Section 356: Taxing Boot in Corporate Reorganizations

Corporate reorganizations, such as mergers and acquisitions, are frequently designed as tax-free events. This allows shareholders to exchange their stock in one company for stock in another without immediately recognizing a taxable gain. The theory is that the shareholder has not “cashed out” but has merely continued their investment in a different corporate form.

When a shareholder receives more than just stock in the exchange, such as cash or other property, the transaction is no longer entirely tax-free. Section 356 of the Internal Revenue Code addresses these scenarios. It provides the framework for treating this additional consideration, known as “boot,” ensuring the portion representing a cashing out of one’s investment is taxed.

Transactions Involving Boot

In corporate reorganizations, “boot” is any property received by a shareholder that is not the permissible stock or securities of the acquiring corporation. The most common form of boot is cash, but it can also include assets like debt securities or real estate. The receipt of boot triggers tax consequences because it represents value that is not being reinvested.

Section 356 becomes relevant in several types of corporate reorganizations. These include “Type A” statutory mergers, “Type C” stock-for-asset acquisitions, and certain “Type D” reorganizations involving a transfer of assets to a controlled corporation.

The rule also governs certain distributions under Section 355, which deals with corporate spin-offs, split-offs, and split-ups. If shareholders receive property or cash in addition to the subsidiary’s stock, Section 356 dictates the tax treatment. The assumption of a corporation’s liabilities by an acquirer is generally not treated as boot, unless the purpose is tax avoidance or lacks a bona fide business purpose.

Calculating Recognized Gain

A shareholder receiving boot in a reorganization must recognize gain equal to the lesser of two amounts: the total gain realized on the exchange or the fair market value of the boot received. The realized gain is the total economic profit, calculated as the fair market value of all consideration received minus the shareholder’s adjusted basis in the surrendered stock.

For example, a shareholder owns stock with a $1,000 tax basis. In a merger, they exchange this stock for new stock worth $3,000 and $500 in cash. The total consideration is $3,500, and the realized gain is $2,500 ($3,500 total consideration – $1,000 basis). The shareholder must recognize a gain of $500, as this is the lesser of the $2,500 realized gain and the $500 of boot.

If the boot in the same example was $3,000 cash, the recognized gain would be limited to the realized gain of $2,500. A shareholder cannot recognize more gain than they economically realized on the transaction. This is known as the “boot-within-gain” limitation.

While gains may be recognized, losses are not. Section 356 prohibits a shareholder from recognizing a loss on an exchange where boot is received. If a shareholder’s basis in their surrendered stock is higher than the total value of the consideration received, the economic loss cannot be deducted at the time of the reorganization.

Characterizing the Gain

After calculating the recognized gain, its character as either a dividend or a capital gain must be determined, as they can be subject to different tax rates. The “dividend within gain” rule states that if an exchange has the effect of a dividend distribution, the recognized gain is taxed as a dividend.