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 (1945), and United States v. Davis, 397 U.S. 301 (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."
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.
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:
Thus, 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 contrast, if the exchange does not have "the effect of the distribution of a dividend," the boot must be treated as a payment in exchange for property and, insofar as gain is realized, accorded capital gains treatment. The question in this case is thus whether the exchange between the taxpayer and the acquiring corporation had "the effect of the distribution of a dividend" within the meaning of § 356(a)(2).
The relevant facts are easily summarized. For approximately 15 years prior to April 1979, the taxpayer was the president of Basin Surveys, Inc. (Basin). In January 1978, he became sole shareholder in Basin, a company in which he had invested approximately $85,000. The corporation operated a successful business providing various technical services to the petroleum industry. In 1978, N. L. Industries, Inc. (NL), a publicly owned corporation engaged in the manufacture and supply of petroleum equipment and services, initiated negotiations with the taxpayer regarding the possible acquisition of Basin. On April 3, 1979, after months of negotiations, the taxpayer and NL entered into a contract.
The agreement provided for a "triangular merger," whereby Basin was merged into a wholly owned subsidiary of NL. In exchange for transferring all of the outstanding shares in Basin to NL's subsidiary, the taxpayer elected to receive 300,000 shares of NL common stock and cash boot of $3,250,000, passing up an alternative offer of 425,000 shares of NL common stock. The 300,000 shares of NL issued to the taxpayer amounted to approximately 0.92% of the outstanding
Respondents filed a joint federal income tax return for 1979. As required by § 356(a)(1), they reported the cash boot as taxable gain. In calculating the tax owed, respondents characterized the payment as long-term capital gain. The Commissioner on audit disagreed with this characterization. In his view, the payment had "the effect of the distribution of a dividend" and was thus taxable as ordinary income up to $2,319,611, the amount of Basin's accumulated earnings and profits at the time of the merger. The Commissioner assessed a deficiency of $972,504.74.
Respondents petitioned for review in the Tax Court, which, in a reviewed decision, held in their favor. 86 T.C. 138 (1986). The court started from the premise that the question whether the boot payment had "the effect of the distribution of a dividend" turns on the choice between "two judicially articulated tests." Id., at 140. Under the test advocated by the Commissioner and given voice in Shimberg v. United States, 577 F.2d 283 (CA5 1978), cert. denied, 439 U.S. 1115 (1979), the boot payment is treated as though it were made in a hypothetical redemption by the acquired corporation (Basin) immediately prior to the reorganization.
This decision by the Court of Appeals for the Fourth Circuit is in conflict with the decision of the Fifth Circuit in Shimberg v. United States, 577 F.2d 283 (1978), in two important respects. In Shimberg, the court concluded that it was inappropriate to apply stock redemption principles in reorganization cases "on a wholesale basis." Id., at 287; see also ibid., n. 13. In addition, the court adopted the pre-reorganization
To resolve this conflict on a question of importance to the administration of the federal tax laws, we granted certiorari. 485 U.S. 933 (1988).
We agree with the Tax Court and the Court of Appeals for the Fourth Circuit that the question under § 356(a)(2) 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. We think the language and history of the statute, as well as a commonsense understanding of the economic substance of the transaction at issue, support this approach.
The language of § 356(a) strongly supports our understanding that the transaction should be treated as an integrated whole. Section 356(a)(2) asks whether "an exchange is described in paragraph (1)" that "has the effect of the distribution of a dividend." (Emphasis supplied.) The statute does not provide that boot shall be treated as a dividend if its payment has the effect of the distribution of a dividend. Rather, the inquiry turns on whether the "exchange" has that effect. Moreover, paragraph (1), in turn, looks to whether "the property received in the exchange consists not only of property permitted by section 354 or 355 to be received without the recognition of gain but also of other property or money." (Emphasis supplied.) Again, the statute plainly refers to one integrated transaction and, again, makes clear that we are to look to the character of the exchange as a whole and not simply its component parts. Finally, it is significant that § 356 expressly limits the extent to which boot may be taxed to the amount of gain realized in the reorganization. This limitation suggests that Congress intended that boot not be treated in isolation from
Our reading of the statute as requiring that the transaction be treated as a unified whole is reinforced by the well-established "step-transaction" doctrine, a doctrine that the Government has applied in related contexts, see, e. g., Rev. Rul. 75-447, 1975-2 Cum. Bull. 113, and that we have expressly sanctioned, see Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938); Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945). Under this doctrine, interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus "linking together all interdependent steps with legal or business significance, rather than taking them in isolation," federal tax liability may be based "on a realistic view of the entire transaction." 1 B. Bittker, Federal Taxation of Income, Estates and Gifts ¶ 4.3.5, p. 4-52 (1981).
Viewing the exchange in this case as an integrated whole, we are unable to accept the Commissioner's prereorganization analogy. The analogy severs the payment of boot from the context of the reorganization. Indeed, only by straining to abstract the payment of boot from the context of the overall exchange, and thus imagining that Basin made a distribution to the taxpayer independently of NL's planned acquisition, can we reach the rather counterintuitive conclusion urged by the Commissioner — that the taxpayer suffered no meaningful reduction in his ownership interest as a result of the cash payment. We conclude that such a limited view of the transaction is plainly inconsistent with the statute's direction that we look to the effect of the entire exchange.
The prereorganization analogy is further flawed in that it adopts an overly expansive reading of § 356(a)(2). As the Court of Appeals recognized, adoption of the prereorganization approach would "result in ordinary income treatment in
The postreorganization 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. Unlike the prereorganization view, this approach acknowledges that there would have been no cash payment absent the exchange and also that, by accepting the cash payment, the taxpayer experienced a meaningful reduction in his potential ownership interest.
Once the postreorganization approach is adopted, the result in this case is pellucidly clear. Section 302(a) of the
The Commissioner objects to this "recasting [of] the merger transaction into a form different from that entered
Moreover, we doubt that abandoning the prereorganization and postreorganization analogies and the principles of § 302 in favor of a less artificial understanding of the transaction would lead to a result different from that reached by the Court of Appeals. Although the statute is admittedly ambiguous and the legislative history sparse, we are persuaded — even without relying on § 302 — that Congress did not intend to except reorganizations such as that at issue
Section 356(a)(2) finds its genesis in § 203(d)(2) of the Revenue Act of 1924. See 43 Stat. 257. Although modified slightly over the years, the provisions are in relevant substance identical. The accompanying House Report asserts that § 203(d)(2) was designed to "preven[t] evasion." H. R. Rep. No. 179, 68th Cong., 1st Sess., 15 (1924). Without further explication, both the House and Senate Reports simply rely on an example to explain, in the words of both Reports, "[t]he necessity for this provision." Ibid.; S. Rep. No. 398, 68th Cong., 1st Sess., 16 (1924). Significantly, the example describes a situation in which there was no change in the stockholders' relative ownership interests, but merely the creation of a wholly owned subsidiary as a mechanism for making a cash distribution to the shareholders:
The "effect" of the transaction in this example is to transfer accumulated earnings and profits to the shareholders without altering their respective ownership interests in the continuing enterprise.
Of course, this example should not be understood as exhaustive of the proper applications of § 356(a)(2). It is nonetheless noteworthy that neither the example, nor any other legislative source, evinces a congressional intent to tax boot accompanying a transaction that involves a bona fide exchange between unrelated parties in the context of a reorganization as though the payment was in fact a dividend. To the contrary, the purpose of avoiding tax evasion suggests that Congress did not intend to impose an ordinary income tax in such cases. Moreover, the legislative history of § 302 supports this reading of § 356(a)(2) as well. In explaining the "essentially equivalent to a dividend" language of § 302 (b)(1) — language that is certainly similar to the "has the effect. . . of a dividend" language of § 356(a)(2) — the Senate Finance Committee made clear that the relevant inquiry is "whether or not the transaction by its nature may properly be characterized as a sale of stock . . . ." S. Rep. No. 1622, 83d Cong., 2d Sess., 234 (1954); cf. United States v. Davis, 397 U. S., at 311.
Examining the instant transaction in light of the purpose of § 356(a)(2), the boot-for-stock exchange in this case "may
In this context, even without relying on § 302 and the postreorganization analogy, we conclude that the boot is better characterized as a part of the proceeds of a sale of stock than
The judgment of the Court of Appeals is accordingly
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 outstanding
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. § 1.368-1(b), 26 CFR § 1.368-1(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).
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 425,000 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
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.
"(A) a statutory merger or consolidation;
"(D) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356;
"(E) a recapitalization;
"(F) a mere change in identity, form, or place of organization of one corporation, however effected . . . ."
"The acquisition by one corporation, in exchange for stock of a corporation (referred to in this subparagraph as `controlling corporation') which is in control of the acquiring corporation, of substantially all of the properties of another corporation which in the transaction is merged into the acquiring corporation shall not disqualify a transaction under paragraph (1)(A) if (i) such transaction would have qualified under paragraph (1)(A) if the merger had been into the controlling corporation, and (ii) no stock of the acquiring corporation is used in the transaction." 26 U. S. C. § 368(a) (2)(D) (1976 ed.).
Under either test, a prereorganization distribution by Basin to the taxpayer would have qualified as a dividend. Because the taxpayer was Basin's sole shareholder, any distribution necessarily would have been pro rata and would not have resulted in a "meaningful reduction of the [taxpayer's] proportionate interest in [Basin]."
"(a) General rule
"If a corporation redeems its stock (within the meaning of section 317 (b)), and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock.
"(b) Redemptions treated as exchanges
"(2) Substantially disproportionate redemption of stock
"(A) In general
"Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder.
"This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.
"For purposes of this paragraph, the distribution is substantially disproportionate if —
"(i) the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time,
"is less than 80 percent of —
"(ii) the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time.
"For purposes of this paragraph, no distribution shall be treated as substantially disproportionate unless the shareholder's ownership of the common stock of the corporation (whether voting or nonvoting) after and before redemption also meets the 80 percent requirement of the preceding sentence. . . ."
As the Tax Court explained, receipt of the cash boot reduced the taxpayer's potential holdings in NL from 1.3% to 0.92%. 86 T.C. 138, 153 (1986). The taxpayer's holdings were thus approximately 71% of what they would have been absent the payment. Ibid. This fact, combined with the fact that the taxpayer held less than 50% of the voting stock of NL after the hypothetical redemption, would have qualified the "distribution" as "substantially disproportionate" under § 302(b)(2).
The "automatic dividend rule" developed as a result of some imprecise language in our decision in Commissioner v. Estate of Bedford, 325 U.S. 283 (1945). Although Estate of Bedford involved the recapitalization of a single corporation, the opinion employed broad language, asserting that "a distribution, pursuant to a reorganization, of earnings and profits `has the effect of a distribution of a taxable dividend' within [§ 356(a)(2)]." Id., at 292. The Commissioner read this language as establishing as a matter of law that all payments of boot are to be treated as dividends to the extent of undistributed earnings and profits. See Rev. Rul. 56-220, 1956-1 Cum. Bull. 191. Commentators, see, e. g., Darrel, The Scope of Commissioner v. Bedford Estate, 24 Taxes 266 (1946); Shoulson, Boot Taxation: The Blunt Toe of the Automatic Rule, 20 Tax L. Rev. 573 (1965), and courts, see, e. g., Hawkinson v. Commissioner, 235 F.2d 747 (CA2 1956), however, soon came to criticize this rule. The courts have long since retreated from the "automatic dividend rule," see, e. g., Idaho Power Co. v. United States, 161 F.Supp. 807 (Ct. Cl.), cert. denied, 358 U.S. 832 (1958), and the Commissioner has followed suit, see Rev. Rul. 74-515, 1974-2 Cum. Bull. 118. As our decision in this case makes plain, we agree that Estate of Bedford should not be read to require that all payments of boot be treated as dividends.