Commissioner v. Clark
489 U.S. 726 (1989)

Annotate this Case

U.S. Supreme Court

Commissioner v. Clark, 489 U.S. 726 (1989)

Commissioner of Internal Revenue v. Clark

No. 87-1168

Argued November 7, 1988

Decided March 22, 1989

489 U.S. 726

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR

THE FOURTH CIRCUIT

Syllabus

Under the Internal Revenue Code of 1954, gain resulting from the sale or exchange of property is generally treated as capital gain. Although the Code imposes no current tax on certain stock-for-stock exchanges, § 356(a)(1) provides that, if such an exchange pursuant to a corporate reorganization plan is accompanied by a cash payment or other property -- commonly referred to as "boot" -- any gain which the recipient realizes from the exchange is treated in the current tax year as capital gain up to the value of the boot. However, § 356(a)(2) creates an exception, specifying that, if the "exchange . . . has the effect of the distribution of a dividend," the boot must be treated as a dividend, and is therefore appropriately taxed as ordinary income to the extent that gain is realized. In 1979, respondent husband (hereinafter the taxpayer), the sole shareholder of Basin Surveys, Inc. (Basin), entered into a "triangular merger" agreement with NL Industries, Inc. (NL), whereby he transferred all of Basin's outstanding shares to NL's wholly owned subsidiary in exchange for 300,000 NL shares -- representing approximately 0.92% of NL's outstanding common stock -- and substantial cash boot. On their 1979 joint federal income tax return, respondents reported the boot as capital gain pursuant to § 356(a)(1). Although agreeing that the merger at issue qualified as a reorganization for purposes of that section, the Commissioner of Internal Revenue assessed a deficiency against respondents, ruling that the boot payment had "the effect of the distribution of a dividend" under § 356(a)(2). On review, the Tax Court held in respondents' favor, and the Court of Appeals affirmed. Both courts rejected the test proposed by the Commissioner for determining whether a boot payment has the requisite § 356(a)(2) effect, whereby the payment would be treated as though it were made in a hypothetical redemption by the acquired corporation (Basin) immediately prior to the reorganization. Rather, both courts accepted and applied the post-reorganization test urged by the taxpayer, which requires that a pure stock-for-stock exchange be imagined, followed immediately by a redemption of a portion of the taxpayer's shares in the acquiring corporation (NL) in return for a payment in an amount equal to the boot. The courts ruled that NL's

Page 489 U. S. 727

redemption of 125,000 of its shares from the taxpayer in exchange for the boot was subject to capital gains treatment under § 302 of the Code, which defines the tax treatment of a redemption of stock by a corporation from its shareholders.

Held: Section 356(a)'s language and history, as well as a common sense understanding of the economic substance of the transaction at issue, establish that NL's boot payment to the taxpayer is subject to capital gains, rather than ordinary income, treatment. Pp. 489 U. S. 737-745.

(a) The language of § 356(a) strongly supports the view that the question whether an "exchange . . . has the effect of the distribution of a dividend" should be answered by examining the effect of the exchange as a whole. By referring to the "exchange," both § 356(a)(2) and § 356(a)(1) plainly contemplate one integrated transaction, and make clear that the character of the exchange as a whole, and not simply its component parts, must be examined. Moreover, the fact that § 356 expressly limits the extent to which boot may be taxed to the amount of gain realized in the reorganization suggests that Congress intended that boot not be treated in isolation from the overall reorganization. Pp. 489 U. S. 737-738.

(b) Viewing the exchange in this case as an integrated whole, the pre-reorganization analogy is unacceptable, since it severs the payment of boot from the context of the reorganization, and since it adopts an overly expansive reading of § 356(a)(2) that is contrary to this Court's standard approach of construing a statutory exception narrowly to preserve the primary operation of the general rule. Pp. 489 U. S. 738-739.

(c) The post-reorganization approach is preferable, and is adopted, since it does a far better job of treating the payment of boot as a component of the overall exchange. Under that approach, NL's hypothetical redemption easily satisfied § 302(b)(2), which specifies that redemptions whereby the taxpayer relinquishes more than 20% of his corporate control, and thereafter retains less than 50% of the voting shares, shall not be treated as dividend distributions. P. 489 U. S. 739-740.

(d) The Commissioner's objection to this "recasting [of] the merger transaction," on the ground that it forces courts to find a redemption where none existed, overstates the extent to which the redemption is imagined. Since a tax-free reorganization transaction is, in theory, merely a continuance of the proprietary interests in the continuing enterprise under modified corporate form, the boot-for-stock transaction can be viewed as a partial repurchase of stock by the continuing corporate enterprise -- i.e., as a redemption. Although both the pre-reorganization and post-reorganization analogies "recast the transaction," the latter view at least recognizes that a reorganization has taken place. Pp. 489 U. S. 740-741.

Page 489 U. S. 728

(e) Even if the post-reorganization analogy and the principles of § 302 were abandoned in favor of a less artificial understanding of the transaction, the result would be the same. The legislative history of § 356(a)(2) suggests that Congress was primarily concerned with preventing corporations from evading tax by "siphon[ing] off" accumulated earnings and profits at a capital gains rate through the ruse of a reorganization. This purpose, in turn, suggests that Congress did not intend to impose ordinary income tax on boot accompanying a transaction that involves a bona fide, arm's-length exchange between unrelated parties in the context of a reorganization. In the instant transaction, there is no indication that the reorganization was used as a ruse. Thus, the boot is better characterized as part of the proceeds of a sale of stock, subject to capital gains treatment, than as a proxy for a dividend. Pp. 489 U. S. 741-745.

828 F.2d 221, affirmed.

STEVENS, J., delivered the opinion of the Court, in which REHNQUIST, C.J., and BRENNAN, MARSHALL, BLACKMUN, O'CONNOR, and KENNEDY, JJ., joined, and in all but Part III of which SCALIA, J., joined. WHITE, J., filed a dissenting opinion, post, p. 489 U. S. 745.

JUSTICE STEVENS delivered the opinion of the Court. *

This is the third case in which the Government has asked us to decide that a shareholder's receipt of a cash payment in exchange for a portion of his stock was taxable as a dividend. In the two earlier cases, Commissioner v. Estate of Bedford,325 U. S. 283 (1945), and United States v. Davis,397 U. S. 301 (1970), we agreed with the Government largely because the transactions involved redemptions of stock by single corporations that did not "result in a meaningful reduction of the shareholder's proportionate interest in the corporation."

Page 489 U. S. 729

Id. at 397 U. S. 313. In the case we decide today, however, the taxpayer, [Footnote 1] in an arm's-length transaction, exchanged his interest in the acquired corporation for less than one percent of the stock of the acquiring corporation and a substantial cash payment. The taxpayer held no interest in the acquiring corporation prior to the reorganization. Viewing the exchange as a whole, we conclude that the cash payment is not appropriately characterized as a dividend. We accordingly agree with the Tax Court and with the Court of Appeals that the taxpayer is entitled to capital gains treatment of the cash payment.

I

In determining tax liability under the Internal Revenue Code of 1954, gain resulting from the sale or exchange of property is generally treated as capital gain, whereas the receipt of cash dividends is treated as ordinary income. [Footnote 2] The Code, however, imposes no current tax on certain stock-for-stock exchanges. In particular, § 354(a)(1) provides, subject to various limitations, for nonrecognition of gain resulting from the exchange of stock or securities solely for other stock or securities, provided that the exchange is pursuant to a plan of corporate reorganization and that the stock or securities

Page 489 U. S. 730

are those of a party to the reorganization. [Footnote 3] 26 U.S.C. § 354(a)(1).

Under § 356(a)(1) of the Code, if such a stock-for-stock exchange is accompanied by additional consideration in the form of a cash payment or other property -- something that tax practitioners refer to as "boot" --

"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."

26 U.S.C. § 356(a)(1). That is, if the shareholder receives boot, he or she must recognize the gain on the exchange up to the value of the boot. Boot is accordingly generally treated as a gain from the sale or exchange of property, and is recognized in the current tax year.

Section 356(a)(2), which controls the decision in this case, creates an exception to that general rule. It provided in 1979:

"If an exchange is described in paragraph (1) but has the effect of the distribution of a dividend, then there shall be treated as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after

Page 489 U. S. 731

February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be treated as gain from the exchange of property."

26 U.S.C. § 356(a)(2) (1976 ed.). Thus, if the "exchange . . . has the effect of the distribution of a dividend," the boot must be treated as a dividend, and is therefore appropriately taxed as ordinary income to the extent that gain is realized. In contrast, if the exchange does not have "the effect of the distribution of a dividend," the boot must be treated as a payment in exchange for property, and, insofar as gain is realized, accorded capital gains treatment. The question in this case is thus whether the exchange between the taxpayer and the acquiring corporation had "the effect of the distribution of a dividend" within the meaning of § 356(a)(2).

The relevant facts are easily summarized. For approximately 15 years prior to April 1979, the taxpayer was the president of Basin Surveys, Inc. (Basin). In January, 1978, he became sole shareholder in Basin, a company in which he had invested approximately $85,000. The corporation operated a successful business providing various technical services to the petroleum industry. In 1978, N. L. Industries, Inc. (NL), a publicly owned corporation engaged in the manufacture and supply of petroleum equipment and services, initiated negotiations with the taxpayer regarding the possible acquisition of Basin. On April 3, 1979, after months of negotiations, the taxpayer and NL entered into a contract.

The agreement provided for a "triangular merger," whereby Basin was merged into a wholly owned subsidiary of NL. In exchange for transferring all of the outstanding shares in Basin to NL's subsidiary, the taxpayer elected to receive 300,000 shares of NL common stock and cash boot of $3,250,000, passing up an alternative offer of 425,000 shares of NL common stock. The 300,000 shares of NL issued to the taxpayer amounted to approximately 0.92% of the outstanding

Page 489 U. S. 732

common shares of NL. If the taxpayer had instead accepted the pure stock-for-stock offer, he would have held approximately 1.3% of the outstanding common shares. The Commissioner and the taxpayer agree that the merger at issue qualifies as a reorganization under §§ 368(a)(1)(A) and (a)(2)(D). [Footnote 4]

Respondents filed a joint federal income tax return for 1979. As required by § 356(a)(1), they reported the cash boot as taxable gain. In calculating the tax owed, respondents characterized the payment as long-term capital gain. The Commissioner, on audit, disagreed with this characterization. In his view, the payment had "the effect of the distribution of a dividend," and was thus taxable as ordinary income up to $2,319,611, the amount of Basin's accumulated earnings and profits at the time of the merger. The Commissioner assessed a deficiency of $972,504.74.

Respondents petitioned for review in the Tax Court, which, in a reviewed decision, held in their favor. 86 T.C. 138 (1986). The court started from the premise that the question whether the boot payment had "the effect of the distribution of a dividend" turns on the choice between "two judicially articulated tests." Id. at 140. Under the test advocated by the Commissioner and given voice in Shimberg v. United States, 577 F.2d 283 (CA5 1978), cert. denied, 439 U.S. 1115 (1979), the boot payment is treated as though it were made in a hypothetical redemption by the acquired corporation (Basin) immediately prior to the reorganization.

Page 489 U. S. 733

Under this test, the cash payment received by the taxpayer indisputably would have been treated as a dividend. [Footnote 5] The second test, urged by the taxpayer and finding support in Wright v. United States, 482 F.2d 600 (CA8 1973), proposes an alternative hypothetical redemption. Rather than concentrating on the taxpayer's pre-reorganization interest in the acquired corporation, this test requires that one imagine a pure stock-for-stock exchange, followed immediately by a post-reorganization redemption of a portion of the taxpayer's shares in the acquiring corporation (NL) in return for a payment in an amount equal to the boot. Under § 302 of the Code, which defines when a redemption of stock should be treated as a distribution of dividend, NL's redemption of 125,000 shares of its stock from the taxpayer in exchange for the $3,250,000 boot payment would have been treated as capital gain. [Footnote 6]

Page 489 U. S. 734

The Tax Court rejected the pre-reorganization test favored by the Commissioner because it considered it improper "to view the cash payment as an isolated event totally separate from the reorganization." 86 T.C. at 151. Indeed, it suggested

Page 489 U. S. 735

that this test requires that courts make the "determination of dividend equivalency fantasizing that the reorganization does not exist." Id. at 150 (footnote omitted). The court then acknowledged that a similar criticism could be made of the taxpayer's contention that the cash payment should be viewed as a post-reorganization redemption. It concluded, however, that, since it was perfectly clear that the cash payment would not have taken place without the reorganization, it was better to treat the boot "as the equivalent of a redemption in the course of implementing the reorganization," than "as having occurred prior to and separate from the reorganization." Id. at 152 (emphasis in original). [Footnote 7]

Page 489 U. S. 736

The Court of Appeals for the Fourth Circuit affirmed. 828 F.2d 221 (1987). Like the Tax Court, it concluded that, although "[s]ection 302 does not explicitly apply in the reorganization context," id. at 223, and although § 302 differs from § 356 in important respects, id. at 224, it nonetheless provides "the appropriate test for determining whether boot is ordinary income or a capital gain," id. at 223. Thus, as explicated in § 302(b)(2), if the taxpayer relinquished more than 20% of his corporate control and retained less than 50% of the voting shares after the distribution, the boot would be treated as capital gain. However, as the Court of Appeals recognized,

"[b]ecause § 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 corporation [the taxpayer] lost interest in."

Id. at 224. Thus, like the Tax Court, the Court of Appeals was left to consider whether the hypothetical redemption should be treated as a pre-reorganization distribution coming from the acquired corporation or as a post-reorganization distribution coming from the acquiring corporation. It concluded:

"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-reorganization stock redemption by N. L. that affected [the taxpayer's] interest in the new corporation. Because this redemption reduced [the taxpayer's] N. L. holdings by more than 20%, the boot should be taxed as a capital gain."

Id. at 224-225.

This decision by the Court of Appeals for the Fourth Circuit is in conflict with the decision of the Fifth Circuit in Shimberg v. United States, 577 F.2d 283 (1978), in two important respects. In Shimberg, the court concluded that it was inappropriate to apply stock redemption principles in reorganization cases "on a wholesale basis." Id. at 287; see also ibid., n. 13. In addition, the court adopted the prereorganization

Page 489 U. S. 737

test, holding that

"§ 356(a)(2) requires a determination of whether the distribution would have been taxed as a dividend if made prior to the reorganization or if no reorganization had occurred."

Id. at 288.

To resolve this conflict on a question of importance to the administration of the federal tax laws, we granted certiorari. 485 U.S. 933 (1988).

II

We agree with the Tax Court and the Court of Appeals for the Fourth Circuit that the question under § 356(a)(2) whether an "exchange . . . has the effect of the distribution of a dividend" should be answered by examining the effect of the exchange as a whole. We think the language and history of the statute, as well as a common sense understanding of the economic substance of the transaction at issue, support this approach.

The language of § 356(a) strongly supports our understanding that the transaction should be treated as an integrated whole. Section 356(a)(2) asks whether "an exchange is described in paragraph (1)" that "has the effect of the distribution of a dividend." (Emphasis supplied.) The statute does not provide that boot shall be treated as a dividend if its payment has the effect of the distribution of a dividend. Rather, the inquiry turns on whether the "exchange" has that effect. Moreover, paragraph (1), in turn, looks to whether

"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."

(Emphasis supplied.) Again, the statute plainly refers to one integrated transaction and, again, makes clear that we are to look to the character of the exchange as a whole, and not simply its component parts. Finally, it is significant that § 356 expressly limits the extent to which boot may be taxed to the amount of gain realized in the reorganization. This limitation suggests that Congress intended that boot not be treated in isolation from

Page 489 U. S. 738

the overall reorganization. See Levin, Adess, & McGaffey, Boot Distributions in Corporate Reorganizations -- Determination of Dividend Equivalency, 30 Tax Lawyer 287, 303 (1977)

Our reading of the statute as requiring that the transaction be treated as a unified whole is reinforced by the well-established "step-transaction" doctrine, a doctrine that the Government has applied in related contexts, see, e.g., Rev.Rul. 75-447, 1975-2 Cum.Bull. 113, and that we have expressly sanctioned, see Minnesota Tea Co. v. Helvering,302 U. S. 609, 302 U. S. 613 (1938); Commissioner v. Court Holding Co.,324 U. S. 331, 324 U. S. 334 (1945). Under this doctrine, interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus "linking together all interdependent steps with legal or business significance, rather than taking them in isolation," federal tax liability may be based "on a realistic view of the entire transaction." 1 B. Bittker, Federal Taxation of Income, Estates and Gifts

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