Ensuring capital gain treatment for boot received in a reorganization.

• Author: Ellentuck, Albert B.
• Position: Case study

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...