489 U.S. 726 (1989)
For approximately 15 years prior to April 1979, Donald E. Clark served as president of Basin Surveys, Inc.1
In January 1978 he became the sole shareholder of Basin after investing approximately $85,000 in the company that provided technical services to the petroleum industry.2
In 1978 N. L. Industries, Inc. initiated negotiations with Clark regarding the possible acquisition of Basin, and on April 3, 1979, after months of negotiations, Clark and NL entered into a contract for a triangular merger.3 The agreement provided that Basin would merge into a wholly owned subsidiary of NL.4 Clark elected to receive 300,000 shares of NL common stock amounting to approximately 0.92 percent of NL's outstanding shares together with cash of $3,250,000 rather than accepting an alternative of 425,000 shares of NL stock that would have represented about 1.3 percent ownership.5 The merger qualified as a reorganization under sections 368(a)(1)(A) and (a)(2)(D) of the Internal Revenue Code.6
Clark and his wife Peggy filed a joint federal income tax return for 1979 in which they reported the cash payment as long-term capital gain.7 The Commissioner of Internal Revenue audited the return and determined that the payment had the effect of the distribution of a dividend, assessing a deficiency of $972,504.74 on the basis that $2,319,611 constituted ordinary income.8
The Clarks petitioned the Tax Court for review, and that court in a reviewed decision held in their favor.9 The Court of Appeals for the Fourth Circuit affirmed the Tax Court decision.10 This result conflicted with the Fifth Circuit's decision in Shimberg v. United States, prompting the Supreme Court to grant certiorari.11
Whether the exchange between the taxpayer and the acquiring corporation had the effect of the distribution of a dividend within the meaning of section 356(a)(2) of the Internal Revenue Code?12
Section 356(a)(2) provides that if an exchange described in paragraph (1) has the effect of the distribution of a dividend, then the boot shall be treated as a dividend to the extent of the distributee's ratable share of undistributed earnings and profits.13 The statute requires examination of the effect of the exchange as a whole under the step-transaction doctrine rather than isolating the boot payment.14 The preferred approach applies section 302(b)(2) through a hypothetical post-reorganization redemption by the acquiring corporation.15
No. The post-reorganization hypothetical redemption shows that Clark relinquished approximately 29 percent of his interest in NL.16 He retained less than a 1 percent voting interest after the transaction. This satisfies the substantially disproportionate standards of section 302(b)(2).17 Therefore the boot payment did not have the effect of a dividend.18
The cash payment did not have the effect of the distribution of a dividend and was properly treated as capital gain.19
Related opinions on this issue
Justice White dissented from the majority's conclusion that the boot lacked dividend effect.20 He maintained that Clark necessarily received a pro rata distribution of moneys exceeding Basin's undistributed earnings and profits of $2,319,611.21 The simultaneous timing of the merger and cash obligation preserved the pro rata character of the payment.22
Justice White argued that the majority's hypothetical post-reorganization redemption under section 302 was inappropriate because it ignored the pro rata nature of the distribution to the sole shareholder and the fact that Clark had refused the pure stock-for-stock exchange. The transaction had the effect of a dividend under section 356(a)(2), requiring ordinary income treatment for the boot to the extent of earnings and profits. This approach better prevents the bailout of corporate earnings at capital gains rates through reorganizations.
Whether the determination of dividend equivalence for boot received in a reorganization should employ a hypothetical redemption by the acquired corporation immediately prior to the reorganization or by the acquiring corporation immediately after the reorganization?23
The language of section 356(a) directs that the inquiry focus on whether the exchange as a whole has the effect of a dividend.24 This reading is reinforced by the step-transaction doctrine that treats interrelated steps as a unified transaction.25 The post-reorganization hypothetical redemption test is the appropriate method because it acknowledges the reality that no cash payment would have occurred absent the reorganization and better preserves the general rule of capital gains treatment for boot.26
No. The prereorganization test is inappropriate because it severs the boot from the context of the overall exchange and would result in ordinary income treatment in most reorganizations involving pro rata distributions.27 The post-reorganization approach is required because it treats the payment of boot as a component of the integrated transaction. It recognizes that the taxpayer experienced a meaningful reduction in ownership interest only because of the reorganization.28 It aligns with the statutory direction to examine the effect of the entire exchange rather than an isolated pre-reorganization event.29
The determination of dividend equivalence should employ a hypothetical redemption by the acquiring corporation immediately after the reorganization.30
Related opinions on this issue
Justice White dissented from the majority's adoption of the post-reorganization test.31 He argued that transporting section 302 principles into the reorganization context is problematic.32 This approach obscures the core attribute of a dividend as a pro rata distribution to a corporation's shareholders out of earnings and profits.33
The majority's recharacterization describes the exact stock-for-stock exchange that Clark refused when he agreed to the merger containing cash boot.34 The pro rata distribution during the reorganization therefore triggered ordinary income treatment under section 356(a)(2).35