Commissioner of Internal Revenue v. Clark, 87-1168

• Decision Date: 22 March 1989
• Docket Number: No. 87-1168,87-1168
• Citation: 109 S.Ct. 1455,489 U.S. 726,103 L.Ed.2d 753
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner v. Donald E. CLARK et ux
• Court: U.S. Supreme Court

489 U.S. 726

109 S.Ct. 1455

103 L.Ed.2d 753

COMMISSIONER OF INTERNAL REVENUE, Petitioner

v Donald E. CLARK et ux.

No. 87-1168.

Argued Nov. 7, 1988.

Decided March 22, 1989.

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 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 commonsense 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. 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. 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. 738-739.

(c) The postreorganization 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. Pp. 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 prereorganization and postreorganization analogies "recast the transaction," the latter view at least recognizes that a reorganization has taken place. Pp. 740-741.

(e) Even if the postreorganization 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 th t 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. 741-745.

828 F.2d 221 (CA 4 1987), 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. 745.

Alan I. Horowitz, Washington, D.C., for petitioner.

Walter B. Slocombe, Washington, D.C., for respondents.

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, 65 S.Ct. 1157, 89 L.Ed. 1611 (1945), and United States v. Davis, 397 U.S. 301, 90 S.Ct. 1041, 25 L.Ed.2d 323 (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." Id., at 313, 90 S.Ct. at 1048. In the case we decide today, however, the taxpayer ¹ in an arm's-length transaction exchanged his interest in the acquired corporation for less than 1% 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.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 securi- ties are those of a party to the reorganization.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 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...