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The correct E&P for measuring Sec. 356(a)(2) dividend income.

If an acquisition of assets qualifies as a reorganization under Sec. 368(a), the receipt of stock of the transferee (acquiring) corporation by the shareholders of the transferor (acquired) corporation is nontaxable. However, if the shareholders of the transferor corporation receive boot (money or other property), the transaction can result in partial taxation to the recipient shareholders. Specifically, if boot is received by the transferor corporation's shareholders "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."(1) If the exchange 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 . . . as is not in excess of his ratable share of the undistributed earnings and profits [E&P] of the corporation . . . ."(2) If any additional gain is recognized, that gain is treated as a gain from the exchange of property (normally capital gain).

The statute is unclear as to how to determine whether the exchange has the effect of the distribution of a dividend. After years of speculation and numerous conflicting judicial decisions, the Supreme Court addressed this issue in 1989 in the Clark(3) case. The Court held that a "post-reorganization redemption" construct was the preferable method of interpreting the statutory language of Sec. 356(a)(1). Although the Court settled "how" to determine if a distribution had the effect of a dividend, it did not address whose E&P should be used to measure the amount of dividend income, if any.

This article will discuss the problems facing taxpayers who must, post-Clark, determine whose E&P is to be used to measure the amount of dividend income described in Sec. 356(a)(2). The current status of the law in this area is confusing at best. This uncertainty is expressly evidenced by the inconsistent positions taken by the IRS in letter rulings issued since the Clark decision. The article will also provide taxpayers with suggestions on how deal with this issue until further guidance is given in regulations or other authoritative pronouncements.

Pre-Clark: Sec. 356(a)(2) E&P

Prior to Clark, in acquisitive reorganizations in which the distributee-shareholder did not control both the transferor and transferee corporations, it was relatively clear that only the E&P of the transferor corporation was to be used to measure dividend income under Sec. 356(a)(2). Even though the regulations under Sec. 356 are silent on this point, the regulations under Sec. 381 provide that the carryover of E&P to the transferee corporation "shall be computed by taking into account the amount of earnings and profits properly applicable to the distribution . . . ."(4) This clearly implies that the amount of the transferor's E&P carried to the transferee is determined after adjustment for the boot distribution. The IRS has further confirmed this position in a number of published revenue rulings.(5)

Controversy has existed, however, when the shareholders of the transferor and transferee corporations were identical. In this situation, the IRS maintained that the E&P of the transferor and transferee corporations should be combined to measure dividend income for purposes of Sec. 356(a)(2).(6) Relying on the legislative history of Sec. 356(a)(2), the Service has consistently argued that a reorganization involving corporations with the same shareholders represents an obvious opportunity to bail out E&P.

Davant(7) i the only case in which a court has agreed with this IRS position. In Davant, which presents an abusive liquidation-reincorporation fact pattern, the Service was successful in convincing the Fifth Circuit that "[w]here there is complete identity of stockholders, the use of the earnings and profits of both corporations is the only logical way to test which distributions have the effect of a dividend."(8)

Previously, the Tax Court had disagreed with this conclusion under a strict reading of the statutory language of Sec. 356(a)(2); which refers to "the undistributed earnings and profits of the corporation." The Tax Court held that the reference to the corporation meant a single corporation and, thus, the legislative history implied that this corporation was the transferor. The Fifth Circuit, however, did not accept this narrow statutory interpretation when there was complete identity of shareholders because it felt that both the transferee and transferor corporations "were but different pockets in the same pair of trousers worn by [the taxpayers]."(9)

Since the Fifth Circuit's decision, the Tax Court has had several opportunities to review this issue,(10) but has consistently held that even if the transferee and transferor corporations have identical shareholders, the amount of dividend income under Sec. 356(a)(2) is limited to the transferor's E&R In its most comprehensive discussion of the correct E&P to be used under Sec. 356(a)(2), in American Manufacturing Co., the court stated:

While we recognize that in particular circumstances a loophole may exist, yet, in light of the statutory language and the lack of warrant in the congressional history of the statute, we think to adopt respondent's multicorporation interpretation would strain the statutory language too far. we think it is up to Congress to correct this defect which has remained in the Code since its enactment and which in reality only exists in certain limited situations.(11)

Thus, with the exception of the ongoing dispute between the IRS and the Tax Court involving acquisitions of commonly controlled corporations, prior to Clark the amount of dividend income for corporate reorganizations was routinely limited to the transferor's E&P.

The Supreme Court's Clark Decision

The Court addressed the issue of whether the receipt of property other than stock or securities as part of a forward triangular merger had the effect of a dividend distribution. In its determination, the Court recast the transaction as a "postreorganization redemption" by developing a construct in which a distribution solely of the transferee corporation stock(12) to the transferor shareholders was followed by a hypothetical redemption of a portion of the transferee corporation's stock for the amount of boot property actually received by the transferor shareholders in the reorganization. Dividend equivalency was determined using the criteria in Sec. 302(b) for corporate redemptions. The Court explained its position:

The post-reorganization approach adopted by the Tax Court and the Court of Appeals is, in our view, preferable to the Commissioner's approach. most significantly, this approach does a far better job of treating the payment of boot as a component of the overall exchange.(13)

Unfortunately, the Clark decision addressed only whether the boot received as part of the forward triangular merger had the effect of the receipt of a dividend. Since the conclusion was that it did not, the Court did not address the source of E&P for a dividend distribution.

Based on the Supreme Court's rationale, in many cases the E&P determination will be moot because the sale or exchange requirements of Sec. 302(b) will be met. For example, acquisitions involving public companies will satisfy the less-than-50% requirement of Sec. 302(b)(2)(b), since almost certainly no shareholders will own 50% or more of the acquiring corporation after the reorganization. If these same public shareholders receive more than 20% boot, the less-than-80% of prior stock ownership requirement of Sec. 302(b)(2)(c) will also be satisfied. The satisfaction of these two requirements will result in sale or exchange treatment under the substantially disproportionate rules of Sec. 302(b)(2). Even if the public shareholders do not receive more than 20% boot as part of their consideration, presumably the hypothetical redemption will still result in sale or exchange treatment under the "not essentially equivalent to a dividend" test of Sec. 302(b)(1).(14)

Dissenting shareholders involved in a Sec. 368(a) reorganization will normally qualify for sale or exchange treatment under the complete termination of interest test of Sec. 302(b)(3). Shareholders who receive cash for fractional shares should also have no difficulty qualifying the cash for sale or exchange treatment under Sec. 302(b)(1).

In contrast, in the following circumstances a Sec. 302(b) analysis will result in Sec. 301 distribution treatment: (1) a very large or sole shareholder of the "whale" that merges into the "minnow" will fail the Sec. 302(b)(2)(b) 50% control threshold; (2) a shareholder of a closely held target who ends up owning less than 50% of the acquiring corporation, but receives less than 20% boot in the transaction; and (3) both the acquiring and target are commonly controlled corporations and any boot given in the reorganization is received pro rata by the target shareholders. In situation (3), no matter how large the boot distribution is, the target shareholders will be treated as owning, after the hypothetical redemption, 100% of the stock they owned before the redemption. In these situations the determination of dividend income is most relevant. Another situation that results in several unresolved issues is when the target corporation is an S corporation. Does Sec. 356 determine any gain recognized or does Sec. 1368 apply and treat the distribution as tax free to the extent of basis in the target stock? Depending on how this question is resolved, the issues discussed in this article could be of paramount importance.(15)

E&P Alternatives After Clark

There are several possible alternatives for the source of E&P in an acquisitive reorganization. The two most likely possibilities are (1) the transferor's E&P or (2) the E&P of the redeeming corporation.

Note: A possible third alternative exists when the acquisition is in the form of a triangular reorganization. The E&P of the acquiring (transferee) corporation itself could be the measure of the Sec. 356(a)(2) dividend income. Since stock of the controlling corporation is used as the consideration in the acquisition, the target shareholders do not end up with any stock ownership in the transferee. Thus, it makes no sense to attempt to determine the ratable share of E&P in a corporation in which the shareholders do not have any stock ownership.

* Transferor's E&P only

Since the law's interpretation before Clark was that only the transferor's E&P was used to measure dividend income, can the Clark opinion be read in a way that alters this established result? Those supporting the use of the transferor's E&P can continue to argue that "the corporation" referred to in Sec. 356(a)(2) refers simply to the transferor corporation. Furthermore, since nothing in the Clark opinion specifically addresses this issue, it can certainly be argued that Clark does not change the current status of the law.

To further support this position, the shareholder receives the distribution solely as a consequence of his stock ownership in the transferor corporation. Thus, is it reasonable that additional dividend income potential should be created merely because the shareholder is involved in a corporate reorganization? A shareholder who receives boot in a reorganization should not have to recognize a greater amount of dividend income than if the distribution had been made directly from the transferor to the shareholder in the ordinary course of business.

* Redeeming corporation's E&P

If one asserts that the transferor's E&P only is not the correct interpretation, the E&P of the redeeming corporation is an appropriate alternative measure of dividend income. This interpretation, which literally follows the postreorganization rationale of Clark, can yield dramatically differing results depending on the form of the acquisition. Since the redeeming corporation will vary depending on the form of the transaction, the relevant E&P will also vary.

If the acquisition is a straight asset reorganization (A, C or acquisitive D reorganization), the redeeming corporation is the transferee or acquiring corporation. Sec. 381(c)(2) requires that the E&P of the transferor corporation be carried over to the transferee corporation. If the postreorganization rationale of the Clark opinion is applied, then logically the combined E&P of both the transferor and transferee corporations would be available to measure the amount, if any, of dividend income.

If the acquisition is a triangular asset reorganization (forward triangular merger, reverse triangular merger or triangular C), the redeeming corporation is the controlling corporation. Again, if the postreorganization rationale of the Clark opinion is applied, then only the controlling corporation's E&P (as opposed to the combined E&P of both the transferor and transferee corporations) would be available to measure the amount, if any, of dividend income. The Service, however, could contend that Sec. 304(a) (redemption through the use of a related corporation) applies to reach the E&P of both the transferee and redeeming corporations by asserting that the redemption of the parent's stock is accomplished through the transferee subsidiary. This will have no effect if a new subsidiary is the transferee in a forward triangular merger, but could be a problem in a reverse triangular merger or if an existing subsidiary with E&P is used in the forward triangular merger.

In addition, the argument that the dividend recognized by the transferor's shareholders in a reorganization should not exceed that recognized on a direct distribution from the transferor corporation would be viewed as irrelevant since Sec. 301/302 and 356 transactions are intrinsically very different. Sec. 356(a)(2) provides its own limitation over and above any consideration of E&P; that is, a dividend is recognized only to the extent of gain realized. This permits the shareholder to recover basis before recognizing the gain/dividend. if the shareholder realized no gain, there can be no dividend income regardless of the amount of boot received or the E&P of the reorganizing corporations. There is no such limitation in either a Sec. 301 distribution or a Sec. 302 redemption treated as a distribution.

The IRS's Post-Clark Ruling Position

The Service has unofficially announced that it is working on providing guidance to help clarify Sec. 356(a)(2) either through regulations or other administrative pronouncements. An analysis of the letter rulings dealing with Sec. 356(a)(2) issued since the 1989 Clark decision may provide some insight into what these new rules might contain. While Sec. 6110(j)(3) states that letter rulings are not precedent for other taxpayers, such rulings can often be used to determine the Service's position on a particular issue. If the Service does in fact have a specified ruling position, it is logical to conclude that this position would be consistent with future regulations or published revenue rulings that address this issue.

* Reorganizations with common shareholders

The IRS has long held that when the same shareholders control both the transferee and the transferor corporations, the shareholders can manipulate which corporation is the surviving corporation in order to minimize, if desired, the potential dividend income. Therefore, it would seem logical that the IRS would use the Clark analysis to argue again that it is the combined E&P of both the transferor and the transferee corporations that should be used in Sec. 356(a)(2) boot distributions.

A review of the letter rulings since the Supreme Court's Clark decision reveals some curious inconsistencies. For example, Letter Rulings 9118004(16) and 9127023(17) both dealt with Sec. 368(a)(1)(d) acquisitive reorganizations. Consistent with its position in Rev. Rul. 70-240(18) and Davant, the IRS held that gains recognized by the transferor shareholders would be treated as a dividend under Sec. 356(a)(2) to the extent of the combined E&P of both the transferee and transferor corporations.

Letter Rulings 9112026(19) and 9143082(20) also dealt with acquisitive Sec. 368(a)(1)(d) reorganizations. For no obvious reason and without any explanation, the IRS held in both rulings that if the exchange had the effect of a dividend under Sec. 356(a)(2), only the transferor's E&P would be used in determining the amount of dividend income to the transferor shareholders.

Even though the four letter rulings were issued after Clark, the IRS obviously came to different conclusions. It is difficult to determine from reading them why the inconsistencies exist, and it is doubtful that the different conclusions reached were inadvertent. Thus, it appears some confusion exists within the Service as to how the Clark decision affects the determination of whose E&P should be used in a Sec. 356(a)(2) boot distribution.

* Reorganizations without common shareholders

Other letter rulings issued since Clark reveal some even more surprising results. Letter Ruling 9039029(21) dealt with the consolidation of two target corporations under Sec. 368(a)(1)(A). In a position inconsistent with prior published revenue rulings on this point,(22) the Service held that "the amount of gain recognized that is not in excess of each such shareholder's taxable share of undistributed earnings and profits of Acquiring is treated as a dividend." (Emphasis added.) For some unexplained reason, this ruling specified that the acquiring (transferee) corporation's E&P, rather than the transferor's, is used for dividend determination. The most obvious conclusion is that the Service simply extended the Clark rationale to the E&P issue without considering the ramifications. As a newly formed corporation, Acquiring has no E&P except for that acquired from Targets 1 and 2 under Sec. 381(c)(2). As a result, dividend income could be created for the shareholders of one target corporation that had no prereorganization E&P simply because the other target corporation did have prereorganization E&P. Although reference is made to each shareholder's "ratable share" of Acquiring's E&P, there is nothing in the letter ruling that would effectively limit this to their share of the appropriate target's E&P. Creating dividend income for shareholders based on the prereorganization E&P of an unrelated corporation would seem to be a questionable result.

Letter Ruling 9041086(23) dealt with a reverse triangular merger under Sec. 368(a)(2)(E). While the facts of the ruling are somewhat involved, the important issue is that the Service again looked to the E&P of a corporation other than the target corporation. In this case, the Service used the parent's (the corporation that controlled the merging corporation and whose voting stock was being used as the consideration for the acquisition) E&P, instead of the transferor's E&P, to measure the potential Sec. 356(a)(2) dividend income. Again, the most likely explanation is that the Service applied the "post-reorganization redemption" analysis to determine whose E&P should be used, since it is the parent's stock that is hypothetically being redeemed.

Most of the other letter rulings issued since Clark that dealt with acquisitive reorganizations declined to specify whose E&P was being used.(24) Instead, they simply stated that the transferor shareholders had dividend income to the extent of their ratable share of undistributed E&P. Nowhere in the rulings did the IRS offer any opinion as to whose undistributed E&P was to be used.

Extending the Clark rationale to Sec. 356(a)(2) also raises several additional questions not addressed in the letter rulings. For example, what percentage stock ownership should be used to determine the shareholder's "ratable" share of E&P? Should the percentage stock ownership in the redeeming corporation from before or after the hypothetical redemption be used? When should this E&P be measured - at redemption or at the end of the tax year?

Example 1: T merges into P in a Sec. 368(a)(1)(A) reorganization. Under the application of Clark, A (the former sole shareholder of T) is deemed to receive 70% of P's stock. After the hypothetical redemption, A actually ends up with 57% of P's stock. For purposes of determining dividend income under Sec. 356(a)(2), is A's ratable share of E&P 70% (before the deemed redemption) or 57% (after the deemed redemption)? Should the E&P be measured at the time of the hypothetical redemption or will A be subject to the uncertainty of waiting until after P's year-end and the determination of its current E&P before A knows the exact dividend consequences of the hypothetical redemption?

It is interesting to note that Letter Rulings 9039029 and 9041086, which used other than the transferor's E&P, were issued from Branch 2 of the Corporate division. No other branch has so ruled. Apparently, different results can be obtained depending on the branch to which a letter ruling request is assigned. If this degree of confusion exists within the Service as to how the Clark decision affects the determination of the correct amount of Sec. 356(a)(2) dividend income, it becomes an almost impossible task for the taxpayer to correctly determine the tax consequences of a boot distribution within the context of the acquisitive reorganization provisions.

The use of the redeeming corporation's E&P as the measure of Sec. 356(a)(2) income is not supported by statute or by judicial precedent. Clark does not speak to whose E&P is to be used under Sec. 356(a)(2) and any attempt to apply the Clark rationale to this issue results in unwarranted complexity and inconsistent results.

For example, ff the Clark opinion is interpreted to mean that the redeeming corporation's E&P is the appropriate measure of dividend income, it will be a simple matter to manipulate whose E&P is used by selecting the appropriate form for the reorganization.

Example 2: Target (T) has substantial E&P, but the P corporation, which is interested in acquiring T, has no E&P. The acquisition is to be structured as a merger and any gain recognized will satisfy the dividend equivalency rule of Sec. 356(a)(1). However, ff possible, the T shareholders want any gain recognized to be capital gain due to the existence of net capital loss carryovers that they cannot currently use.

If the Clark construct is applied literally, the acquisition should be structured as a Sec. 368(a)(2)(d) forward triangular merger. P creates Newco and merges T into Newco. Under Sec. 381(c)(2), T's E&P carries over to Newco. The deemed redemption occurs between P and the former T shareholders. Since P has no E&P, any gain recognized will be capital gain.(25)

Example 3: Assume the same facts as in Example 2, except that T has a corporate shareholder that wants any gain recognized to be dividend income to take advantage of the dividends-received deduction. Thus, the acquisition should be structured as a straight Sec. 368(a)(1)(a) merger with T merging directly into P. Under Sec. 381(c)(2), T's E&P would carry over to P and since the dividend equivalency rule of Sec. 356(a)(1) is satisfied, to the extent of P's E&P (now the combined E&P of P and T), any gain recognized will be dividend income.

Thus, under the application of the Clark construct to the determination of whose E&P should measure the amount of dividend income, taxpayers can manipulate the form of the reorganization to achieve whatever type of gain best suits their tax objectives.(26)


While the interpretation of the statutory language of Sec. 356(a)(2) has been in question for some time, the Supreme Court's Clark decision offered some clarification on how the statutory language ("has the effect of the distribution of a dividend") should be interpreted. However, the amount of E&P that should be used in measuring Sec. 356(a)(2) dividend income is still shrouded in uncertainty. With the attention drawn to this issue by Clark, it is an appropriate time for further clarification.

The most logical measure of Sec. 356(a)(2) dividend income is the E&P of the transferor, for the following reasons. (1) Equitably, the shareholder should not be exposed to greater dividend potential as a result of the reorganization than had existed if the property had been distributed as a simple dividend by the target without benefit of the reorganization. (2) The shareholder's ratable share of the target's E&P is fixed by the actual percentage ownership in the target at the time of the reorganization and provides a measure of certainty in determining any dividend amount. (3) Generally, in all but a reverse triangular merger, the target's tax year will end at the date of acquisition, establishing the date to determine current E&P.(27) (4) Moreover, the use of the target's E&P is consistent with the preponderance of established judicial precedent.

The use of the target's E&P alone for determination of the dividend amount in a boot distribution treated as a dividend under Sec. 356(a)(2) is clearly a better solution. It provides a simple, equitable and generally certain answer to the shareholders involved at the date of the transaction. Given the confusion that currently exists in this area, these attributes provide more than sufficient reason for adopting this position - a position with clear authoritative support.

(1) Sec. 356(a)(1). (2) Sec. 356(a)(2). (3) Donald E. Clark, 489 US 726 (1989)(63 AFTR2d 89-860, 89-1 USTC [paragraph] 9230), aff'g 828 F2d 221 (4th Cir. 1987) (60 AFTR2d 87-5592, 87-2 USTC [paragraph] 9504), aff'g 86 TC 138 (1986). (4) Regs. Sec. 1.381(c)(2)-1(c). (5) Rev. Ruls. 71-364, 1971-2 CB 182; 72-327, 1972-2 CB 197; and 72-498, 1972-2 CB 516. (6) Rev. Rul. 70-240, 1970-1 CB 81; J.E. Davant, 366 F2d 874 (5th Cir. 1966)(18 AFTR2d 5523, 66-2 USTC [paragraph] 9618), aff'g in part and rev'g in part 43 TC 540 (1965); American Manufacturing Co., Inc., 55 TC 204 (1970); Est. of John L. Bell, TC Memo 1971-285 285; and Atlas Tool Co., Inc., 70 TC 86 (1978), aff'd, 614 F2d 860 (3d Cir. 1980)(45 AFTR2d 80-645, 80-1 USTC [paragraph] 9177). (7) Davant, id. (8) Davant, note 6, at 66-2 USTC 87,013. (9) Id. (10) See American Manufacturing, Bell and Atlas Tool, note 6. (11) American Manufacturing, note 6, at 231. (12) Whenever the terms "transferee" or "acquiring" corporation are used in this article, if the form of the acquisition being discussed is a triangular asset reorganization, the term "controlling" corporation should be substituted. (13) Clark, note 3, at 89-1 USTC 87,495. (14) See, e.g., Rev. Ruls. 76-364, 1976-2 CB 91; 75-512, 1975-2 CB 112; and 76-385, 1976-2 CB 92. (15) For a more detailed discussion, see Boyle and Stone, "S Corporations," BNA Tax Management Practice Scries, [paragraph] 4330.02.H.3; and Eustice and Kuntz, Federal Income Taxation of S Corporations (Boston: Warren, Gorham & Lamont, 1993), at [paragraph] 12.02 [8][b]. (16) IRS Letter Ruling 9118004 (1/30/91). (17) IRS Letter Ruling 9127023 (4/4/91). (18) Rev. Rul. 70-240, note 6. (19) IRS Letter Ruling 9112026 (12/27/90). (20) IRS Letter Ruling 9143082 (8/5/91). (21) IRS Letter Ruling 9039029 (6/29/90). (22) See the revenue rulings cited in note 5. (23) IRS Letter Ruling 9041086 (7/19/90). (24) For a representative sample, see IRS Letter Rulings 9040069 (7/12/90), 9041021 (7/12/90), 9041084 (7/19/90), 9135019 (5/5/91) and 9224049 (3/17/92). (25) Sec. 356(a)(2), last sentence. (26) This same flexibility would also exist with other triangular reorganizations, i.e., a straight C reorganization versus a triangular C reorganization and a straight A merger versus a reverse triangular merger under See. 368(a)(2)(E). (27) If the target joins a consolidated group, its year ends even if it is acquired through a reverse triangular merger. Another exception caused by the consolidated return regulations is when the target is acquired in a transaction qualifying as a "reverse acquisition" as described in Regs. Sec. 1. 1502-75(d)(3); the target's year does not end as a result of the acquisition.
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Title Annotation:earnings and profit
Author:Fortin, Karen A.
Publication:The Tax Adviser
Date:Jul 1, 1993
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