## Facts

- Harold and Marie Paulsen owned 17,459 shares of guaranty stock in Commerce Savings and Loan Association, a state-chartered stock savings and loan; Harold was Commerce’s president.
- In 1976, Commerce merged into Citizens Federal Savings and Loan Association, a federally chartered mutual savings and loan with no capital stock.
- Under the merger plan, Commerce ceased to exist and Citizens survived.
- The Paulsens exchanged their Commerce stock (basis about $56,802) for Citizens passbook savings accounts and time certificates of deposit worth about $209,508.
- The Paulsens did not report the resulting gain (about $152,706), treating the exchange as nonrecognition in a tax-free reorganization under I.R.C. §§ 354(a)(1) and 368(a)(1)(A).
- The IRS issued a deficiency notice asserting the gain was taxable.
- The Tax Court ruled for the Paulsens, reasoning that the Citizens accounts were the only “equity” in a mutual association and thus satisfied continuity of interest.
- The Ninth Circuit reversed, characterizing the Citizens instruments as essentially equivalent to cash.
- The Supreme Court granted review.

## Issues

1. Whether a statutory merger of a stock savings and loan into a mutual savings and loan qualifies as a tax-free reorganization under I.R.C. §§ 354(a)(1) and 368(a)(1)(A) when shareholders receive passbook accounts and certificates of deposit.
2. Whether the continuity-of-interest requirement is satisfied when the consideration received has predominant debt-like features and functions as a cash equivalent rather than a continuing proprietary stake.

## Decision

- The Supreme Court affirmed the Ninth Circuit.
- The Citizens passbook accounts and certificates of deposit were cash equivalents, not a continuing proprietary interest.
- Because continuity of interest was not satisfied, the exchange did not qualify for nonrecognition under §§ 354 and 368.
- The Paulsens’ gain on the exchange was taxable in full.

## Legal Principles

- Reorganization nonrecognition requires continuity of proprietary interest: the prior owners must retain a meaningful, substantial proprietary stake in the reorganized enterprise.
- Continuity is a substance-based inquiry; formal labels and corporate-law characterizations do not control federal tax treatment.
- Instruments with predominant debt-like characteristics—non-subordination, withdrawability at face value, non-permanent capital, and a fixed/preannounced return—may be treated as cash equivalents for continuity purposes even if accompanied by voting rights or “dividend” terminology.
- Receipt of cash or cash equivalents in exchange for stock is treated as a taxable disposition rather than a reorganization exchange.

## Conclusion

The merger failed the continuity-of-interest requirement because the deposit accounts and certificates of deposit received by the former stockholders functioned primarily as withdrawable, fixed-return cash equivalents rather than a continuing equity stake, making the realized gain fully taxable.


Paulsen v. Comm’r, 469 U.S. 131 (1985)