## Facts

- Donald E. Clark owned 100% of Basin Surveys, Inc. (Basin).
- NL Industries, Inc. (NL) acquired Basin through a triangular merger in which Basin merged into an NL wholly owned subsidiary.
- Clark transferred all Basin shares and received (1) 300,000 shares of NL common stock (about 0.92% of NL) and (2) a substantial cash payment (boot).
- The Clarks reported the stock exchange as nonrecognition and reported gain attributable to the cash boot as capital gain under I.R.C. § 356(a)(1).
- The Commissioner agreed the transaction qualified as a reorganization but asserted the boot had “the effect of the distribution of a dividend” under § 356(a)(2), taxable as ordinary income to the extent of earnings and profits.
- The dispute turned on how to determine dividend equivalence: the Commissioner urged a pre-reorganization hypothetical redemption by Basin; the taxpayers urged a post-reorganization hypothetical redemption by NL (tested under § 302).

## Issues

1. Whether cash boot received in a qualifying reorganization must be treated as a dividend under I.R.C. § 356(a)(2) or as capital gain under § 356(a)(1).
2. Whether dividend equivalence under § 356(a)(2) is tested using a post-reorganization hypothetical redemption of acquiring-corporation stock under I.R.C. § 302 rather than a pre-reorganization hypothetical redemption by the target.

## Decision

- The Supreme Court affirmed the Fourth Circuit.
- The Court held the boot was subject to capital gains treatment, not dividend (ordinary income) treatment.
- The Court approved the post-reorganization hypothetical: treat the deal as a stock-for-stock exchange followed immediately by a redemption of part of the acquiring corporation’s stock for cash equal to the boot, analyzed under § 302.
- Because Clark’s ownership shifted from full control of Basin to a small minority interest in NL, the transaction functioned economically as a sale rather than a dividend-like distribution.

## Legal Principles

- I.R.C. § 356(a)(1) generally treats recognized gain attributable to boot in a reorganization as capital gain; § 356(a)(2) is a narrow exception when the boot is dividend-equivalent.
- Dividend equivalence under § 356(a)(2) is properly assessed by viewing the reorganization as an integrated transaction and applying a post-reorganization § 302 redemption framework to the acquiring corporation’s stock.
- A significant reduction in a shareholder’s interest and control supports sale-or-exchange (capital gain) characterization rather than dividend characterization.
- An approach that isolates boot via a pre-reorganization hypothetical may misstate the economic effect and improperly broaden § 356(a)(2).

## Conclusion

The Court held that boot in a qualifying reorganization is not taxed as a dividend under § 356(a)(2) when, evaluated under a post-reorganization hypothetical redemption analyzed through § 302, the shareholder’s interest is substantially reduced such that the payment resembles sale proceeds rather than a dividend.


Commissioner v. Clark, 489 U.S. 726 (1989)