Generally, shareholders may receive stock tax-free in certain entity reorganizations. This stock received qualifies for non-recognition treatment under the theory that the new stock is a continuation of the old investment. However, when a shareholder receives something other than stock, also known as “boot”, the shareholder must often recognize gain on the sale.
The term “boot” is not clearly defined in the Internal Revenue Code. However, “boot” generally refers to the fair market value of cash, benefits, or other non-“like-kind” property received in an exchange, sale, or reorganization. The treatment of boot depends largely on the reorganization structure that is implemented, and the amount of boot permitted to be received in each type of reorganization varies.
The recipient of boot is generally taxable in an otherwise tax-free reorganization. The amount and character of the tax liability depends on the type of boot distributed to the shareholder. Certain reorganizations may even allow for the treatment of boot as a dividend, which could be beneficial for corporate taxpayers who are entitled to the dividends received deduction. The receipt of boot in a sale or exchange generally can have one of three consequences to the shareholder.
- The reorganization retains its tax-free status, but the transferring shareholder recognizes gain to the extent of boot received. A Section 351 transaction, for example, allows for tax-free treatment if property is transferred solely in exchange for stock. However, if cash is received in addition to stock (and the shareholder retains control after the exchange), the shareholder shall recognize gain in an amount no greater than the cash received. The distributing corporation may also be required to recognize a gain on the distribution of boot.
- The receipt of boot disrupts the tax-free status of the exchange or sale. Certain types of reorganizations have limitations on how much boot a shareholder may receive in order for it to qualify for tax-free treatment. A “C” reorganization permits the shareholder to receive 20% of total consideration as boot. Any boot received over the 20% limit disqualifies the reorganization from tax-free treatment, causing the entire transaction to be taxable. It is important to consider whether the receipt of boot may violate the tax-free reorganization and result in a taxable transaction.
- The receipt of boot functionally may be treated as a distribution separate from the sale or exchange. This does not limit dividend treatment to the amount of shareholder’s gain or ratable share of earnings and profits. The dividends are then taxed as ordinary income to the extent of the shareholder’s allocated earnings and profits, while the excess is taxed at capital gains rates.
As a general rule, the assumption of liabilities by a corporation in an exchange will not be treated as boot and will not prevent the exchange from qualifying for tax-free treatment. However, there are certain exceptions to this rule. For example, the assumption of liabilities for purposes of tax avoidance as well as liabilities in excess of basis may result in a taxable gain. It is also important to note that nonqualifed preferred stock (“NQPS”), along with rights to acquire NQPS is treated as boot.
The receipt of boot in a sale, exchange, or reorganization could result in tax consequences to the shareholder, and the classification and taxability of boot can be very complex. If you are considering receiving other property in a transaction, we advise that you contact an experienced tax advisor.
Please feel free to contact your L&B professional at 858-558-9200 to further discuss these details.