Determining whether boot received in an acquisitive reorganization has dividend effect.

Facts: Sara owns all the outstanding shares of Target Corp. After extensive negotiations with Acquiring Corp., Sara agrees to merge Target into Acquiring. Both corporations are calendar-year S corporations.* The reorganization is structured to qualify as a Type A acquisitive reorganization and is scheduled to close on January 1 of the following year.* In the merger, Target win transfer all of its assets and liabilities to Acquiring, and Sara will exchange all her stock in Target for 175 shares of Acquiring stock (worth $1,000 per share) and $75,000 cash. Acquiring has five unrelated shareholders who own all 1,000 shares of its currently outstanding stock.* Sara is concerned about the tax treatment of the cash payment and its effect on any gain realized on the merger. Issues: Must Sara recognize gain on the exchange of Target stock for Acquiring stock?* Is the $75,000 cash payment equivalent to a distribution?

Analysis

A tax adviser should begin by reviewing the proposed transaction and be satisfied that it will qualify as a Type A merger. Sara's tax adviser projects that she will have a $50,000 basis in her Target stock on the day of the merger. She will realize a gain of$200,000 on the exchange of her Target stock for Acquiring stock, determined as follows:

Amount realized:
Fair market value (FMV)
of 175 shares of
Acquiring stock            $175,000
Cash                         75,000

                            250,000

Less: Adjusted basis
of Target stock              50,000

Gain realized              $200,000

No gain or loss is recognized if stock or securities in a corporation that is a party to a reorganization are exchanged solely for stock or securities in the same or another corporation that is also a party to the reorganization. However, gain must be recognized to die extent of the gain realized or boot received, whichever is less. The recipient of the boot must treat the gain recognized on the exchange as a distribution if the boot has the effect of the distribution of a dividend. In Clark, 489 US 726 (1989), the Supreme Court applied the Sec. 302(b) dividend equivalency rules for redemptions to determine whether a boot payment had the effect of a dividend distribution. The Court held that, in an acquisitive reorganization, the dividend equivalency rules should be applied post-reorganization to the acquiring corporation. Thus, the boot payment should be treated as a redemption of the acquiring corporation in a hypothetical redemption of the acquiring corporation's stock that the shareholder would have received if there had been no boot distribution. In other words, the transaction is recast as a reorganization followed by a hypothetical redemption.

In Rev. Rul. 93-61, the IRS held that in an acquisitive reorganization, boot is tested for dividend equivalency by comparing the interest the shareholder actually received in the acquiring corporation with the interest the shareholder would have received in the acquiring corporation (assuming only stock had been received). The Sec. 302(b) tests are used for this purpose.

The cash received (boot) is treated as a distribution in exchange for the acquiring corporation's stock if the hypothetical redemption distribution is substantially disproportionate with respect to the shareholder. The tax adviser applies the mechanical test of Sec. 302(b)(2) to determine whether the $75,000 cash payment to Sara has the effect of a dividend.

The Sec. 302(b) (2) test for a substantially disproportionate redemption is applied by assuming that Sara received only stock in Acquiring and no cash. Thus, Sara would have received an additional 75 shares ($75,000 [divided by] $1,000 FMV per share) of Acquiring stock if she had not received the $75,000 cash payment. She would have received a total of 250 (175 + 75) Acquiring shares, and Acquiring would have had 1,250 (1,000 + 250) shares outstanding as a result of the merger. The 250 shares would have represented 20% (250 [divided by] 1,250) of Acquiring's outstanding stock. After the hypothetical redemption of the 75 shares, Sara owns 14.9% (175 [divided by] 1,175) of Acquiring's outstanding shares. The $75,000 cash payment does not have the effect of a distribution because: 1. Immediately after the hypothetical redemption, Sara owns less than 50% of the total combined voting power of all classes of voting stock, and 2. Sara's voting stock ownership percentage after the hypothetical redemption (14.9%) is less than 80% of her hypothetical ownership percentage (20%) immediately before the redemption (0.8 X 0.2 = 0.16).

Conclusion

The tax adviser concluded that the $75,000 payment to Sara did not have the effect of the distribution of a dividend because it met the mechanical test of Sec. 302(b)(2) as a substantially disproportionate redemption of stock. Thus, the cash is treated as payment in exchange for stock (instead of a distribution). Sara must recognize $75,000 of the $200,000 gain realized on the exchange as capital gain.

Sara's basis in the Acquiring stock is $50,000, which equals her basis in Target stock ($50,000) less the cash payment received ($75,000) plus the capital gain recognized ($75,000). Target's accumulated adjustments account (AAA) is merged with Acquiring's AAA. Presumably, the post-reorganization combined AAA of Acquiring is reduced 6% (75 [divided by] 1,250) for the shares redeemed in the hypothetical redemption. If acquiring had any earnings and profits (E&P), they would be similarly reduced by 6%.

Variation

Assume that Sara received 225 shares of Acquiring stock and $25,000 cash in exchange for her Target stock. In this situation, she tentatively realizes $200,000 of gain, of which $25,000 is potentially recognizable (if the $25,000 payment is treated as boot), determined as follows:

Amount realized:
FMV of 225 shares of
Acquiring stock         $225,000
Cash                      25,000

                         250,000
Less: Adjusted basis
of Target stock           50,000
Gain tentatively
realized                $200,000

The Sec. 302(b)(2) test for a substantially disproportionate redemption is again applied by assuming that Sara received only stock in Acquiring and no cash. Thus, Sara would have received an additional 25 shares ($25,000 [divided by] $1,000 FMV per share) of Acquiring stock if she had not received the $25,000 cash payment. She would have received a total of 250 (225 + 25) shares in Acquiring, and Acquiring would have had 1,250 (1,000 + 250) shares outstanding as a result of the merger. The 250 shares would have represented 20% (250 [divided by] 1,250) of the outstanding Acquiring stock. After the hypothetical redemption of the 25 shares, Sara owns 18.4% (225 [divided by] 1,225) of the outstanding Acquiring shares. The $25,000 cash payment has the effect of a dividend distribution because her voting stock ownership percentage after the hypothetical redemption (18.4%) is not less than 80% of her hypothetical ownership percentage (20%) immediately before the redemption 0.8 X 0.2 = 0.16) (Sec. 302(b)(2)).

Presumably, the $25,000 payment to Sara has the effect of a distribution. Under Rev. Rul. 95-14, when an S shareholder receives a redemption payment characterized as a distribution that has the effect of a dividend, the redemption payment is treated as an S distribution under Sec. 1368, reducing AAA and stock basis. Evidently, under the reasoning in Clark, the post-reorganization AAA and stock basis are used in determining the tax consequences of the $25,000 distribution. Thus, Sara realizes $175,000 of gain, determined as follows:

Amount realized:
FMV of 225 shares of
Acquiring stock        $225,000
Less:.Adjusted basis
of Target stock          50,000

Gain realized          $175,000

Sara's post-redemption stock basis equals her basis in the Target stock ($50,000). Presumably, the stock basis is not increased because no gain is recognized, and stock basis is not immediately reduced because the cash payment is treated as a distribution instead of as boot (Sec. 358). Target's AAA is merged with the AAA of Acquiring. Presumably, the combined AAA is reduced by the $25,000 payment and Sara's stock basis is reduced by the $25,000 distribution.

The treatment of the $25,000 cash payment as a distribution results in the reduction of gain realized. The $25,000 deemed distribution is treated as a tax-free reduction of Sara's basis in Target stock. If the deemed distribution exceeds the combined AAA or Sara's stock basis, the excess would be treated as capital gain under Sec. 1368. If either corporation had E&P, a portion of the distribution could be treated as a dividend, if the distribution exceeded the combined AAA.

Editor's Note: This case study has been adapted from "PPC Tax Planning Guide - S Corporations," 10th edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1996.