Commissioner v. Clark

Background

A sole-owner of a small company (the seller) agreed to a triangular merger in which he turned over his firm to a subsidiary of a public company and received $3,250,000 in cash plus a small block of the buyer’s stock. The seller took 300,000 shares (about 0.92% of the buyer) instead of an all-stock offer of 425,000 shares (about 1.3%). The IRS said the cash was effectively a dividend and should be taxed as ordinary income up to Basin’s accumulated earnings and profits; the Tax Court and the Fourth Circuit disagreed and treated the cash as capital gain.

Reasoning

The Court asked whether the whole exchange “had the effect of the distribution of a dividend.” It viewed the transaction as an integrated deal and adopted the postreorganization hypothetical: treat the cash as if it were a redemption by the acquiring company. Because the seller’s percentage interest in the buyer fell substantially (about a 29% reduction from the hypothetical all-stock position) and he retained far less than 50% of voting power, the Court applied the redemption rules and held the cash was sale proceeds, not a dividend. The opinion relied on the statute’s wording, the step-transaction idea, and legislative history aimed at preventing tax-evasion schemes.

Real world impact

The decision means that in arm’s-length mergers where a seller receives cash plus a small continuing stake, courts may treat the cash as capital gain rather than an ordinary dividend, changing tax treatment for similar deals and affecting how buyers and sellers structure transactions.

Dissents or concurrances

Justice White dissented, arguing the cash was a pro rata distribution to the seller and thus had the effect of a dividend; Justice Scalia joined most of the opinion, but not Part III.