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Paulsen v. Commissioner - 469 U.S. 131, 105 S. Ct. 627 (1985)

Rule:

Satisfying the literal terms of the reorganization provisions, is not sufficient to qualify for nonrecognition of gain or loss. The purpose of these provisions is to free from the imposition of an income tax purely "paper profits or losses" wherein there is no realization of gain or loss in the business sense. In order to exclude sales structured to satisfy the literal terms of the reorganization provisions but not their purpose, the U.S. Supreme Court has construed the statute to also require that the taxpayer's ownership interest in the prior organization must continue in a meaningful fashion in the reorganized enterprise.

Facts:

Pursuant to a merger plan where Commerce Savings and Loan Association, a state-chartered stock savings and loan association, was merged in 1976 into Citizens Federal Savings and Loan Association, a federally chartered mutual savings and loan association, petitioners, husband and wife, exchanged their "guaranty stock" in Commerce for passbook savings accounts and time certificates of deposit in Citizens representing share interests in Citizens. Relying on §§ 354(a)(1) and 368(a)(1)(A) of the Internal Revenue Code, which provided an exception to recognizing a gain on the sale or exchange of property for corporate reorganizations, petitioners did not report on their 1976 income tax return the gain they realized on the exchange because they considered the merger to be a tax-free reorganization. The Commissioner of Internal Revenue, however, issued a notice of deficiency and found petitioners liable for tax on the entire gain. Petitioners then sought redetermination of the deficiency in the Tax Court, which rendered a decision in petitioners' favor. The court reasoned that the savings accounts and certificates of deposit were the only forms of equity in Citizens, and held that the requisite continuity of interest existed under the rule that even though the literal terms of the reorganization provisions of the statute are satisfied, the statute also requires that the taxpayer's ownership interest in the prior organization must continue in a meaningful fashion in the reorganized enterprise and the retained interest must represent a substantial part of the value of the thing transferred. On appeal, the Court of Appeals reversed, holding that despite certain equity characteristics, the Citizens savings accounts and certificates of deposit were indistinguishable from ordinary savings accounts and were essentially the equivalent of cash.

Issue:

Were Petitioners Harold and Marie Paulsen entitled to treat the Commerce-Citizens merger as a tax-free exchange?

Answer:

No.

Conclusion:

The Supreme Court held that the sale or exchange of property was taxable under 26 U.S.C.S. § 1002 because the corporate reorganization exception was inapplicable. The exchange did not satisfy the continuity-of-interest requirement for tax-exempt status, as petitioner's ownership interest in the acquired association did not continue in the reorganized enterprise. The acquired shares were essentially cash and did not satisfy the equity requirement of a reorganization. The Court explained that the retained equity had almost no value and was not a "material part" of the stock previously held by petitioner. The Court observed further that the debt characteristics of the acquired shares outweighed the equity.

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