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Saturday, September 30, 2006


The Internal Revenue Code attempts to be tax-neutral in regard to corporate reorganizations. One aspect of this tax neutrality is that generally no gain or loss is recognized by a shareholder who is a party to a tax-free reorganization. For example, a shareholder of an acquired corporation can receives shares of stock in the acquiring corporation and not recognize any gain on the transaction. This nonrecognition arises under Section 354 and applies only if the reorganization involves an exchange solely for stocks and securities of a corporation that is also a party to the exchange. If the taxpayer received other property ("boot"), under Section 356 gain recognition results to the extent of boot received. No loss recognition is allowed.

A taxpayer who receives boot may have a different adjusted basis (that is, investment in the stock against which the amount of gain or loss is calculated) in the various shares he exchanges in the reorganization, and indeed may be giving up shares of different classes of stock. When boot is received, to which shares should the boot be allocated? This allocation determines how much gain arises if there is a different adjusted basis in different exchanged shares, and whether gain is long term or short term gain if there are different holding periods for the shares exchanged.

The courts have adopted the average-cost method to make the allocation, which is a pro rata allocation of the surrendered stock's bases to each block of stock received.

Earlier this year, new Treas.Regs. Section 1.356-1 provides useful flexibility to taxpayers. It adopts a tracing method. More particularly, in computing the gain, if any, recognized on an exchange, to the extent the terms of the exchange (1) specify (or trace) the other property or money that is received in exchange for a particular share of stock or security surrendered, and (2) are "economically reasonable," those terms control and the average-cost method need not apply.

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