## Facts

- Twenty-seven wholly owned subsidiaries of McDonald’s Corporation operated restaurants acquired from a group of developers (the Garb‑Stern group).
- McDonald’s sought to acquire all Garb‑Stern restaurant companies in a single transaction structured to qualify for pooling-of-interests accounting, which required consideration in McDonald’s common stock.
- The Garb‑Stern group wanted cash and required assurance that any stock received could be converted into cash promptly.
- The parties structured the deal as a statutory merger in which Garb‑Stern shareholders received McDonald’s stock plus a contractual demand registration right requiring McDonald’s to register the stock within two years, facilitating public sale.
- McDonald’s planned to register the shares in connection with a near-term registration; after delay, the shares were registered and the Garb‑Stern group sold them on the open market.
- McDonald’s then contributed the acquired restaurant assets to its 27 subsidiaries, which claimed depreciation using a stepped-up basis tied to the fair market value of the stock issued.
- The IRS recharacterized the acquisition as a tax-free reorganization, required carryover basis for the assets, reduced depreciation, and assessed deficiencies that the Tax Court sustained.

## Issues

1. Whether the acquisition qualified as a tax-free reorganization requiring continuity of proprietary interest, resulting in carryover basis for the subsidiaries.
2. Whether receiving acquiring-corporation stock coupled with a bargained-for demand registration right and an anticipated near-term stock sale satisfied continuity of interest.

## Decision

- The Seventh Circuit reversed the Tax Court.
- The court held the transaction did not qualify as a tax-free reorganization because continuity of interest was not satisfied.
- The acquisition was treated as a taxable sale, entitling the subsidiaries to a stepped-up basis equal to the value of the stock exchanged.
- The subsidiaries’ depreciation deductions based on the higher basis were allowed, and the asserted deficiencies were rejected.

## Legal Principles

- A reorganization requires continuity of proprietary interest: target shareholders must retain a meaningful continuing equity interest in the acquiring corporation rather than being cashed out.
- Continuity is defeated when an integrated plan, from the outset, effectively ensures a prompt conversion of stock consideration into cash.
- Courts may look beyond transactional form and apply substance-over-form where stock is used only as a temporary medium to deliver cash to sellers.
- A post-closing stock disposition may not defeat continuity when not planned or guaranteed, but contractual liquidity mechanisms integral to the bargain can show an intended cash sale.

## Conclusion

Because the sellers’ stock interest was transitory and supported by a contractual mechanism designed to permit a near-term cash-out, the transaction lacked continuity of interest and was treated as a taxable purchase, allowing stepped-up basis and corresponding depreciation.


McDonald’s Rests. of Ill., Inc. v. Comm’r, 688 F.2d 520 (7th Cir. 1982)