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Ensuring capital gain treatment for boot received in a reorganization.

Facts: Peter Hanson owns all 10,000 shares of Brick Corporation (Brick), which manufactures bricks. His basis in the stock is $10,000. Brick has accumulated earnings and profits (AE&P) of $90,000. * Home Repair, Inc. (Home Repair), a home repair and building supply company, has offered to acquire all of Peter's stock in Brick for either: (1) 6,000 shares of Home Repair's voting stock (currently trading for $90 per share), for a total value of $540,000 or (2) 4,500 shares of its voting stock plus $150,000 cash. * Home Repair is offering Peter, in effect, a price of $100 per share for the 1,500-share difference between the two options. * Home Repair currently has 100,000 shares of voting stock outstanding. * Alternative 1 could be structured as either a Type A or B reorganization (because it involves an exchange of stock for stock), but could not be a C reorganization (which is a stock-for-assets acquisition). Alternative 2 can only be structured as an A reorganization; the presence of boot (i.e., the $150,000 cash) would disqualify it as a B, and the exchange of stock for stock does not qualify as a C reorganization. * The acquisition will be consummated in the current year. * Peter is quite wealthy and is thus more interested in capital appreciation than immediate cash flow. He believes stock in Home Repair will appreciate substantially in the next five years. Therefore, he would prefer to hold the Home Repair stock rather than sell it. * When Peter consulted his tax adviser about the consequences of the two options, he mentioned that he has an unused capital loss of $150,000 from his prior year's Form 1040. Issue: Which type of reorganization structure should be recommended?

Analysis

Generally, a shareholder does not have to recognize gain or loss if stock or securities in one corporate party to a reorganization are exchanged solely for stock or securities in another corporate party to a reorganization. However, the shareholder must recognize gain to the extent he receives any cash or property other than stock and securities. This cash or other property is considered boot.

Under Sec. 356(a)(2), the recognized gain will be ordinary income (to the extent of the shareholder's undistributed share of the corporation's earnings and profits) if the property (including cash) received has the effect of a dividend. The IRS position has generally been that all pro rata distributions of boot should be treated as dividend income. However, the courts have not always agreed.

In Clark, 489 US 726 (1989), a shareholder sold his wholly owned corporation to a publicly held corporation. The publicly held corporation offered him the choice of 425,000 shares of its stock or 300,000 shares plus $3,250,000 cash. The shareholder chose the stock plus the cash.

The Service claimed the cash payment (boot) of $3,250,000 was dividend income (to the extent of the wholly owned corporation's earnings and profits of $2,319,611 at the time of the merger). According to the IRS, the transaction should be viewed in two parts:

1. A dividend paid by the wholly owned corporation (the acquired corporation); and

2. A merger of the wholly owned corporation into the acquiring corporation.

However, the Supreme Court disagreed with the Service, holding that the treatment of the boot as ordinary income or capital gain should be resolved by viewing the transaction as an integrated whole. According to the Court, the transaction should be interpreted as an exchange of all of the shareholder's stock in his wholly owned corporation for 425,000 shares of stock in the publicly held corporation, followed by a redemption of 125,000 of those shares for the $3,250,000 in cash. The portion of the transaction involving the 125,000 shares had to meet the requirements for a redemption to qualify for capital gain treatment (e.g., as a meaningful reduction of the shareholder's interest and thus a redemption not essentially equivalent to a dividend). If it had not, it would have been treated as a dividend.

In 1993, the IRS stated that it would follow Clark in determining the treatment of boot in acquisitive reorganizations (Rev. Rul. 93-61). The determination of dividend treatment in an acquisitive reorganization is made by comparing the interest the shareholder actually receives in the acquiring corporation with the interest that would have been received if only stock in the acquiring corporation had been received. The Service will not challenge a shareholder's tax treatment of boot received in an acquisitive reorganization if the treatment is consistent with Clark.

Based on Clark,Alternative 2 would be treated as follows:

1. A tax-free merger of Brick into Home Repair under Sec. 368(a)(1)(A), in which 10,000 shares in Brick are exchanged for 6,000 shares in Home Repair. Peter's basis in the 6,000 shares will be $10,000; and

2. A redemption of 1,500 shares of Home Repair for $150,000 in cash under Sec. 302.

The tax adviser must verify that the redemption portion of the transaction meets the requirements for capital gain treatment. If it does, the tax adviser could recommend that Peter accept Alternative 2 (4,500 shares plus $150,000 cash). Peter would have to recognize a capital gain of $147,500 ($150,000 distribution less $2,500 basis ($10,000 total basis times 1,500/6,000 shares)). Peter's capital loss carryover of $150,000 would fully offset his gain. He could then sell the 4,500 shares of stock at his discretion and thus control the timing of the recognition of any further income.

If, for any reason, the transaction does not meet the requirements for treatment as a redemption (i.e., an exchange), the $150,000 will be considered a dividend to the extent of Brick's $90,000 AE&P: the $60,000 balance of the distribution (less Peter's $10,000 basis) will be eligible for capital gain treatment.

Conclusion

If the $150,000 cash received qualifies for exchange treatment as a redemption, the tax adviser should recommend that Peter accept Alternative 2 so that he can use the $147,500 capital gain to offset his $150,000 capital loss in the current year.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 11th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter Craig, Lewis A. Siegel, Joan Wilson Gray, James F. Carpenter and Richard L. Burris, published by Practitioners Publishing Company, Fort Worth, TX, 1998.
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Title Annotation:case study
Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 1999
Words:1094
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