Court Opinion

ID: 9431618
Source: CourtListenerOpinion
Date Created: 2023-08-02 23:32:44.142797+00
Date Added: 2024-06-11T17:23:29.342427
License: Public Domain

Justice White,
dissenting.
The question in this case is whether the cash payment of $3,250,000 by N. L. Industries, Inc. (NL) to Donald Clark, which he received in the April 18, 1979, merger of Basin Surveys, Inc. (Basin), into N. L. Acquisition Corporation (NLAC), had the effect of a distribution of a dividend under the Internal Revenue Code of 1954, 26 U. S. C. § 356(a)(2) (1976 ed.), to the extent of Basin’s accumulated undistributed earnings and profits. Petitioner, the Commissioner of Internal Revenue (Commissioner), made this determination, taxing the sum as ordinary income, to find a 1979 tax deficiency of $972,504.74. The Court of Appeals disagreed, stating that because the cash payment resembles a hypothetical stock redemption from NL to Clark, the amount is taxable as capital gain. 828 F. 2d 221 (CA4 1987). Because the majority today agrees with that characterization, in spite of Clark’s explicit refusal of the stock-for-stock exchange imagined by the Court of Appeals and the majority, and because the record demonstrates, instead, that the transaction before us involved a boot distribution that had “the effect of the distribution of a dividend” under § 356(a)(2) — and hence properly alerted the Commissioner to Clark’s tax deficiency — I dissent.
The facts are stipulated. Basin, Clark, NL, and NLAC executed an Agreement and Plan of Merger dated April 3, 1979, which provided that on April 18, 1979, Basin would merge with NLAC. The statutory merger, which occurred pursuant to §§ 368(a)(1)(A) and (a)(2)(D) of the Code, and therefore qualified for tax-free reorganization status under § 354(a)(1), involved the following terms: Each outstanding share of NLAC stock remained outstanding; each out*746standing share of Basin common stock was exchanged for $56,034,482 cash and 5,172.4137 shares of NL common stock; and each share of Basin common stock held by Basin was canceled. NLAC’s name was amended to Basin Surveys, Inc. The Secretary of State of West Virginia certified that the merger complied with West Virginia law. Clark, the owner of all 58 outstanding shares of Basin, received $3,250,000 in cash and 300,000 shares of NL stock. He expressly refused NL’s alternative of 425,000 shares of NL common stock without cash. See App. 56-59.
Congress enacted § 354(a)(1) to grant favorable tax treatment to specific corporate transactions (reorganizations) that involve the exchange of stock or securities solely for other stock or securities. See Paulsen v. Commissioner, 469 U. S. 131, 136 (1985) (citing Treas. Reg. § 1.368-l(b), 26 CFR § 1.368-l(b) (1984), and noting the distinctive feature of such reorganizations, namely, continuity of interests). Clark’s “triangular merger” of Basin into NL’s subsidiary NLAC qualified as one such tax-free reorganization, pursuant to § 368(a)(2)(D). Because the stock-for-stock exchange was supplemented with a cash payment, however, § 356(a)(1) requires that “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.” Because this provision permitted taxpayers to withdraw profits during corporate reorganizations without declaring a dividend, Congress enacted § 356(a)(2), which states that when an exchange has “the effect of the distribution of a dividend,” boot must be treated as a dividend, and taxed as ordinary income, to the extent of the distributee’s “ratable share of the undistributed earnings and profits of the corporation. ...” Ibid,.; see also H. R. Rep. No. 179, 68th Cong., 1st Sess., 15 (1924) (illustration of §356(a)(2)’s purpose to frustrate evasion of dividend taxation through corporate reorganization distributions); S. Rep. No. 398, 68th Cong., 1st Sess., 16 (1924) (same).
*747Thus the question today is whether the cash payment to Clark had the effect of a distribution of a dividend. We supplied the straightforward answer in United States v. Davis, 397 U. S. 301, 306, 312 (1970), when we explained that a pro rata redemption of stock by a corporation is “essentially equivalent” to a dividend. A pro rata distribution of stock, with no alteration of basic shareholder relationships, is the hallmark of a dividend. This was precisely Clark’s gain. As sole shareholder of Basin, Clark necessarily received a pro rata distribution of moneys that exceeded Basin’s undistributed earnings and profits of $2,319,611. Because the merger and cash obligation occurred simultaneously on April 18, 1979, and because the statutory merger approved here assumes that Clark’s proprietary interests continue in the restructured NLAC, the exact source of the pro rata boot payment is immaterial, which truth Congress acknowledged by requiring only that an exchange have the effect of a dividend distribution.
To avoid this conclusion, the Court of Appeals — approved by the majority today — recast the transaction as though the relevant distribution involved a single corporation’s (NL’s) stock redemption, which dividend equivalency is determined according to §302 of the Code. Section 302 shields distributions from dividend taxation if the cash redemption is accompanied by sufficient loss of a shareholder’s percentage interest in the corporation. The Court of Appeals hypothesized that Clark completed a pure stock-for-stock reorganization, receiving 426,000 NL shares, and thereafter redeemed 125,000 of these shares for his cash earnings of $3,250,000. The sum escapes dividend taxation because Clark’s interest in NL theoretically declined from 1.3% to 0.92%, adequate to trigger § 302(b)(2) protection. Transporting §302 from its purpose to frustrate shareholder sales of equity back to their own corporation, to § 356(a)(2)’s reorganization context, however, is problematic. Neither the majority nor the Court of Appeals explains why § 302 should obscure the core attribute *748of a dividend as a pro rata distribution to a corporation’s shareholders;1 nor offers insight into the mechanics of valuing hypothetical stock transfers and equity reductions; nor answers the Commissioner’s observations that the sole shareholder of an acquired corporation will always have a smaller interest in the continuing enterprise when cash payments combine with a stock exchange. Last, the majority and the Court of Appeals’ recharacterization of market happenings describes the exact stock-for-stock exchange, without a cash supplement, that Clark refused when he agreed to the merger.
Because the parties chose to structure the exchange as a tax-free reorganization under § 354(a)(1), and because the pro rata distribution to Clark of $3,250,000 during this reorganization had the effect of a dividend under § 356(a)(2), I dissent.2

 The Court of Appeals’ zeal to excoriate the “automatic dividend rule” leads to an opposite rigidity — an automatic nondividend rule, even for pro rata boot payments. Any significant cash payment in a stock-for-stock exchange distributed to a sole shareholder of an acquired corporation will automatically receive capital gains treatment. Section 356(a)(2)’s exception for such payments that have attributes of a dividend disappears. Congress did not intend to handicap the Commissioner and courts with either absolute; instead, § 356(a)(1) instructs courts to make fact-specific inquiries into whether boot distributions accompanying corporate reorganizations occur on a pro rata basis to shareholders of the acquired corporation, and thus threaten a bailout of the transferor corporation’s earnings and profits escaping a proper dividend tax treatment.

 The majority’s alternative holding that no statutory merger occurred at all — rather a taxable sale — is difficult to understand: All parties stipulate to the merger, which, in turn, was approved under West Virginia law; and Congress endorsed exactly such tax-free corporate transactions pursuant to its § 368(a)(1) reorganization regime. However apt the speculated sale analogy may be, if the April 3 Merger Agreement amounts to a sale of Clark’s stock to NL, and not the intended merger, Clark would be subject to taxation on his full gain of over $10 million. The fracas over tax treatment of the cash boot would be irrelevant.