratable share of the corporate E&P.

While the Commissioner has illustrated several impor-

tant differences between the two sections, they are irrele-

vant in this case. As Clark notes, the differences relate only

to the amount of the gain treated as a dividend, not to the

character of the corporate distribution. Any potential pro-

blems created by the differences in the provisions can be

avoided by using § 302 only to determine whether the boot

had the effect of a dividend and relying on § 356 to evaluate

what specific portion of the payment, if any, should be tax-

ed as ordinary income. In return for abandoning the § 302

analysis, the Commissioner offers no realistic alternative,

except perhaps a return to the abandoned rule that any pro

rata distribution in a reorganization must automatically be

treated as a dividend. Rather than ignore a code section

that specifically addresses the same problem as § 356, we

join the long line of courts that have applied § 302 in the

reorganization context. See, e.g., Wright, 482 F.2d at 605:

Hawkins, 235 F.2d at 751; King Enterprises, 418 F.2d at

520-21.

Although § 302 provides that a boot payment is a capital

gain if Clark relinquished enough corporate control, the

section cannot resolve this case. The boot can be seen as

affecting either Clark’s interest in Basin or in N.L., with

radically different tax treatment depending on whether the

boot was paid before or after the reorganization. Because

§ 302 was designed to deal with a stock redemption by a

single corporation, rather than a reorganization involving

two companies, the section does not indicate which cor-

poration Clark actually lost interest in. Based on the

language and legislative history of § 356, the change-in-

ownership principle of § 302, and the need to review the

reorganization as an integrated transaction, we conclude

that the boot should be characterized as a post-re-

organization stock redemption by N.L. that affected

Clark’s interest in the new corporation. Because this

redemption reduced Clark’s N.L. holdings by more than

20%, the boot should be taxed as a capital gain.

The transaction in this case involved two steps: Clark

received a $3,250,000 corporate distribution and ex-

changed his Basin stock for N.L. stock. The character-

ization of the corporate boot presents a problem primarily

because these two steps can be combined into at least two

plausible stories. In the first version, Clark received the

$3,250,000 from Basin in a pre-reorganization distribution

and subsequently merged his shrunken company with

N.L. for 300,000 shares. Under this pre-reorganization

view, the boot would be ordinary income because Clark

was the sole shareholder of Basin. In the second version,

Clark exchanged his Basin stock for 425,000 shares of

N.L. stock and N.L. subsequently redeemed 125,000

shares for $3,250,000. Because this redemption reduced

Clark’s interest in N.L. by almost 30%, he would be en-

titled to capital gain treatment.

Of course, both of these hypothetical stories are slightly

unrealistic. In the pre-reorganization view, Basin is treated

as distributing over three million dol. ars to Clark, but no

such distribution occurred. Under the post-view, Clark is

seen as receiving 425,000 N.L. shares, an offer he refused,

and then hypothetically redeeming 125,000 shares. Despite

the flaws in each story, they represent the only realistic op-

tions. No matter how the story is told, the boot was re-

ceived either before or after the reorganization. If the boot

was paid by Basin before the reorganization, the ap-

propriate question is whether the payment affected Clark’s

ownership interest in Basin. If the boot was received after

the reorganization, the focus should be on how it reduced

Clark’s holdings in N.L. Industries. Each version has its

theoretical arguments and judicial adherents. See

Shimberg v. United States, 577 F.2d 283 (Sth Cir. 1978)

applying pre-organization view); Wright v. United States,

482 F.2d 60 (8th Cir. 1973) (applying post-reorganization

view).

In determining which view is more appropriate, the

Starting point of analysis is the statutory language of §

356. Section 356(a)(2) provides that, if the boot is a divi-

dend, the shareholder is taxed at ordinary income rates on-

ly to “his ratable share of the undistributed earnings and

profits of the corporation.” The Commissioner argues that

if the boot is deemed to come from N.L., Clark would

have to determine his ratable share of N.L.’s earnings and

profits (E&P), a task that is both difficult and slightly

unrealistic. Moreover, if the focus is on the E&P of the ac-

quirer, the shareholders of a target company could receive

a distribution that has the effect of a dividend and pay vir-

tually no ordinary income tax if the acquirer has a low

E&P account. Thus, the Commissioner argues that “the

corporation” in § 356(a)(2) must be Basin and hence that a

pre-reorganization perspective is envisioned in the statute.

We do not think this statutory language is nearly so

clear as the Commissioner suggests. In fact, much of the

language of § 356 supports an integrated view of the trans-

action. Section 356(a)(1) provides that if the transaction

would have been a tax-free reorganization “but for the fact

that the property received in the exchange consists not

only of property permitted by section 354 or 355. . . but

also of other property or money, then the gain, if any, to

the receipient shall be recognized.” 26 U.S.C. § 356(a)(1)

(1982) (emphasis added). At a minimum, this language in-

dicates that a shareholder of the target corporation may

receive cash from the acquiring company; the section also

strongly implies that all property involved in_ the

reorganization, both the stock and the boot; should be

seen as coming from the acquirer in a single exchange.

Hankin & Lerer, Wright v. Wrong: The Final Solution to

the Dividend Equivalency Problem, 23 Santa Clara L.

Rev. 1 (1983). The Commissioner’s pre-reorganization

view conflicts with this language because it invariably sees

the boot as coming from the target corporation, thereby

separating the boot payment from the exchange of stock.

The post-reorganization view of the language of § 356 is

bolstered by the legislative history. In enacting § 112(c)(2)

of the 1939 Code, the precursor of § 356(a)(2), Congress

provided an example of when a distribution has the “effect

of a dividend.” In the example, shareholders of corpora-

tion A tried to withdraw the company’s E&P by forming

corporation B, transferring all the assets of the old cor-

poration to this new corporation in a reorganization, and

receiving as consideration some stock of B plus a cash pay-

ment. H. Rep. 179, 68th Cong., Ist Sess 15 (1924), 1939-1

C.B. (Pt. 2) 241, 252. The boot in that case should ob-

viously be treated as a dividend: the shareholders have

received corporate earnings ina pro rata distribution while

retaining the same level of control in corporation B. As the

10a

Tax Court properly noted, this example suggests that “the

primary objective of Congress was to prevent shareholders

from bailing out earnings and profits at capital gain rates

when in essence the shareholders stood substantially in the

same position before the reorganization as they did after

the reorganization.” 86 T.C. at 143. There is no evidence

of such a bail-oui in this case.

We cannot accept the Commissioner’s view of the

legislative history. According to the Commissioner, Con-

gress enacted § 356 to ensure that corporate boot would be

taxed as ordinary income if the distribution would have

been a dividend without the reorganization. The Commis-

sioner concludes that Clark should pay an ordinary in-

come tax, even though his corporate control was affected

by an acquisitive reorganization, because the boot would

have been a dividend if paid by Basin absent the

reorganization. This reading of the legislative history is

unsupportable; there is no indication that Congress in-

tended to impose virtually automatic dividend treatment

on boot received during an acquisilive reorganization in

which the shareholder of the target corporation relin-

quished a portion of his interest in the new corporation.

Note, Taxation of Boot Distributions: A Return to Bed-

ford?, 7 Hofstra L. Rev. 987 (1979); Note, Treatment of

Cash Distributions to the Shareholders Pursuant to a Cor-

porate Reorganization: Shimberg v. United States, 20

B.C.L. Rev. 601 (1979).

The principles underlying § 302 also support the post-

reorganization view. The critical inquiry under § 302 is

whether Clark lost any corporate control as a result of the

transaction. Under the Commissioner’s view, Clark lost no

control because, after the redemption, he was sul the ma-

jority shareholder of Basin. This version, however, fails to

recognize that Basin ceased to exist immediately after the

hypothetical distribution to Clark. An examination of

Clark’s pre-reorganization interest in Basin reveals

————

lla

nothing about how much corporate control he retained

after the reorganization was completed. An accurate

evaluation of Clark’s corporate interest for purposes of

§ 302 requires an examination of his holdings in N.L.,

which is the continuing corporation. Hurley, Capital Gain

Possibilities for Boot in Acquisitive Reorganizations:

Lessened by Shimberg Case, 50 J. Tax’n 334 (1979).

IV.

In addition to finding scant support in the language and

legislative history of § 356 and the rationale of § 30%, the

Commissioner’s version of the transaction suffers from

several serious flaws. First, as a practical matter, the Com-

missioner’s view inexplicably favors shareholders of cor-

porations which merge with larger corporations. Milner,

Boot under the Senate Finance Committee’s Reorganiza-

tion Proposal: a Step in the Wright Direction, But Too

Far, 62 Taxes 507 (1984). When a shareholder merges with

a corporation listed on a major stock exchange, he can

avoid ordinary income and virtually ensure capital gain

treatment by taking only stock from the acquirer, waiting

a sufficiently long time, and then selling the stock on the

market as a capital gain. Note, Boot Hill— Characterizing

Property Distributed with Corporate Reorganizations, 4

J. Corp. Law. 711 (1979). If, on the other hand, a

Shareholder merges with a closely held company, he may

be forced to choose between taking only stock or receiving

some cash and paying an ordinary income tax.

Second, the Commissioner’s view comes close to resur-

recting the abandoned automatic dividend rule of Bed-

ford. See Note, 20 B.C.L. Rev. 601 (1979). The Commis-

sioner’s view will result in ordinary income treatment in

most reorganizations because corporate boot is usually

distributed pro rata to the shareholders of the target cor-

poration. In cases where the target company has only one

12a

shareholder, the Commissioner’s rule would go even fur-

ther and virtually guarantee dividend treatment because

cash distributed to a sole shareholder will almost never

result in a loss of corporate control and thus will almost

always be deemed a dividend. The statutory language in

§ 356 clearly does not impose such automatic dividend

treatment.

Third, the Commissioner’s pre-reorganization perspec-

tive leads to anomalous results in some cases. Even the

adherents of that view admit that the approach may be in-

appropriate when an individual owns stock in both the

target and the acquiring corporation, as the following ex-

ample illustrates: Shareholder A owns 30 of the 100 shares

of corporation X, which is worth $100, and holds all 100

shares of corporation Y, also worth $100. Corporation X

merges with corporation Y, creating XY corporation, a

new company worth $200. As consideration for the

merger, Shareholder A receives 110 shares of XY stock

plus $20, instead of the 130 shares of XY stock he would

have received in a pure stock-for-stock reorganization.

The remaining shareholders of Corporation X receive only

XY stock. When the reorganization is finished, A owns

110 of the 180 shares of XY stock and has $20. See, e.g.,

Note, Boot Distributions in Acquisitive Reorganizations:

The Wright-Shimberg Controversy, 59 S. Cal. L. Rev.

1295 (1980).

Under the pre-reorganization view, A would pay capital

gain on the boot because he will be treated as if he re-

deemed 20 of his 30 shares in Corporation X for $20, im-

mediately before the reorganization, thus falling within

the § 302 safe harbor provision. Shareholder A, however,

should pay ordinary income because he is the majority

shareholder of the reorganized corporation. The in-

tergrated view, by focusing on A’s post-reorganization in-

terest in the new company, would properly impose an or-

dinary income tax.

—

l3a

Fourth, as the Tax Court recognized, the leading case

for the Commissioner’s view, Shimberg v. United States,

misconstrued the comparisons of shareholder interests re-

quired under an integrated view of the reorganization. 86

T.C. at 148-49; Note, 32 Tax Lawyer 834. Shimberg in-

volved a “minnow-whale” reorganization, in which a small

corporation merged with a larger corporation. The district

court held that the shareholder of the target company

satisfied the safe harbor provision of § 302 because he

went from being the majority shareholder of the target to

a less than 1% shareholder in the acquirer. As the

Shimberg court noted, this approach would lead to a vir-

tual automatic capital gain rule in minnow-whale

reorganizations because the target shareholders will in-

variably fall with the § 302 safe harbor provisions.

Shimberg, 577 F.2d at 287-88.

The Shimberg court was wrong to suggest, however,

that an integrated perspective automatically provides for

capital gain treatment. Rather than comparing the

shareholder’s interest in the target with his interest in the

acquirer, the integrated view focuses on the shareholder’s

loss of interest in the acquiring corporation. If the boot

does not reduce his ownership interest in the surviving cor-

poration by the amount required in § 302, the shareholder

must pay ordinary income.

Finally, the Commissioner’s view artificially segments

the Basin-N.L. reorganization. The step transaction doc-

trine, which encourages the view of transactions in their

entirety, confirms our view that an integrated perspective

is more appropriate. The classic exposition of the doctrine

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

also involved a choice between two plausible versions of a

transaction. In Zenz, a shareholder redeemed a portion of

his stock and sold the other portion to an outside buyer.

The Commissioner argued that the redemption occurred

first, which required the taxpayer to pay ordinary income

l4a

on the redemption. According to the taxpayer, the sale oc-

curred first, which resulted in capital gain treatment for

the redemption because it completely liquidated the

shareholder’s interest in the company. Both versions were

theoretically plausible. Zenz noted that the overall effect

of the sale and redemption was a complete elimination of

the taxpayer’s interest in the corporation, which should

have entitled the taxpayer to a capital gain. 213 F.2d at

917. To ensure that the shareholder paid only capital gain

rates, the court treated the transaction as if the sale oc-

curred first, followed by a complete redemption.

This case presents the same problem faced by the Zenz

court: determining which transaction—the redemption or

the exchange of stock —occurred first. Zenz resolved the

problem by focusing on the net effect of both steps in the

transaction. The Commissioner here focuses on only one

part of the transaction and fails to recognize that the cash

and the stock exchange were integral parts of one

reorganization. See, Levin, Adess & McGaffey, Boot

Distributions in Corporation Reorganizations, 30 Tax

Lawyer 287 (1977); Note, 59S. Cal. L. Rev 1295; Note, 32

Tax Lawyer 834. The facts show that as a part of the

reorganization, Clark was offered a choice between

125,000 shares of N.L. stock and $3,250,000. The cash

that Clark chose was clearly a substitute for additional

N.L. stock; the Tax Court found that “there is not the

slightest evidence that the cash payment was a concealed

distribution from Basin.” 86 T.C. at 155.

The tax consequences of the transaction should reflect

the reality of Clark’s choice to forego 125,000 shares of

N.L. stock. There is no question in this case that the value

of the boot received was roughly equivalent to the value of

the shares foregone by Clark. By taking the cash, Clark

surrendered his potential interest in N.L. to the extent of

almost 30%. This 30% drop satisfied the safe-harbor pro-

visions of § 302 and entitled Clark to capital gain treat-

ment.

The judgment of the Tax Court is AFFIRMED.

lSa

APPENDIX B

Docket No. 9428-83

DONALD E. CLARK AND PEGGY S. CLARK,

PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Filed February 6, 1986

TANNENWALD, Judge: Respondent determined a defi-

ciency in petitioners’ Federal income taxes for the taxable

year 1979 of $972,504.74. The sole issue for decision is

whether the receipt by petitioners of cash (boot) as partial

consideration under a plan of reorganization pursuant to

sec. 368(a)(1)(A) and (a)(2)(D),' should be treated as a

dividend pursuant to sec. 356(a)(2), instead of long-term

capital gain under sec. 356(a)(1).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

This reference incorporates the stipulation of facts and at-

tached exhibits. )

Petitioners, husband and wife, resided in Buckhannon,

West Virginia, at the time they filed their petition in this

case. They timely filed a joint Federal income tax return

for the calendar year 1979 with the Internal Revenue Serv-

ice Center in Memphis, Tennessee.

' Unless otherwise indicated, all statutory references are to the In-

ternal Revenue Code of 1954 as amended and in effect during the year

in issue, and all Rule references are to the Rules of Practice and Pro-

cedure of this Court.

l6a

For some time prior to April 18, 1979, petitioner hus-

band Donald E. Clark (hereinafter referred to as peti-

tioner) Owned all the outstanding stock (58 shares) of

Basin Surveys, Inc. (BASIN), a West Virginia corporation.

BASIN’s principal business was furnishing radiation,

nuclear, and electronic open-hole logging services to the

petroleum industry. Petitioner was the president of BASIN

from 1964 until April 18. 1979.

N.L. Industries, inc. (N.L.), is a New Jersey corporation

engaged in the manufacturing and supplying of petroleum

equipment and services, chemicals, and metals. NL is a

publicly held corporation whose stock is traded on the

New York Stock Exchange and the Pacific Stock Ex-

change. As of the end of March 1979, Ni had outstanding

approximately 32,533,000 shares of its single class of com-

mon stock (par value $2.50 per share) and 500,000 shares

of preferred stock. N.L. Acquisition Corp. (NLAC) was a

wholly owned subsidiary of NL.

In 1978, NL initiated discussions with petitioner regard-

ing the possible acquisition of BASIN by NL. After several

months of negotiations, on March 6, 1979, NL offered

petitioner a choice between two alternatives: in exchange

for petitioner’s BASIN stock, NI was willing to give peti-

tioner either (1) 425,000 share of NL common stock and no

cash, or (2) a combination of 300,000 shares of common

stock and $3,250,000 cash. Petitioner accepted NL’s com-

bined stock and cash offer. By accepting this offer, the

total number of NL common shares Outstanding increased

to approximately 32,833,000 shares, and petitioner’s

stockholdings represented approximately 0.92 percent of

that total. If petitioner had accepted the all-stock deal of

425,000 shares, the total number of NL common shares

Outstanding would have increased to approximately

32,958,000 shares, and petitioner’s stockholdings would

have represented approximately 1.3 percent of that total.

17a

On April 3, 1979, an agreement and plan of merger (the

plan) was executed by BASIN, NLAC, petitioner, and NL. The

plan provided that on April 18, 1979, BASIN would merge

with and into NLAC and that each outstanding share of

NLAC would remain outstanding, each outstanding share

of BASIN common stock would be exchanged for

$56,034.482 cash and 5,172.4137 shares of NL common

stock, and each share of BASIN common stock held in the

treasury Of BASIN would be canceled. The plan further pro-

vided that the articles of incorporation of NLAC would be

amended to change its name to Basin Surveys, Inc.

Moreover, pursuant to the plan, petitioner signed a cove-

nant not to compete for 5 years and an employment agree-

ment to remain with Basin Survey, Inc., for 3 years.

For the purposes of this case, the parties agree that the

merger Of BASIN intO NLAC (the merger) was effected pur-

suant to, and qualified as a reorganization under, section

368(a)(1)(A) and (a)(2)(D). The closing price of NL com-

mon stock on the New York Exchange on April 18, 1979,

was $23% per share. Based on that closing price, the NL

stock received by petitioner had a value of $6,937,500

which constituted 68.1 percent of the total value of the

consideration which petitioner received for his BASIN

stock. Prior to the merger, petitioners did not Own any

stock in NL Or NLAC.

Petitioner’s basis for his BASIN stock immediately prior

to the merger was $84,515. He incurred expenses of

$25,013 in connection with the merger. In their joint

Federal income tax return for 1979, petitioners reported

recognition of $3,195,294 of long-term capital gain as a

result of the merger. As of April 18, 1979, BASIN had ac-

cumulated undistributed earnings and profits of

$2,319,611, and total assets of $2,758,069 and liabilities of

$808,132. Among its assets were $138,490 in cash,

$1,231,552 in trade notes and accounts receivable (after

18a

allowance for bad debts), and buildings and other fixed

depreciable assets with a book value net of accumulated

depreciation of $929,306.

OPINION

The issue for decision is whether the cash (boot) re-

ceived by petitioner had the effect of a dividend under sec-

tion 356(a)(2), and should therefore be taxed as ordinary

income. Resolution of this issue requires us to choose be-

tween two judicially articulated tests (the so-called Wright

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

and the so-called Shimberg test, Shimberg v. United

States, 577 F.2d 283 (Sth Cir. (1978)), in interpreting what

is, at best, an ambiguous statute. Respondent argues that

we should choose the Shimberg test and treat the

$3,250,000 cash payment as if it constituted a distribution

in redemption of stock by the acquired corporation

(BASIN) prior to, and separate from, the merger. If this is

our choice, then, according to respondent, since the

redemption fails to satisfy the requirements of either sec-

tion 302(b)(1) or (b)(2), the cash payment should be

treated as a dividend from BASIN under section 356(a)(2) to

the extent of its earnings and profits ($2,319,611), and as

capital gain in respect of the excess.? Petitioner, on the

other hand, urges us to choose the Wright test and treat

the cash payment as a distribution by the acquiring cor-

poration (NL) ina hypothetical redemption of the shares of

NL stock that would have been received if petitioner had

accepted stock in lieu of the cash consideration under the

all-stock alternative available to him. Petitioner then

argues that such a redemption would have resulted in a

meaningful or substantially disproportionate reduction in

? Since the amount of the cash is not in excess of petitioner’s gain

from the exchange, the limitation of sec. 356(a)(1) does not come into

play. We note that for the same reason, this limitation does not apply

to the Wright test advocated by petitioner.

19a

petitioner’s stock interest in NL and that consequently, the

entire $3,250,000 cash payment should be treated as a pay-

ment in exchange for NL stock, under section 302(a),? tax-

able as capital gain under section 356(a)(1). For the

reasons hereinafter set forth, in the context of this case, we

agree with petitioners.

The issue of choice is not a novel one, although as will

subsequently appear, the number of judicial precedents is

limited. It has spawned a large number of articles and

commentaries of both an historical and analytical nature*

dealing with the proper test to be used in applying section

356 to acquisitive reorganizations.’ While we deem it un-

3 The general rule of sec. 302(a) provides that “If a corporation

redeems its stock (within the meaning of section 317(b)), and if

paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemp-

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

change for the stock.”

4 See Kyser, “The Long and Winding Road: Characterization of

Boot Under Section 356(a)(2),” 39 Tax L. Rev. 297 (1984), and cita-

tions collected at p. 299, nn. 14 & 15; Rands, “Section 356(a)(2): A

Study of Uncertainty in Corporate Taxation,” 38 U. Miami L. Rev. 75

(1983); Levin, Adess & McGaffey, “Boot Distributions in Corporate

Reorganizations — Determination of Dividend Equivalency,” 30 Tax

Law. 287 (1977); Golub, “ ‘Boot’ in Reorganizations — The Dividend

Equivalency Test of Section 356(a)(2),” 58 Taxes 904 (1980); Com-

ment, “Determining Dividend Equivalence of ‘Boot’ Received in a

Corporate Reorganization,” 32 Tax Law. 834 (1979). See also B. Bitt-

ker & J. Eustice, Federal Income Taxation of Corporations and

Shareholders, par 14.34, at 14-116 to 14-119 and S14-53 to S14-56 (4th

ed. 1979 & Supp. 1985); D. Kahn, Basic Corporate Taxation, par.

10.51 (3d ed. 1981).

5 Since sec. 368(a)(1)(E) (recapitalization) and (F) (mere change in

identity, form, or place of organization) only involves a single cor-

poration, a choice between the Wight test and the Shimberg test is not

required. Similarly, in view of the “solely” requirement of sec.

368(a)(1)(B) (see Heverly v. Commissioner, 621 F.2d 1227 (3d Cir.

1980), revg. and remanding Pierson v. United States, 472 F. Supp. 957

(D. Del. 1979), and Reeves v. Commissioner, 71 T.C. 727 (1979); and

20a

necessary to lay out a detailed, evolutionary history, a

brief review of the statutory provisions and their historical

genesis appears to be in order as a prerequisite to

understanding the parameters of the choice we are called

upon to make.

Sections 354 and 356 provide the tax treatment to be af-

forded shareholders of corporations which are parties to

reorganizations qualifiying as such under section

368(a)(1). Specifically, under section 354(a)(1)—

No gain or loss shall be recognized if stock or

securities in a corporation a party to a reorganization

are, in pursuance of the plan of reorganization, ex-

changed solely for the stock or securities in such cor-

poration or in another corporation a party to the

reorganization. [Emphasis added.]

In situations in which the reorganization is not a straight

stock-for-stock deal, but instead includes some additional

consideration, the Internal Revenue Code (the Code) does

not simply recategorize the entire transaction as a taxable

exchange. Rather, it provides for a limited recognition of

gain under section 356(a)(1)—

(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,

Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980), revg. and

remanding Reeves v. Commissioner, supra), there never should be any

“boot” and hence no occasion for choice where a “B” reorganization is

involved. See also McDonald v. Commissioner, 52 T.C. 82 (1969),

where a choice was made because respondent erroneously conceded

the existence of a “B” reorganization (see Rev. Rul 75-360, 1975-2

C.B. 110).

2la

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.

This gain is to be treated as a capital gain unless the ex-

change qualifies for dividend treatment under section

356(a)(2), which provides —

if an exchange is described in paragraph (1) but Aas

the effect of the distribution of a dividend * * * then

there shali 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 undistributed earnings and profits of the corpora-

tion accumulated after February 28, 1913. The re-

mainder, if any, of the gain recognized under

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

change of property. [Emphasis added. ]

The precursor of section 356(a)(2) first appeared in the

Revenue Act of 1924, which became, without significant

change, section 112(c)(2) of the Internal Revenue Code of

1939. The following example, found in the report of the

House Ways and Means Committee, is illuminating —

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 6, to which it transfers all its assets, the

consideration for the transfer being the issuance by B

of all its stock and $50,000 in cash to the stockholders

of Corporation A in exchange for their stock in Cor-

poration A. Under the existing law, the $50,000

22a

distributed with the stock of Corporation 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 corpora-

tion had declared out as a dividend its $50,000 earn-

ings 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.

[H. Rept. 179, 68th Cong., Ist Sess. 15 (1924),

1939-1 (Part 2) 241, 252].

Thus, it appears that the primary objective of Congress

was to prevent shareholders from bailing out earnings and

profits at capital gain rates when in essence the

shareholders stood substantially in the same position

before the reorganization as they did after the reorganiza-

tion, i.e., “to prevent the bailout of earnings and profits at

capital gains rates through the device of a reincorporation

reorganization.” See Kyser, supra note 4, at 302.

In Commissioner v. Estate of Bedford, 325 U.S. 283

(1945), the Supreme Court ruled that any distribution of

“boot” pursuant to a reorganization would have the effect

of a taxable dividend to the extent of the corporation’s ac-

cumulated earnings and profits, i.e., the so-called

“automatic dividend rule.” That decision met with much

criticism, however (see, e.g., Hawkinson v. Commis-

sioner, 235 F.2d 747, 750-751 (2d Cir. 1956)), and both the

courts and the Internal Revenue Service have now

retreated from the rule. See, e.g., Shimberg v. United

States, 577 F.2d at 290; King Enterprises, Inc. v. United

States, 189 Ct. Cl. 466, 418 F.2d 511, 520 (1969); Johnson

v. Commissioner, 78 T.C. 564, 575-576 (1982); Rev. Rul.

74-515, 1974-2 C.B. 118, 120.

23a

In its place, the courts have developed a concept which

encompasses the determination of whether a distribution

has “the effect * * * of a dividend” by looking to the pro-

visions of section 302, although there is no express

reference to that section in section 356(a)(2). Most of the

courts have said that these two sections are to be read in

pari materia. Wright v. United States, 482 F.2d at 605;

King Enterprises, Inc. v. United States, 418 F.2d at 520;

Ross v. United States, 146 Ct. Cl. 223, 173 F. Supp. 793,

797 (1959); Hawkinson v. Commissioner, supra at 751.

The Fifth Circuit Court of Appeals, however, has adopted

a somewhat more ambiguous approach by embracing and

considering section 302 simply as providing “ ‘in ap-

propriate cases’ * * * ‘useful guidelines for purposes of ap-

plying section 356(a)(2j.’” Shimberg v. United States,

supra at 287 n.13. (Citation omitted.) Although Congress

has not chosen specifically to amend the Code to reflect

the interrelationship of these two sections, its acquiescence

and tacit approval of such a conclusion is apparent in the

Conference Committee Report for the Deficit Reduction

Act of 1984, in which it was unequivocally stated that

“The principles of section 302 are applicable in testing for

dividend equivalency under section 356.” H. Rept. 98-861

(Conf.) (1984), 1984-3 C.B. (Vol. 2) 1, 99. Furthermore,

the Internal Revenue Service has adopted this position in

its published rulings.® In point of fact, the distinction be-

tween the “in pari materia” and the “useful guidelines”

standard is little more than one of nuance and without any

impact on the instant case since neither standard provides

any significant help in making the choice before us.

Turning to section 302(b), we find two situations, in-

sofar as relevant to the case before us, in which a distribu-

tion in redemption of stock is to be treated as a distribu-

tion in part or full payment in exchange for such stock and

6 See 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.

24a

not as a dividend. Section 302(b)(1) provides for such

treatment, i.e., capital gain under section 302(a), “if the

redemption is not essentially equivalent to a dividend.”

The Supreme Court has held that for a redemption to meet

this test it “must result in a meaningful reduction of the

shareholder’s proportionate interest in the corporation.”

United States v. Davis, 397 U.S. 301, 312 (1970). Section

302(b)(2)(A) provides for such treatment if the “distribu-

tion is substantially disproportionate with respect to the

shareholder.” (Emphasis added.) A distribution qualifies

as being “substantially disproportionate” if the share-

holder’s interest in the voting stock and the common stock

(whether voting or nonvoting) of the corporation im-

mediately after the redemption is less than 80 percent of

his interest in such stock immediately before the redemp-

tion, and if immediately after the redemption the share-

holder owns less than SO percent of the total combined

voting power of all classes of stock entitled to vote. Sec.

302(b)(2)(B) and (C). If the shareholder falls within this

“safe harbor” constructed by Congress, the redemption is

deemed to be “substantially disproportionate.”

The first case’ directly to confront the issue of whether,

in determining the application of section 356(a)(2), the

tests under section 302 should be applied in the context of

a redemption by the acquired or the acquir-

’ In King Enterprises, Inc. v. United States, 189 Ct. Cl. 466, 418

F.2d 511 (1969), there was no dispute that the dividend determination

should be made with reference to the acquired corporation. See 418

F.2d at 521. In Ross v. United States, 146 Ct. Cl. 223, 173 F. Supp.

793 (1959), the Court of Ciaims thought the facts of that particular

case so clear that it had no choice but to find that the distribution was

made by the acquired corporation. Hawkinson v. United States, 235

F.2d 747 (2d Cir. 1956), seemingly determined dividend equivalency in

terms of a distribution from the acquired corporation but clearly did

not confront the issue of choice between the acquired and the ac-

quiring corporation. See also pp. 151-152, and particularly infra note

15, discussing McDonald vy. Commissioner, 52 T.C. 22 (1969).

25a

ing corporation was Wright v. United States, supra, in

which the Eighth Circuit Court of Appeals held that the

proper test for determining whether the distribution had

“the effect * * * of a dividend” was to view the cash pay-

ment as a reduction of the taxpayer’s stockholdings in the

acquiring, i.e., surviving, corporation. In Rev. Rul. 75-83,

1975-1 C.B. 112, however, the respondent expressly re-

jected the holding in Wright and said it would not be

followed. Instead, respondent focused on the cash pay-

ment as a reduction of the taxpayer’s stockholdings in the

acquired corporation, prior to the reorganization. The

Fifth Circuit Court of Appeals adopted a similar stance in

Shimberg v. United States, supra, in which it also rejected

the holding and reasoning of Wright as erroneously plac-

ing the emphasis on the surviving, instead of the acquired,

corporation. See 577 F.2d at 287.

Wright v. United States, supra, involved the consolida-

tion of two closely held corporations into a new corporate

entity (Omni). The old corporations were commonly

owned, but in different proportions. A simple merger in-

volving the exchange of shares of these corporations for

shares of Omni would not have resulted in the ownership

percentages in Omni desired by the controlling share-

holders. As a result, pursuant to the reorganization,

“boot,” in the form of a promissory note, was paid to the

majority stockholder to compensate him for taking a

reduced equity interest in Omni.

In determining dividend equivalency, the Eighth Circuit

first focused on who in fact issued the note constituting

the “boot,” i.e., the old corporations or Omni. While

recognizing that “it is not material whether the distribution

is actually made by the corporation entering the reorgan-

ization or by the corporation résulting from the reorgan-

ization,” the court emphasized that it could not ignore “the

factual circumstance that there were two corpora-

tions * * * before reorganization and one after reorganiz-

26a

ation.” 482 F.2d at 607. The court found that, within the

context of the entire plan of reorganization, it was ar-

tificial for respondent to contend that the note was issued

by the old corporations. Instead the court held that “the

note was issued by Omni in exchange for a portion of Om-

ni stock that the taxpayer would have received if he had

taken Omni stock entirely instead of receiving Omni stock

and a note issued to him by Omni.” 482 F.2d at 607. The

court concluded that the rationale underlying the redemp-

tion provisions mandated such a result —

The entire concept of a redemption contemplates a

change in ownership between an ongoing corporation

and a newly formed corporation or within an ongoing

corporation itself. For example, underlying the “safe

harbor” provision, sec. 302(b)(2), is the rationale that

a substantially disproportionate redemption of stock

leads to the conclusion that the exchange is a redemp-

tion. The percentage requirements, e.g., the 50 per

cent rule, refers to the necessity of having 50 per cent

of the total voting stock after redemption. This rule

and other redemption provisions make sense only in

relation to a corporation that will continue to exist. If

a substantially disproportionate redemption of stock

has occurred the distribution clearly can be said to be

a Sale rather than a dividend because the stockholder

has relinquished valuable rights in the future

business. Further, the rights of stock ownership —to

vote, tO participate in earnings, and to share in net

assets On liquidation—are all affected by a redemp-

tion. But these rights and the effect of a redemption

only make sense in relation to a corporation that will

be engaged in doing business after the redemption. To

analyze the present case as a redemption of [the old

corporations] stock alone *** is an_ artificial

reading of the redemption provisions, for (the old

corporations] were dissolved as part of the Plan. The

27a

change in ownership that would be significant due to

a redemption would be a change in ownership in Om-

ni, the corporation that would exist after the redemp-

tion and would have voting stock, earnings, and

assets that would be affected. [482 F.2d at 607-608.

Emphasis supplied. ]

In Shimberg v. United States, supra, the Fifth Circuit

Court of Appeals was faced with a factual set of cir-

cumstances similar to the instant case. The taxpayer in

that case owned approximately 67 percent of a LaMonte-

Shimberg Corp. (LSC), of which he was president and

chief executive officer. Pursuant to a plan of reorganiz-

ation, LSC was merged into a large publicly held corpora-

tion called MGIC Investment Corp. (MGIC) whose stock

was traded on the New York Stock Exchange. According

to the terms of the merger, the stockholders of LSC re-

ceived ratably, in exchange for all their LSC stock, stock

of MGIC and cash “boot” of $625,000. The taxpayer

received $417,449 in cash and stock in MGIC constituting

less than 1 nercent of MGIC’s total shares outstanding.

Immediately prior to the merger, LSC had undistributed

earnings and profits in excess of $625,000.

As in Wright, the issue before the Fifth Circuit was

whether the taxpayer’s receipt of cash “boot” had the ef-

fect of a dividend distribution. The District Court had

found for the taxpayer, basing its decision on an apparent

misinterpretation of the holding in Wright. Shimberg v.

United States, 415 F. Supp. 832 (M.D. Fla. 1976). After a

preliminary discussion of the Eighth Circuit’s application

of the Davis “meaningful reduction” test in Wright, the

District Court concluded that the taxpayer’s relinquish-

ment of ownership and control of a small, local company

in exchange for a “miniscule percentage of the outstanding

stock of a huge, publicly-held corporation [made it] * * *

clear that the merger resulted in a radical change and

28a

meaningful reduction in the nature of the [taxpayer’s] in-

terest in the continuing business.” 415 F. Supp. at 836.

Thus, rather than focusing solely on the taxpayer’s interest

in the surviving corporation, the District Court miscon-

strued Wright to mean that the proper test for determining

dividend equivalency was a comparison between the tax-

payer’s interest in the acquiring, i.e., surviving, corpora-

tion after the reorganization and the interest he held prior

to the reorganization in the acquired corporation.

The Fifth Circuit Court of Appeals reversed, finding

that the District Court’s application of the “meaningful

reduction” test of section 302(b)(1) was incorrect and that

the “undifferentiating invocation of stock redemption

principles in a reorganization case such as this is er-

roneous.” 577 F.2d at 287. It is apparent that the Court of

Appeals predicated its rejection of the lower court’s

holding on its mistaken view that the District Court had

properly interpreted and applied the Wright test. This is

clearly borne out by the court’s finding that —

A contrary holding would render section 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. [577

F.2d at 288.*]

* The Fifth Circuit’s misunderstanding of the Wright holding is

even more clearly evidenced in General Housewares Corp. v. United

States, 615 F.2d 1056 (Sth Cir. 1980). In that case, pursuant to a plan

of reorganization qualifying as such under sec. 368(a)(1)(C), the two

shareholders of Olivier Co., Inc. (Olivier), who held two-thirds and

one-third of its stock, respectively, received pro rata cash payments

and stock of U.S. Industries (USI), constituting 0.4 percent and 0.2

= eee

29a

Having rejected the District Court’s analysis, the Fifth

Circuit reasoned that, according to the theory and

legislative history behind the reorganization provisions

“section 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 oc-

curred.” 577 F.2d at 288. It then concluded that, since ab-

sent the reorganization, a pro rata distribution of $625,000

to LSC shareholders would have been a dividend taxable

as ordinary income, “The taxpayer should not be able to

reap the benefits of capital gain treatment simply because

he received 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.” 577 F.2d at 289.

After careful consideration, we have concluded that, at

least in the context of the factual situation before us, the

Wright test is the better choice in respect of the application

of section 302 to the determination of whether “boot” has

“the effect of the distribution of a dividend” under section

356(a)(2). Several considerations have led us to this

conclusion. :

The genesis of section 356(a)(2) (see p. 143 supra), lay in

Congress’ concern for the possibilities of manipulated

withdrawals within the framework of reorganizations

which approached the types of transactions which have

been dealt with in later years through the application of

percent, respectively, of the total outstanding stock of USI. The Fifth

Circuit, in discussing the decision in Wright, stated —

“Here, if the Wright test were applicable, we would be concerned

with a reduction from a 6624% and 33'3% interest in Oliver

stock for [the two shareholders] respectively to a 0.4% and 0.2%

respective interest in the Outstanding USI stock. [615 F.2d at

1066.}”

Once again, the Fifth Circuit misinterpreted the Wright test as com-

paring shareholder interests in the old corporation to those in the sur

viving corporation.

30a

the liquidation-reincorporation doctrine. See B. Bittker &

J. Eustice, supra note 4, par. 14.54.9

While we recognize this clear intent by Congress to pre-

vent abusive cash bailouts made pursuant to planned

reorganizations, as well as the fact that the language used

in section 356(a)(2) may have been broader than necessary

to deal with the legislative concern, contrary to respond-

ent’s position we do not think it follows that we must test

“boot” distributions in connection with a reorganization,

as if they were made by the acquired corporation prior to

and separate from the reorganization. As we have noted in

the past, in legitimate reorganizations that substantially

reduce a shareholder’s ownership interest, although it may

be true “that a decision in favor of the petitioner would

allow him to withdraw substantial corporate earnings at

no tax (Or, if his basis in the redeemed stock were less than

the amount distributed, at capital gains rates) * * * such

result does not require us to hold that the distribution is a

dividend.” McDonald v. Commissioner, 52 T.C. 82, 89

(1969).

Respondeni asks us to follow a twisted path. After con-

ceding that the distribution has been made pursuant to a

legitimate reorganization under section 368(a)(1)(A), a

necessary prerequisite to invoking section 356(a)(2),

respondent then asks us to make our determination of

dividend equivalency fantasizing that the reorganization

does not exist.'® Clearly, if Congress had wanted the

* Subsequent legislative history is of little help in resolving the

choice issue. Proposals in 1954 and 1959 seem to have embraced

respondent’s position herein while more recent proposals embrace the

position espoused by petitioner; none of these proposals have been

adopted. See Kyser, supra note 4, at 322-323; Rands, supra note 4, at

93-94; Golub, supra note 4, at 905-906; B. Bittker & J. Eustice, supra

note 4, at S14-51 to $14-56.

ba See supra note 9 for the conflicting attempts by Congress to deal

with the choice issue.

3la

distribution to be viewed in this manner, it could easily

have said so in 1924 or in connection with the passage of

numerous revenue acts in the ensuing 60 years.'?

We reject respondent’s attempt to bootstrap the hold-

ings that the acquired corporation’s earnings and profits

should be the measure of any dividend under section

356(a)(2) into a conclusion that the determination of the

requisite reduction in interest under section 302(b) must be

necessarily made with reference to the same corporation.

In our opinion, there is no such necessary correlation.

There is no reason why the redemption cannot be con-

sidered as having been made by one corporation with the

consequences to be measured by the earnings and profits

of another corporation. Compare section 304(b)(1) with

section 304(b)(2)(A). Moreover, the courts are not in

agreement as to the standard of measurement to be used.

See Atlas Tool Co. v. Commissioner, 70 T.C. 86, 106-107

(1978), affd. 614 F.2d 860, 868 (3d Cir. 1980).'? Indeed,

respondent on brief has made it clear that his acceptance

of the agreed stipulation of the parties that the earnings

and profits of BASIN will be the measure of any dividend

determined herein is not to be construed as an acceptance

of this test in any other case.

Respondent’s attempt to view the cash payment as an

isolated event totally separate from the reorganization

runs counter to the established case-law principle known

as the “step-transaction” doctrine—a doctrine which

respondent has zealously and generally successfully sought

to apply in the reorganization arena. See Levin, Adess &

McGaffey, supra note 4, at 290; Rands, supra note 4, at

117. In McDonald v. Commissioner, supra, we held that

'! Furthermore, the limitation of dividend treatment contained in

sec. 356(a)(2) is a clear indication that Congress considered the boot

distribution to be an integral element of the reorganization. See Levin,

Adess & McGaftey, supra note 4, at 303.

‘2 See also Davanit v. Commissioner, 366 b.2d 874, 887-890 (Sih

Cir. 1966), revg. on this issue Sow Texas Rice Warehouse Co. v.

Commissioner, 43 T.C. 540, 570-572 (1965); American Manufactur-

ing Co. v. Commissioner, 55 1.C. 204, 230-231 (1970).

32a

the “step-transaction” doctrine, first set forth in Zenz y.

Quinlivan 213 F.2d 914 (6th Cir. 1954),' was “applicable

in determining whether a redemption is essentially

equivalent to a dividend within the meaning of section

302(b)(1),” 52 T.C. at 87. The facts in McDonald, simply

stated, are as follows. Taxpayer owned 10 of the 11 shares

of the common stock of E & M Enterprises, Inc. (E&M),

and all of its preferred stock. Pursuant to a plan of

reorganization, E&M redeemed all of taxpayer’s preferred

stock for $43,500, and Borden Co. (Borden), the corpora-

tion acquiring E&M, gave 4,839 of its shares in exchange

for the 11 shares of E&M common stock. E&M acquired

the cash to carry out the redemption by obtaining a short-

term bank loan. A week after the redemption, E&M and

Borden exchanged their shares and Borden transferred

cash to E&M which was used in part to pay off the loan.

Respondent argued that the redemption by E&M of tax-

payer’s preferred stock was a totally separate transaction

and thus taxable as a dividend.'* In holding for the tax-

| ‘> The taxpayer in Zenz wished to sell all the stock in a corporation

in which she was the sole stockholder. To satisfy the wishes of the pur-

chaser who did not want to buy all the stock of the corporation, the

parties agreed upon a plan under which the purchaser bought pari ot

the stock and the corporation redeemed the remaining shares. The

court viewed the steps in the transaction as part a single integrated

plan intended to totally liquidate the taxpayer’s holdings in the cor-

poration. In light of this, the court held that redemption was noi

essentially equivaleni to a dividend because it completely terminated

her interest in the corporation. See 213 F.2d at 917.

‘* lt should be noted that, at trial, respondent considered the

redemption and exchange to be separate transactions and therefore

conceded that the exchange constituted a tax-free reorganization

under sec. 368(a)(1)(B). 52 T.C. at 86. However, in Rev. Rul. 75-360,

1975-2 C.B. 110, the respondent recognized that —

i Was In error in argying the various sieps were separate trans-

actions thereby affording tax-free treatment on the siock ev-

change. Accordingly, since the acquisition was not solely tor

33a

payer, we recognized that “The record in this case

establishes clearly that the redemption was merely a step in

the plan of Borden for the acquisition of E&M, so that tt is

the results of the plan that are significant to us.” 52 T.C. at

87 (emphasis added). We concluded that “Taking into ac-

count all the circumstances of this case * * * the redemp-

tion and the reorganization effected such a substantial

change in the petitioner’s interest in E&M as to establish

that the redemption was not essentially equivalent to a

dividend.” 52 T.C. at 89.

We recognize that some argument can be made that the

same failure to apply the step-transaction doctrine exists in

applying the Wrighz test in that such test involves viewing

the cash payment as being in redemption of an imputed

number of shares of the acquired corporation after the

reorganization has occurred. See Rands, supra note 4, al

102-103. But we think this argument fails in that the

Wright test treats the cash payment as the equivalent of a

redemption in the course of implementing the reorganiza-

tion, while the Shimberg test, advocated by respondent,

requires that the redemption by the acquired corporation

be treated as having occurred prior to and separate from

the reorganization. Clearly, the cash payment in situations

of the type involved herein would not have taken place

without the reorganization. The same cannot be said of

the redemption created by the SAimberg test.

In view of the foregoing, we conclude that the deter-

mination of whether the cash payment to petitioner had

“the effect * * * of a dividend” should be viewed and

tested within the context of the entire reorganization. To

hold otherwise, and view and test the cash (boot!) as if il

were distributed as a hypothetical redemption by BASIN

prior to the reorganization, would in effect resurrect the

voting stock of the acquiring corporation, but partly for cash,

that the acquisition of stock of E&M did not consiitute a

reorganization. - Therefore * * * the entire transaction ts: con:

sidered a taxable sale or exchange.”

34a

now discredited “automatic dividend rule” (see pp.

143-144 supra), at least with respect to pro rata distribu-

tions made to an acquired corporation’s shareholders pur-

suant to a plan of reorganization.

We turn now to the question whether petitioner, as a

result of the reorganization, suffered a reduction in in-

terest sufficient to qualify the cash he received as a

redemption under section 302(b). In resolving this ques-

tion, we apply the test enunciated in Wright v. United

States, supra, and look at the effect of the reorganization

on petitioner’s potential and actual interest in NL, the ac-

quiring, 1.€., surviving, corporation. '5

Pursuant to the plan, petitioner received 300,000 shares

of NL common stock, which constituted approximately

0.92 percent of the total shares outstanding of NL com-

mon stock after the merger. If petitioner had accepted the

all stock offer, he would be received 425,000 shares of

stock, which would have constituted approximately 1.3

percent of NL’s total shares outstanding. By treating the

cash “boot” as a redemption of petitioner’s shares, we find

that the cash distribution reduced petitioner’s interest in

NL by approximately 29 percent (from 1.3 percent to 0.92

percent) so that his post-distribution holdings were only

approximately 71 percent of what they would have been

absent the distribution. Coupled with the fact that peti-

'S We recognize that it is possible to construe our opinion in

McDonald v. Commissioner, 52 T.C. 82 (1969), as adopting a test

based upon a comparison of a taxpayer's stock interest in the acquir-

ing corporation with his prior interest in the acquired corporation.

However, we think it significant that McDonald was decided prior to

either Wright or Shimberg, that the isswe before this Court was simply

whether the redemption was separate from, or an integral part of, the

reorganization, and that it appears that the acquired versus acquiring

corporation test for applying sec. 356fa)(2) was not presented to us

Such being the case, and particulariy since the result ip McDonald

would have been the same under the Wright test, we do nox view our

opinion in McDonald as inhibiting our freedom to choose the test

which should be applied herein. |

35a

tioners held less than 50 percent of the voting stock of NL

after the redemption, under section 302(b)(2) the distribu-

tion qualifies as being “substantially disproportionate”

and is not taxable as a dividend. Since the distribution falls

within the mechanistic “safe harbor” of section 302(b)(2),

we need not decide if the redemption resulted in a mean-

ingful reduction of petitioner’s stock interest under section

302(b)(1).

In point of fact, respondent does not argue that the re-

quired reduction in petitioner’s interest does not exist if the

Wright test is applied. Rather, the heart of respondent's

position is that use of the Wright test results in an

“automatic capital gain” rule. Respondent argues that, in

cases involving factual circumstances similar to the instant

case, in which the “whale” swallows the “minnow” and

gives the shareholders of the acquired corporation a pro

rata distribution of boot in addition to stock, those

shareholders will always be afforded capital gain treat-

ment. He reasons that if a shareholder in a small closely

held corporation exchanges his interest in that corporation

for what must be, almost by definition, a much smaller

percent of ownership in a large publicly held corporation,

a comparison of these percentage ownership figures will

always be so disparate as to qualify as a meaningful reduc-

tion or as substantially disproportionate in the context of a

edemption by the acquiring corporation. In effect,

respondent’s position is rooted, as was that of the District

Court in Shimberg v. United States, 415 F. Supp. 832

(M.D. Fla. 1976), in an erroneous equating of the Wright

test with a comparison of a taxpayer’s interest in the ac-

quired corporation before the reorganization with his in-

terest in the acquiring corporation after the reorganiz-

ation. See pp. 147-150 supra. We think we have made it

clear that the Wright test does no such thing. It simply

compares the stock interest which a taxpayer actually

receives in the acquiring, i.e., surviving, corporation in a

36a

reorganization with what he would have received if he had

obtained additional stock in lieu of the cash payment.

Whether the results of such a comparison indicate divi-

dend or capital gain treatment will vary, depending on the

facts and circumstances of each individual case. We think

it signi ficant that respondent in substance accepts the facts

and circumstances limitation in situations involving sec-

tion 356(a)(2).'* In so doing, he reflects the same uncer-

tainties as those of the Fifth Circuit in Shimberg v. United

States, supra—uncertainties which, in a sense, are also

present in Our reservation of the same limitation in adopt-

ing the Wright test.'?

“We are only addressing in this brief a factual situation which is

identical to the one present in Shimberg where a small corpora-

tion (the “minnow”) was merged into a large corporation (the

“whale”), there had been no previous commonality of ownership

between the two corporations, the “minnow’s” shareholders

received cash and stock on a pro rata basis, the “minnow’s”

shareholders stock Ownership in the “whale” was very small vis-a-

vis the number of shares outstanding, and the acquired corpora-

tion had a significant amount of accumulated undistributed earn-

ings and profits.”

In connection with the facts and circumstances limitation, we

observe ihat respondent objected at trial to the relevancy of any

tesumony regarding the merger negotiations. We overruled

respondent’s objection and reserved to respondent the right to

argue the question of admissibility on brief. We are satisfied that

we should adhere to our ruling at trial. See McDonald v. Com-

missioner, 52 T.C. 82, 88 (1969).

r It is interesting to note that the Court of Appeals in Wright vy.

United States, 482 F.2d 600 (8th Cir. 1973), would have reached a dif-

ferent conclusion if the attribution rules of sec. 318(a) had been ap-

plied. See 482 F.2d at 610. See also Kyser, supra note 4, at 312 n. 78

Under sec. 227(b) 9f the Tax Equity and Fiscal Responsibility Act of

1982 (TEFRA), Pub. L. 97-248, 96 Stat. 324, 492, the attribution rules

of sec. 318 now apply to “boot” payments falling within sec. 356(a).

37a

While we are satisfied that the Wright test should not be

equated with the comparison erroneously made by the

District Court in Shimberg v. United States, supra, we

think that the minnow-whale scenario is a background ele-

ment which can be taken into account. Cf. McDonald v.

Commissioner, supra. See also supra note 15.

If we look at the particular facts and circumstances of

the instant case, the correctness of our conclusion that the

cash distribution of $3,250,000 did not have “the ef-

fect * * * of a dividend” under section 356(a)(2) becomes

even clearer. There is not the slightest evidence that the

cash payment was a concealed distribution from BASIN. '*

Indeed, it is hard to conceive that such a possibility could

even have been considered, for a distribution of that

amount was not only far in excess of the accummulated

earnings and profits ($2,319,611), but also of the total

assets of BASIN ($2,758,069). In fact, only if one takes in-

to account unrealized appreciation in the value of

BASIN’s assets, including good will and/or going-concern

value, can one possibly arrive at a $3,250,000. Such a dis-

tribution could only be considered as the equivialent of a

complete liquidation of BASIN, which would call for

capital gain treatment under Zenz v. Quinlivan, supra.

Moreover, the record herein makes i clear that it was NL

which developed the stock plus cash alternative and that

iis foundation was attributable to a desire of NL to mini-

mize the number of shares outstanding. In this connec-

tion, we think that the question of whether the share-

holders of the acquired corporation are given a choice

'* Iw is in this context that the facts and circumstances analysis

might well produce a different result when there ts persuasive evidence

of an identity between the amount of the cash payment, the earnings

and profits of the acquired corporation, and available liquid assets to

support the conclusion that the acquiring corporation was a conduit

for the payment. Cf. Ross v. United States, supra note 7. The problem

of identification of the source of a cash payment is not without its dif-

ficulties. See Levin, Adess & McGaffey, supra, note 4, at 290 n. 15.

38a

between all stock and stock plus cash in the acquired cor-

poration is not the significant factor. See McDonald y.

Commissioner, supra at 89. As a general rule, we would

apply the Wright test where only the latter offer was

available. However, the source of the offer in whatever

form may be a fact and circumstance to be taken into ac-

count in certain situations. See supra note 18.

Our analysis of the issue before us herein has convinced

us that neither the Shimberg test nor the Wright test can be

inexorably applied to “boot” distributions in connection

with a reorganization, fully within which the ambit of sec-

tion 356(a)(2). Each test has its supporting and criticizing

arguments. See, e.g., Kyser, supra note 4; Rands, supra

note 4; Levin, Adess & McGaffey, supra note 4; Com-

ment, supra note 4. However, we think that, on balance,

the Wright test is the more suitable vehicle for decision

principally because its application produces a result more

within the scope of the type of reorganization Congress

had in mind in enacting section 356(a)(2), i.e., where there

is an overlapping of ownership between the acquired and

acquiring corporations, than the Shimberg test which

would tend to produce exactly the opposite result.

Moreover, unlike the Wright test, the Shimberg test would

make the result dependent upon which corporation, the

acquired or the acquiring, survived a merger. Indeed the

deficiencies in the Shimberg test are sufficient to cause its

supporters to suggest that the Wright test be applied whére

there is a “commonality” of ownership of the acquired and

acquiring corporations and the Shimberg test be reserved

for situations where such commonality does not exist. See,

e.g., Kyser, supra note 4, at 331; Rands, supra note 4, at

116. We have difficulty in applying such a bifurcated ap-

proach to a statute which seems to make no distinction

between different reorganizations. Cf. American

Manufacturing Co. v. Commissioner, 55 T.C. 204,

230-231 (1970); Levin, Adess & McGaffey, supra note 4,

39a

at 306. Furthermore, such an approach would add another

difficult dimension to the application of section 356, i.e.,

determining how much overlap of stock ownership would

constitute commonality. See Kyser, supra note 4, at

329-332.

One final word. The root of the problem of choice be-

tween the Wright test and the Shimberg test lies in the low

level of “continuity of interest” required to constitute a

type of tax-free reorganization. The result of this low-level

requirement is to cause transactions to be treated as

reorganizations which really should be considered sales,

i.e., where there is a substantial amount of cash paid

and/or the stock of the acquiring corporation can be

readily disposed of by the taxpayer. See, e.g., Kyser supra

note 4, at 315 n. 90 and 340. But this condition has existed

far too long for the judiciary now to change the rules of

the game. If a change is to come, it must come from the

legislature. We think the same is true with respect to

adopting a bright-line test, under section 356(a)(2), i.e., a

rule applicable without qualification to all cases, to deter-

mine whether a distribution has “the effect * * * of a divi-

dend.” In the meantime, the courts, the Executive, and

taxpayers will be forced to live with a test which admitted-

ly is imprecise in that it will not be inexorably applicable in

all situations.

To reflect the foregoing and petitioners’ concessions on

other issues,

Decision will be entered under Rule 155.

Reviewed by the Court.

STERRETT, GOFFE, NIMS, PARKER, Wit AKER, KORNER,

SHIELDS, HAMBLEN, COHEN, CLAPP, Swirt, JACOBS,

WRIGHT, and WILLIAMS, JJ., agree with this opinion.

SIMPSON, WILBUR, CHABOT, GERBER, and Parr, JJ.,

did not participate in the consideration of this case.

40a

APPENDIX ©

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

No. 86-1736

DONALD E. CLARK; PEGGy S. CLARK,

PLAINTIFFS-APPELLEES

Vv.

COMMISSIONER OF INTERNAL REVENUE

DEFENDANT-APPELLANT

Appeal from the Tax Court of the United States

[Filed: September 4, 1987]

JUDGMENT

bi cause came on to be heard on the trancript of the

ecord trom The Tax Court of the United States, and was

argued by counsel.

Par consideration whereof, it is now here ordered and

: ju ged by this Court that the decision of said The Tax

| ourt ot the United States, in this cause, be, and the same

is hereby, affirmed.

/s/ JOHN M. GREACEN

John M. Greacen

Clerk

A True Copy, Teste:

* John M. Greacen, Clerk

By: BARBARA RAvi

Deputy Clerk

4la

APPENDIX D

The Internal Revenue Code (26 U.S.C.) provides in pertinent part:

Section 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

subsection (b) applies, such redemption shall be treated as

a distribution in part of full payment in exchange for the

stock.

(b) Redemptions treated as exchanges

(1) Redemptions not equivalent to dividends

Subsection (a) shall apply if the redemption is not

essentially equivalent to a dividend.

(2) Substantially disproportionate redemption of

stock

(A) In general

Subsection (a) shall apply if the distribution is

substantially disproportionate with respect to the

shareholder.

(B) Limitation

This paragraph shall not apply unless immediately

after the redemption the shareholder owns less than

50 percent of the total combined voting power of all

classes of stock entitled to vote.

For the purposes of this paragraph, the distribution

is substantially disproportionate if —

(i) the ratio which the voting stock of the cor-

poration owned by the shareholder immediately

after the redemption bears to all of the voting stock

of the corporation at such ume,

is less than 80 percent of —

®t

42a

(ii) the ratio which the voting stock of the cor-

poration owned by the shareholder immediately

before the redemption bears to all of the voting

stock of the corporation at such time.

For purposes of this paragraph, no distribution shall

be treated as substantially disproportionate unless the

shareholder’s ownership of the common stock of the

corporation (whether voting or nonvoting) after and

before redemption also meets the 80 percent require-

ment of the preceding sentence. For purposes of the

preceding sentence, if there is more than one class of

common stock, the determinations shall be made by

reference to fair market value.

(D) Series of redemptions

This paragraph shall not apply to any redemption

made pursuant to a plan the purpose or effect of

which is a series of redemptions resulting in a

distribution which (in the aggregate) is not substan-

tially disappropriate with respect to the shareholder.

(3) Termination of shareholder’s interest

Subsection (a) shall apply if the redemption is in com-

plete redemption of all of the stock of the corporation

owned by the shareholder.

(4) Redemption from noncorporate shareholder in

partial liquidation

Subsection (a) shall apply to a distribution if such

distribution is —

(A) in redemption of stock held by a shareholder

who is not a corporation, and

(B) in partial liquidation of the distributing cor-

poration.

(5) Application of paragraphs

in determining whether a redemption meets the re-

quirements of paragraph (1), the fact that such redemp-

43a

tion fails to meet the requirements of paragraph (2), (3), or

(4) shall not be taken into account. If a redemption meets

the requirements of paragraph (3) and also the require-

ments of paragraph (1), (2), or (4), then so much of

subsection (c)(2) as would (but for this sentence) apply in

respect of the acquisition of an interest in the corporation

within the 10-year period beginning on the date of the

distribution shall not apply.

Section 316. Dividend defined

(a) General rule

For purposes of this subtitle, the term “dividend” means

any distribution of property made by a corporation to its

shareholders —

(1) out of its earnings and profits accumulated after

February 28, 1913, or

(2) out of its earnings and profits of the taxable year

(computed as of the close of the taxable year without

diminution by reason of any distributions made during

the taxable year), without regard to the amount of the

earnings and profits at the time the distribution was

made.

Except as otherwise provided in this subtitle, every

distribution is made out of earnings and profits to the ex-

tent thereof, and from the most recently accumulated

earnings and profits. To the extent that any distribution ts,

under, any provision of this subchapter, treated as a

distribution of property to which section 301 applies, such

distribution shall be treated as a distribution of property:

for purposes of this subsection.

Section 317. Other definitions

(a) Properiy

For purposes of this part, the term “property” means

money, securities, and any other property; except thal

such term does not include stock in the corporation mak-

ing the distribution (or rights to acquire such stock).

44a 45a

(b) Redemption of stock then the gain, if any, to the recipient shall be _—

For purposes of this part, stock shall be treated as nized, but in an amount not In excess of the sum of such

redeemed by a corporation if the corporation acquires its money and the fair market value of such other property.

stock from a shareholder in exchange for property, (2) Treatment as dividend

whether or not the stock so acquired is cancelled, retired,

if an exchange is described in paragraph (1) but has

or held as treasury stock.

the effect of the distribution of a dividend (determined

Section 354. Exchanges of stock and securities in certain with the application of section 318(a)), then none

reorganizations. | be treated as a dividend to each distributee such an

(a) General rule amount of the gain recognized under paragraph (1) as 1s

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 exchange of property.

* * 7 x *

(1) /n general

No gain or loss shall be recognized if stock or

securities in a corporation a party to a reorganization

are, in pursuance of the plan of reorganization, ex-

changed solely for stock or securities in such corpora-

tion or in another corporation a party to the reorganiza-

tion.

* x * x *

(3) Cross referenee

(A) For treatment of the exchange if any property is

received which is not permitted to be received under

this subsection (including an excess principal amount

of securities received over securities surrendered, but

not including property to which paragraph (2)(B)

applies), see section 356.

Section 356. Receipt of additional consideration

(a) 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, US GOVERNMENT PRINTING OFFICE 1986~ 202 037/002 10

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.