COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. DONALD E. CLARK AND
PEGGY S. CLARK

   No. 87-1168

   In the Supreme Court of the United States

   October Term, 1987

   On Writ Of Certiorari To The United States Court Of Appeals For The
Fourth Circuit

   Brief For The Petitioner

            TABLE OF CONTENTS
   Question Presented
   Opinions below
   Jurisdiction
   Statutes and regulations involved
   Statement
   Summary of argument
   Argument:
      Respondent's receipt of cash, in addition to NL stock,
      in exchange for his Basin stock had the effect of the
      distribution of a dividend within the meaning of Section
      356(a)(2) of the Code
      A. The statutory framework
      B. The payment of boot in a reorganization on a pro rata
         basis to the shareholders of the acquired corporation has
         the effect of the distribution of a dividend
      C. The substitution of a hypothetical scenario, consisting
         of a reorganization without boot followed by a partial
         stock redemption, in place of the actual reorganization
         involving boot is not the correct method of determining
         whether the actual boot distribution has the effect of a
         dividend under Section 356(a)(2)
   Conclusion

                            OPINIONS BELOW

   The opinion of the court of appeals (Pet. App. 1a-14a) is reported
at 828 F.2d 221.  The opinion of the Tax Court (Pet. App. 15a-39a) is
reported at 86 T.C. 138.

                             JURISDICTION

   The judgment of the court of appeals (Pet. App. 40a) was entered on
September 4, 1987.  On November 25, 1987, the Chief Justice extended
the time for filing a petition for a writ of certiorari to and
including January 2, 1988.  On December 17, 1987, the Chief Justice
further extended the time for filing a petition for a writ of
certiorari to and including January 11, 1988.  The petition was filed
on that date and was granted on March 7, 1988.  The jurisdiction of
this Court is invoked under 28 U.S.C. 1254(1).

                   STATUTES AND REGULATIONS INVOLVED

   The relevant portions of Sections 301, 302, 316, 317, 354, and 356
of the Internal Revenue Code of 1954 (26 U.S.C.), as amended, are set
forth in the Appendix, infra, 1a-6a.

                          QUESTION PRESENTED

   In this case, a relatively small corporation was merged into a
subsidiary of a large publicly-owned corporation, and the sole
shareholder of the acquired corporation received in return both cash
and shares of the stock of the publicly-owned corporation.  The
question presented is whether that payment of cash had the "effect of
the distribution of a dividend" within the meaning of Section
356(a)(2) of the Internal Revenue Code.

                               STATEMENT

   1. For some 15 years prior to April 1979, respondent Donald E.
Clark /1/ had been the president of Basin Surveys, Inc. (Basin), a
West Virginia corporation that furnished radiation, nuclear, and
electronic open-hole logging services to the petroleum industry, and
he then owned all of its outstanding 58 shares of stock.  N.L.
Industries, Inc. (NL) was then a publicly-held New Jersey corporation
engaged in manufacturing and supplying petroleum equipment and
services, chemicals and metals.  NL had outstanding approximately
32,533,000 shares of a single class of common stock and 500,000 shares
of preferred stock.  That stock was publicly traded on the New York
and Pacific Stock Exchanges.  N.L. Acquisition Corp. (NLAC) was a
wholly owned subsidiary of NL.  Pet. App. 16a;  J.A. 26-27.

   In 1978, NL initiated discussions with respondent concerning the
possible acquisition of Basin.  After several months of negotiations,
in March 1979 NL offered respondent alternative terms for the
acquisition of Basin:  (1) 425,000 shares of NL common stock without
cash;  or (2) 300,000 shares of NL common stock and $3,250,000 in
cash.  Respondent decided in favor of the latter alternative.  Pet.
App. 16a.  /2/

   On April 3, 1979, an agreement and plan of merger was executed by
Basin, NLAC, NL, and respondent.  The plan provided that, on April 18,
1979, Basin would merge with and into NLAC, which would change its
name to Basin Surveys, Inc., and that respondent would receive, with
respect to each of the 58 shares of Basin that he owned, 5,172.4137
shares of NL common stock and $56,034.482 cash.  The merger took place
as planned.  Respondent received a total of 300,000 shares of NL
common stock and $3,250,000 in cash, and he entered into an employment
agreement with the new Basin Surveys, Inc., for three years and an
agreement not to compete for five years.  Respondent and the Internal
Revenue Service (IRS) stipulated that the merger of Basin into NLAC
was effected pursuant to, and qualified as, a reorganization as
defined in Section 368(a)(1)(A) and (a)(2)(D) of the Internal Revenue
Code.  /3/ Pet. App. 16a-17a;  J.A. 27-28.

   2. Section 356(a)(1) of the Code provides that, if cash or other
property (commonly known as "boot") is received in the course of what
would otherwise be a tax-free, stock-for-stock reorganization (see
I.R.C. Section 354(a)(1)), the recipient must recognize his gain on
the transaction up to the value of that cash or other property
received.  Accordingly, in their joint federal income tax return for
1979, respondents reported the cash received in the merger as taxable
gain.  /4/ They characterized this amount as long-term capital gain.
Section 356(a)(2) of the Code, however, requires that, if the exchange
"has the effect of the distribution of a dividend," the distributee
must treat the amount of the gain as a dividend to the extent of his
ratable share of the undistributed earnings and profits of the
corporation accumulated after February 28, 1913.  Applying this
section, the Commissioner on audit determined that $2,319,611 of the
reported gain (which was the amount of the accumulated earnings and
profits of Basin at the time of the merger (J.A. 29)) should be
treated as a dividend.  Because that amount would then be taxable as
ordinary income, rather than as capital gain, this determination
resulted in an asserted deficiency of $972,504.74 in federal income
taxes for 1979 (J.A. 11-22).

   3. Respondents petitioned for review in the Tax Court, which ruled
in their favor in a reviewed decision (Pet. App. 15a-39a).  The court
viewed the question whether respondents' receipt of cash in the merger
had the effect of the distribution of a dividend as turning on a
choice between two "judicially articulated tests" set forth in Wright
v. United States, 482 F.2d 600 (8th Cir. 1973), and Shimberg v. United
States, 577 F.2d 283 (5th Cir. 1978), cert. denied, 439 U.S. 1115
(1979) (Pet. App. 18a).  According to the Tax Court, the Shimberg test
would treat the cash distribution as if it constituted a redemption of
stock in the acquired corporation prior to the merger, and the Wright
test would treat the cash payment as if it constituted "a distribution
by the acquiring corporation (NL) in a hypothetical redemption of the
shares of NL stock that would have been received if petitioner had
accepted stock in lieu of the cash consideration" (Pet. App. 18a
(emphasis in original)).

   The Tax Court then concluded that it should follow Wright and treat
the cash payment as part of a hypothetical post-merger redemption of
the 125,000 shares of NL stock that respondent declined to accept as
part of the exchange for his Basin stock.  The court stated that this
approach was necessary if the cash payment is to "be viewed and tested
within the context of the entire reorganization" (Pet. App. 33a).
Because such a redemption would have reduced respondent's hypothetical
holdings in NL from 425,000 to 300,000 shares, the cash received on
the hypothetical redemption would not have been essentially equivalent
to a dividend under the redemption provisions of the Code (see I.R.C.
Section 302(b)(2)).  /5/ Under the Tax Court's approach, this
conclusion that the funds that would have been received in a
hypothetical post-merger redemption would not be treated as a dividend
meant that the cash received by respondents in the reorganization
should not be viewed as having the effect of a dividend either, and
therefore respondents were entitled to capital gain treatment upon the
reported gain.  Pet. App. 34a-35a.

   4. The court of appeals affirmed (Pet. App. 1a-14a).  Like the Tax
Court, the court of appeals approached the case as requiring it to
choose between Wright and Shimberg (see Pet. App. 8a).  The court
first concluded that the dividend determination is to be made by
importing into the reorganization context the principles applicable to
the redemption of stock of a single corporation under Section 302 of
the Code (Pet. App. 3a-6a).  The court then concluded that the tests
of Section 302 should be applied as if there had been a hypothetical
redemption after a different reorganization was completed, i.e., as if
respondent had received 425,000 shares of NL stock in a
stock-for-stock merger and thereafter had received $3,250,000 in a
redemption of 125,000 of his NL shares.  Under this view, the question
whether the cash payment should be treated as a dividend turns on the
extent of the reduction in respondent's interest in NL that would be
occasioned by the hypothetical redemption of 125,000 shares of NL
stock.  Pet. App. 7a-11a.  The court criticized the Shimberg approach,
which it characterized as treating the cash payment as being made by
the acquired corporation (Pet. App. 10a-14a).  The court of appeals
stated, inter alia, that this approach failed adequately to consider
the "corporate control (respondent) retained after the reorganization
was completed" (id. at 10a-11a).

                          SUMMARY OF ARGUMENT

   1. The reorganization provisions of the Code establish an exception
to the general principle that the entire amount of gain or loss must
be recognized upon the sale or exchange of property.  The premise of
this exception is that transactions that qualify as reorganizations
under the Code entail only a readjustment of continuing interests;
the reorganized corporation is a continuation of the same enterprise
in modified corporate form.  One consequence of this premise of
continuing interests is that a distribution of cash or other property
in the course of the reorganization may operate as a substitute for a
distribution of the accumulated earnings and profits of one of the
corporations involved in the transaction -- a distribution that
ordinarily would be accomplished by the declaration of a dividend.
Accordingly, Section 356(a)(2) provides that such a "boot"
distribution in the course of a reorganization should be treated as a
dividend to the extent of accumulated earnings and profits if it has
"the effect of the distribution of a dividend."

   The basic attribute of a dividend, derived from Sections 301 and
316 of the Code, is a pro rata distribution to shareholders out of
corporate earnings and profits.  When a distribution is made that is
not a formal dividend, "the fundamental test of dividend equivalency"
is whether the distribution is proportionate to the shareholders'
stock interests (United States v. Davis, 397 U.S. 301, 306 (1970)).
Accordingly, this Court concluded in the context of a pro rata
redemption that "Congress clearly mandated that pro rata distributions
be treated under the general rules laid down in Sections 301 and 316"
(id. at 312), and the same is true of pro rata distributions of boot
in the course of a reorganization.  A payment of boot made on a pro
rata basis to the shareholders of one of the corporations involved in
a reorganization (including, as in this case, a corporation wholly
owned by one shareholder) thus has all the earmarks of a dividend.
Moreover, it clearly has the "effect" of a dividend in that the
shareholders are in precisely the same position after a reorganization
that includes boot in the amount of retained earnings and profits that
they would have been in had the corporation instead declared out those
earnings and profits as a dividend before entering into a
reorganization without boot.  Therefore, a long line of authority has
held that a pro rata distribution of boot in the course of a
reorganization to the shareholders of the acquired corporation has
"the effect of the distribution of a dividend" within the meaning of
Section 356(a)(2).

   2. The court of appeals erred in holding that whether a boot
distribution has "the effect of the distribution of a dividend" must
be determined by first recasting the transaction actually entered into
by the parties -- substituting a pure stock-for-stock reorganization
followed by a redemption of some of the shares for cash in the amount
of the boot actually received -- and then applying to that
hypothetical transaction the principles of Section 302 of the Code
that govern redemptions.  There is no reason generally to import with
full effect the principles of Section 302 into the Section 356(a)(2)
inquiry;  the two provisions address different types of transactions
and the reasons that impelled Congress to except certain redemptions
from dividend treatment do not necessarily apply in the reorganization
context.  Cases like this one involving pro rata boot distributions
can and should be resolved simply by reference to the terms of Section
356(a)(2) because such distributions have all the earmarks of a
dividend.

   The court of appeals' hypothetical redemption analysis violates the
general principle that, "while a taxpayer is free to organize his
affairs as he chooses, nevertheless, once having done so, he must
accept the tax consequences of his choice." Commissioner v. National
Alfalfa Dehydrating and Milling Co., 417 U.S. 134, 149(1974).  The
stock-for-stock reorganization hypothesized by the court of appeals is
precisely the option that respondent rejected in favor of a
transaction involving boot;  he decided to reject that option for good
reasons of his own (see note 2, supra), and there is no reason to
permit him to enjoy its tax consequences.  The hypothetical redemption
scenario also introduces other difficulties into the Section 356(a)(2)
analysis.  Because the distribution is to be measured against the
earnings and profits of the acquired corporation to determine how much
of it can be a dividend, the court of appeals' approach imputes to
Congress the intent to establish a peculiar mode of analysis under
Section 356(a)(2) -- the boot is to be viewed as coming from the
acquiring corporation for purposes of determining whether it has "the
effect of the distribution of a dividend," but it is to be viewed as
coming from the acquired corporation for purposes of comparing it to
earnings and profits.  Moreover, the court of appeals' approach
requires a court to base its decision upon what may be an extremely
speculative judgment as to the number of shares that would be redeemed
in the hypothetical transaction.

   Finally, the hypothetical redemption scenario does not comport with
the terms of the statute.  Under Section 356(a)(2), a boot payment
must be treated as a dividend as long as it has "the effect of the
distribution of a dividend." It is clear that the pro rata
distribution in this case had the effect of a dividend distribution by
Basin.  At most, the court of appeals' analysis seeks to demonstrate
that the boot payment also had the effect of a different transaction
-- a hypothetical redemption.  But, even if that were true, it would
not alter the result under the terms of Section 356(a)(2).  In any
event, it is not correct to say that the boot distribution here had
the same effect as the hypothetical post-merger redemption analyzed by
the court of appeals.  If the parties in fact had engaged in the
hypothesized transaction, the recognized gain would have been
different, as would as the continuing earnings and profits accounts of
the surviving corporations and respondent's basis in his NL shares.
There is no basis for equating the two transactions for purposes of
Section 356(a)(2) analysis.

                               ARGUMENT

   RESPONDENT'S RECEIPT OF CASH, IN ADDITION TO NL STOCK, IN EXCHANGE
FOR HIS BASIN STOCK HAD THE EFFECT OF THE DISTRIBUTION OF A DIVIDEND
WITHIN THE MEANING OF SECTION 356(A)(2) OF THE CODE

   Respondent surrendered all of his shares of Basin stock in a
transaction qualifying as a reorganization under Section 368 of the
Code.  In return, he received both shares of NL stock and cash.  The
question in this case is whether the cash or "boot" paid to respondent
had "the effect of the distribution of a dividend" under Section
356(a)(2) of the Code.  A long line of court of appeals decisions has
held that a boot distribution made under circumstances parallel to
those in the case -- i.e., on a pro rata basis to the shareholders of
the acquired corporation, in this case to a sole shareholder -- is to
be treated as a dividend.  That conclusion follows directly from the
statutory language because the boot distribution closely approximates
a dividend, and it has precisely the same effect.  To the extent of
Basin's undistributed earnings and profits (of which there were more
than $2 million at the time of the merger), the payment had all the
earmarks of a classic dividend;  it was a distribution of cash out of
a corporation's earnings and profits made on a pro rata basis to its
shareholders.  And respondent was in precisely the same position after
the merger that he would have been in had the amount of Basin's
accumulated earnings and profits been distributed to him as a formal
dividend, rather than as part of the boot received in the
reorganization.  To the extent of those earnings and profits,
therefore, the boot distribution had "the effect of the distribution
of a dividend."

   The court of appeals, however, rejected this conclusion and the
line of authority that supports it.  The court did so by recasting the
merger transaction into a form different from that entered into by the
parties -- indeed, into a form that respondent had explicitly rejected
in the merger negotiations.  The court of appeals ruled that the
transaction should be treated as if respondent had received 425,000
shares of NL stock in a tax-free stock-for-stock reorganization and
then subsequently had redeemed 125,000 of those shares for $3,250,000
in cash.  The court then applied the dividend equivalency rules for
redemptions of stock in a single corporation (I.R.C. Section 302) to
the hypothetical redemption that it had posited.  Because application
of those rules would not have resulted in dividend treatment for the
hypothetical redemption, the court ruled that the boot distribution
that actually occurred also should not be treated as a dividend.
There is, however, no basis for believing that this hypothetical
redemption analysis furthers congressional intent.  It should be
rejected in favor of a basic application of the terms of Section
356(a)(2), which advances the evident congressional purpose of
applying dividend treatment to distributions of retained earnings and
profits made in the course of a reorganization when those
distributions have the effect of a dividend.

   A. The Statutory Framework

   1. The reorganization provisions of the Code constitute an explicit
exception to the general principle that the entire amount of gain or
loss is to be recognized upon the sale or exchange of property (see
I.R.C. Section 1001 (c)).  As this Court recently explained, the
purpose of this exception 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 but merely the recasting of the
same interests in a different form" (Paulsen v. Commissioner, 469 U.S.
131, 136 (1985) (internal quotation marks omitted)).  The
reorganization provisions seek to define the transactions in which the
continuity of interest is such that it is appropriate to defer
recognition of gain or loss.

   Although Congress has engaged in substantial modification and
refinement over the years, the basic structure of the reorganization
provisions dates back to Section 202(c)(2) of the Revenue Act of 1921,
ch. 136, 42 Stat. 230, and to the further development of those
provisions in Section 203 of the Revenue Act of 1924, ch. 234, 43
Stat. 256-258.  The Code has long defined as reorganizations six basic
types of corporate transactions (see Section 368(a)(1)), including a
"merger or consolidation" (Section 368(a)(1)(A)).  /6/ Section
354(a)(1) of the Code provides that "(n)o gain or loss shall be
recognized if stock or securities in a corporation a party to a
reorganization are, in pursuance of the plan of reorganization,
exchanged solely for stock or securities * * * in another corporation
a party to the reorganization." /7/ Sections 358 and 362(b) reflect
the continuity of interest in the reorganized corporation by providing
that the basis of the stock or securities received shall be the same
as the basis of the stock or securities exchanged, and that the
property received by the acquiring corporation shall have the same
basis that it had in the hands of the transferor corporation.

   Section 354 provides for nonrecognition of gain or loss only when
the transaction involves an exchange of stock or securities solely for
stock or securities.  Some forms of reorganization, however, including
the "A" (merger or consolidation) and "C" (asset acquisition (see
Section 368(a)(1)(C)), permit the receipt of some additional property
without losing their status as reorganizations under the Code.  These
types of transactions are accommodated by Section 356(a)(1), which
dates back to Section 202(e) of the Revenue Act of 1921, ch. 136, 42
Stat. 230-231 (as amended by the Act of Mar. 4, 1923, ch. 294, 42
Stat. 1560).  That provision qualifies the nonrecognition rule by
providing that if, in addition to the property permitted to be
received by Section 354, money or other property (commonly known as
"boot") is received, "then the gain, if any, to the recipient shall be
recognized, but in an amount not in excess of the sum of such money
and the fair market value of such other property." Sections 358 and
362 provide for appropriate adjustments to basis in order to take into
account any such recognition of gain.

   When it sought to improve the early reorganization provisions in
1924, Congress recognized that some adjustment to this treatment of
boot was necessary.  The fundamental premise of special reorganization
treatment is the assumption of a continuing enterprise, but the
predecessor of Section 356(a)(1) allowed a shareholder to receive a
distribution from that enterprise without being subject to dividend
treatment, even though the distribution could represent retained
earnings and profits that ordinarily are taxed as a dividend when
distributed to a shareholder.  Accordingly, Congress enacted what is
now Section 356(a)(2), providing that, when the exchange "has the
effect of the distribution of a dividend," boot received in a
reorganization is to be treated as a dividend to the extent of the
distributee's "ratable share of the undistributed earnings and profits
of the corporation accumulated after February 28, 1913." /8/

   2. Section 356(a)(2) does not define the phrase "has the effect of
the distribution of a dividend," but the Code elsewhere specifically
addresses the tax treatment of "dividends." Section 301(a) of the Code
provides:  "Except as otherwise provided in this chapter, a
distribution of property * * * made by a corporation to a shareholder
with respect to its stock shall be treated in the manner provided in
subsection (c)." That subsection provides that, for distributions
described in subsection (a), "(t)hat portion of the distribution which
is a dividend (as defined in section 316) shall be included in gross
income." Section 316, in turn, broadly defines a dividend as "any
distribution of property made by a corporation to its shareholders * *
* out of its earnings and profits," either those earnings and profits
accumulated after February 28, 1913, or those of the taxable year.
The statute goes on to provide that "(e)xcept as otherwise provided in
this subtitle, every distribution is made out of earnings and profits
to the extent thereof, and from the most recently accumulated earnings
and profits." Thus, the rule that emerges from the combination of
these provisions is that a distribution of property made by a
corporation to its shareholders with respect to its stock is to be
included in gross income as a dividend to the extent of the
corporation's earnings and profits.

   It is established beyond doubt that these statutory provisions
require dividend treatment for corporate distributions that are made
to shareholders on a pro rata basis, since such distributions are
clearly "with respect to (the corporation's) stock," as specified in
Section 301.  In United States v. Davis, 397 U.S. 301, 306 (1970),
this Court held that a pro rata redemption of stock by the corporation
is "essentially equivalent to a dividend" (I.R.C. Section 302(b)(1)),
regardless of its purpose.  The Court described as "the fundamental
test of dividend equivalency" whether a distribution to a shareholder
is "pro rata or proportionate to his stock interest," and the Court
concluded that "Congress clearly mandated that pro rata distributions
be treated under the general rules laid down in Sections 301 and 316
rather than under Section 302 (the provision dealing with stock
redemptions)" (397 U.S. at 312).  In the same vein, the courts of
appeals have consistently recognized that the basic earmark of a
dividend is a "pro rata distribution out of corporate earnings and
profits" (Hawkinson v. Commissioner, 235 F.2d 747, 751 (2d Cir.
1956)).  /9/ These principles derived from Sections 301 and 316
provide the basic framework for determining whether a boot
distribution "has the effect of the distribution of a dividend" under
Section 356(a)(2).

   B. The Payment Of Boot In A Reorganization On A Pro Rata Basis To
The Shareholders Of The Acquired Corporation Has The Effect Of The
Distribution Of A Dividend

   The resolution of this case turns entirely on the correct
application of Section 356(a)(2) of the Code.  It is undisputed that
the merger transaction qualified as a reorganization under Section 368
of the Code and therefore that, under Section 356(a)(1), the gain on
the exchange must be recognized in the amount of the $3,250,000 in
boot received by respondent in the exchange.  The tax treatment of
that amount of gain, however, depends upon whether the exchange "has
the effect of the distribution of a dividend" within the meaning of
Section 356(a)(2).  If it does, then the boot should be treated as a
dividend to the extent of Basin's undistributed earnings and profits
($2,319,611) and therefore taxed as ordinary income;  if the exchange
does not have the effect of a dividend, then the boot should be taxed
as capital gain.  We submit that the type of distribution that
occurred in this case -- on a pro rata basis to the shareholders of
the acquired corporation -- has the "effect of the distribution of a
dividend" under Section 356(a)(2).

   1. As we have noted, the basic attribute of a dividend is a pro
rata distribution to shareholders out of corporate earnings and
profits.  That is what occurred here.  Basin had $2,319,611 in
undistributed earnings and profits at the time of the merger.  In the
course of the merger, that amount (and more) of cash was distributed
to respondent, Basin's sole shareholder.  Since any distribution to a
sole shareholder is, by definition, a pro rata distribution (see
United States v. Davis, 397 U.S. at 307), the payment to respondent in
this case was "with respect to (his) stock" (I.R.C. Section 301) and
had all the earmarks of a dividend.

   It is true, of course, that the payment to respondent in this case
came from NL and therefore did not formally come out of Basin's
earnings and profits.  But Section 356(a)(2) does not require that the
boot distribution literally constitute a formal dividend under Section
316.  As we have seen, Congress recognized that a formal dividend test
was inappropriate because boot distributions might not clearly be made
by a single corporation, but rather could occur in the course of a
reorganization involving more than one corporation.  For that very
reason, Section 356(a)(2) requires only that the exchange have "the
effect of the distribution of a dividend" (emphasis added).  This
condition is clearly satisfied when a pro rata distribution of boot is
made in the course of a transaction that falls within the
reorganization provisions of the Code.

   The principle underlying the statutory reorganization treatment
conferred upon respondent's merger transaction is that the
reorganization yields "a continuance of the proprietary interests in
the continuing enterprise under modified corporate form" (Lewis v.
Commissioner, 176 F.2d 646, 648 (1st Cir. 1949)).  See also Paulsen v.
Commissioner, 469 U.S. at 136;  Treas. Reg. Section 1.368-1(b)
(reorganizations effect "only a readjustment of continuing interest(s)
in property under modified corporate forms").  This principle lies "at
the heart of the nonrecognition provisions and is the reason why gain
or loss, although realized, is not recognized at the time of the
exchange." B. Bittker and J. Eustice, Federal Income Taxation Of
Corporations and Shareholders Paragraph 14.01, at 14-4 (4th ed. 1979).

   Because respondent's interest in the reorganized corporate entity
is thus regarded as a continuation of his interest in Basin, it
follows that it should make no difference that the payment to him
formally came from NL, rather than Basin.  It still should be deemed
to have been "made out of earnings and profits to the extent thereof"
(I.R.C. Section 316(a)).  /10/ In sum, as the Fifth Circuit stated in
connection with a boot distribution indistinguishable from the one in
this case, "(i)f a pro rata distribution of profits from a continuing
corporation is a dividend, and a corporate reorganization is a
'continuance of the proprietary interests in the continuing enterprise
under modified corporate form,' it follows that the pro rata
distribution of 'boot' to shareholders of one of the participating
corporations must certainly have the 'effect of the distribution of a
dividend' within the meaning of Section 356(a)(2)" (Shimberg v. United
States, 577 F.2d 283, 288 (5th Cir. 1978), cert. denied, 439 U.S. 1115
(1979) (quoting Lewis v. Commissioner, 176 F.2d at 648)).  See also
Kyser, The Long and Winding Road:  Characterization of Boot Under
Section 356(a)(2), 39 Tax L. Rev. 297, 324 (1984) (describing the
logic of the above quotation as "unassailable").  /11/

   Moreover, there can be no doubt that the boot distribution here had
the same "effect" that a direct dividend distribution by Basin of its
earnings and profits would have had.  The distribution of such a
dividend would have reduced the value of Basin by the amount of the
dividend and accordingly reduced the amount of the boot that NL would
have given in exchange for respondent's stock.  The post-merger
financial situation of both respondent and the reorganized corporation
would have been the same, whether the amount of Basin's earnings and
profits were distributed to respondent as boot or as a dividend;
hence, in the words of the congressional reports accompanying the
original version of Section 356(a)(2), the "effect" was "the same as
if the corporation had declared out as a dividend its * * * earnings
and profits" (H.R. Rep. 179, 68th Cong. 1st Sess. 15 (1924);  S. Rep.
398, 68th Cong., 1st Sess. 16 (1924);  see note 8, supra).  See
Shimberg v. United States, 577 F.2d at 288.

   More generally, dividend treatment of boot distributions made pro
rata to the shareholders of the acquired corporation is logical and
comports with the apparent congressional purpose to restrict the use
of reorganizations as an avenue to withdraw profits from a corporation
without declaring a dividend.  As one commentator has noted,
"intuition suggests that what is really going on (with such a boot
payment) is that the shareholders of the target are making use of
their last opportunity to withdraw profits from their corporation
before they lose control as a result of dilution by the
reorganization" (Kyser, supra, 39 Tax L. Rev. at 326).  There is
nothing unfair or unreasonable about treating such a boot payment as a
dividend.  The shareholders of the target -- respondent alone in this
case -- are the ones who earned the profits and allowed them to
accumulate in the target corporation rather than distributing them as
dividends prior to the reorganization.  They are also the persons who
negotiate the terms of the acquisition with the acquiring corporation,
including the extent to which there will be a payment of boot and
whether the acquisition will be structured as a tax-free
reorganization, rather than a taxable sale.  The boot, then, appears
to be simply a substitute for the undeclared dividends;  the
shareholders "realize() some or all of the value from earnings of the
transferor corporation at the time of the reorganization rather than
realizing it at a prior time" (Samansky, Taxation of Nonqualifying
Property Distributed in Reorganizations, 31 Case W. Res. 1, 35
(1980)).  See generally Kyser, supra, 39 Tax L. Rev. at 341-342.
Thus, it requires a tortured reading of Section 356(a)(2) to conclude
that such a pro rata boot distribution does not have "the effect of
the distribution of a dividend."

   2. The judicial interpretations of Section 356(a)(2) since its
enactment in 1924 strongly support the conclusion that it contemplates
dividend treatment for boot that is distributed pro rata to the
shareholders of the acquired corporation.  A long and consistent line
of court of appeals decisions in the wake of the 1924 Act recognized
that, where two corporations not previously under common control are
unified, either by statutory merger or consolidation (I.R.C. Section
368(a)(1)(A)) or by the transfer of substantially all of the assets of
one to the other in exchange for voting stock of the latter (I.R.C.
Section 368(a)(1)(C)), and the shareholders of one or both
corporations receive a pro rata payment of boot, that payment has the
effect of a dividend and is to be taxed as such.  The first case in
this line is Commissioner v. Owens, 69 F.2d 597 (5th Cir. 1934), where
two banks merged and the shareholders of the smaller bank received pro
rata both stock in the new bank and cash.  The court held that "so
much of (the cash) as might before consolidating have been declared by
their corporation as an ordinary dividend out of its profits is by
(the predecessor of Section 356(a)(2)) to be so taxed" (69 F.2d at
598).  The court specifically noted (ibid.):  "It is true that the
money was not distributed by the (acquired bank) and thus was not
literally a dividend of that bank.  But the statute speaks of a
distribution which 'has the effect of the distribution of a dividend.'
This pro rata payment to all stockholders of the (acquired bank) * * *
certainly has that effect."

   Subsequently, several other courts of appeals reached the same
conclusion regarding boot received on a pro rata basis.  See King
Enterprises, Inc. v. United States, 418 F.2d 511, 521 (Ct. Cl. 1969)
("The distribution on a pro rata basis, entailing no substantially
disproportionate change in the continuing equity interests of the
Tenco stockholders, constituted a classic example of a transaction
having the effect of the distribution of a dividend.");  Hawkinson v.
Commissioner, 235 F.2d at 751 ("the distribution had all the earmarks
of a taxable dividend, i.e., a pro rata distribution out of corporate
earnings and profits");  Campbell v. United States, 144 F.2d 177, 182
(3d Cir. 1944) ("We (previously) held that when cash was distributed
in a reorganization to the stockholders of the predecessor company
that part of the amount thus distributed which equalled the
accumulated earnings of the predecessor corporation had the effect of
a taxable dividend and was accordingly taxable as such.");  see also
Ross v. United States, 173 F. Supp. 793, 798 (Ct. Cl.), cert. denied,
361 U.S. 875 (1959);  Ross v. Little Investment Co., 86 F.2d 50 (5th
Cir. 1936);  Commissioner v. Forhan Realty Co., 75 F.2d 268 (2d Cir.
1935);  Sheldon v. Commissioner, 6 T.C. 510 (1946);  Woodard v.
Commissioner, 30 B.T.A. 1216, 1229-1230 (1934);  Woodward v.
Commissioner, 23 B.T.A. 1259 (1931);  but see Wright v. United States,
482 F.2d 600 (8th Cir. 1973) (rejecting dividend treatment for
distribution to 99% shareholder where there was commonality of
ownership in the merging corporations).  /12/ On the other hand, where
the cash payment was not pro rata to the shareholders of one of the
corporations, but rather was made only to holders of preferred stock
who did not own any common stock in order to call and retire that
preferred stock, the payment was held not to have the effect of a
dividend.  Idaho Power Co. v. United States, 161 F. Supp. 807 (Ct.
Cl.), cert. denied, 358 U.S. 832 (1958).

   This line of cases also repeatedly reaffirmed the conclusion of the
court in Owens (see 69 F.2d at 598) that it is immaterial which
corporation actually pays out the cash to the shareholders.  While
that may be relevant to whether the payment is technically a dividend,
it has no bearing on whether the payment has "the effect of the
distribution of a dividend." As the Court of Claims stated,
"regardless of who physically paid out the money, and regardless of
whose name is placed on those earnings, the effect is the same as if
the Trust Company (the acquired corporation) had made a distribution
out of funds specifically labeled 'Trust Company earnings and
profits'" (Ross v. United States, 173 F. Supp. at 798).  See also
Campbell v. United States, 144 F.2d at 182;  Woodward v. Commissioner,
23 B.T.A. at 1262.

   This established line of authority was noted approvingly and relied
upon by this Court in Commissioner v. Estate of Bedford, 325 U.S. 283
(1945).  That case dealt with a factual situation somewhat different
from the one here in that it involved a recapitalization (an "E"
reorganization), which is the one form of reorganization that involves
a single corporation.  The taxpayer estate in Bedford was a
shareholder of a corporation that had accumulated earnings and
profits, but was disabled under state law from declaring dividends.
To remedy that situation, the corporation amended its capital
structure.  In exchange for its 3,000 shares of preferred stock, the
estate received 3,500 shares of a lesser preferred, 1,500 shares of
common stock, and $45,240 in cash.  Invoking the statutory definition
of "dividend" in the predecessor of Section 316, the Court concluded
that the cash must be regarded as having come out of the corporation's
accumulated earnings and hence had the effect of a distribution of a
dividend (325 U.S. at 290).  The Court buttressed its holding by
referring with approval to the existing cases cited above (see pages
21-22, supra) that required dividend treatment in the cases of
reorganizations involving two corporations.  The Court stated (325
U.S. at 291):  "It has been ruled in a series of cases that where the
stock of one corporation was exchanged for the stock of another and
cash and then distributed, such distributions out of earnings and
profits had the effect of the distribution of a taxable dividend under
(the predecessor of Section 356(a)(2)).  * * * We cannot distinguish
the two situations and find no implication in the statute restricting
(the predecessor of Section 356(a)(2)) to taxation as a dividend only
in the case of an exchange of stock and assets of two corporations."
/13/

   This line of court of appeals authority was capped by Shimberg v.
United States, supra.  As the Tax Court noted below (Pet. App. 27a),
the facts of Shimberg are essentially indistinguishable from those
here.  A smaller corporation was there merged into a larger one, and
the shareholders of the acquired corporation received shares in the
acquiring corporation, plus $625,000 in cash, to be allocated among
the shareholders on a pro rata basis.  The court of appeals upheld the
Commissioner's determination that the boot was taxable as a dividend.
The court noted the long line of authority supporting the proposition
that pro rata boot distributions have the effect of a dividend (577
F.2d at 288), and it found distinguishable the one decision that
diverged from this line, Wright v. United States, supra, because of
the commonality of ownership of the combining corporations there (577
F.2d at 287 (see note 16, infra).  The court explained the basis for
its conclusion as follows (id. at 288):

         If a pro rata distribution of profits from a continuing
      corporation is a dividend, and a corporate reorganization is a
      "continuance of the proprietary interests in the continuing
      enterprise under modified corporate form," it follows that the
      pro rata distribution of "boot" to shareholders of one of the
      participating corporations must certainly have the "effect of
      the distribution of a dividend" within the meaning of Section
      356(a)(2).  * * * Moreover, the legislative history of Section
      356(a)(2)'s predecessor statute makes clear that a distribution
      that would have been a dividend if made prior to the
      reorganization is subject to the same treatment when made as
      part of the transaction.

   The court concluded that "(t)he taxpayer should not be able to reap
the benefits of capital gain treatment simply because he received his
share of the distribution after the merger in the form of a 'boot'
rather than before the merger in the form of a dividend" (577 F.2d at
289).  See also General Housewares Corp. v. United States, 615 F.2d
1056, 1066 (5th Cir. 1980).  Thus, a consistent line of decisional law
confirms that boot distributed on a pro rata basis to the shareholders
of the acquired corporation has the "effect of the distribution of a
dividend" within the meaning of Section 356(a)(2).

   C. The Substitution Of A Hypothetical Scenario, Consisting Of A
Reorganization Without Boot Followed By A Partial Stock Redemption, In
Place Of The Actual Reorganization Involving Boot Is Not The Correct
Method Of Determining Whether The Actual Boot Distribution Has The
Effect Of A Dividend Under Section 356(a)(2)

   The court of appeals in this case did not directly examine the
merger transaction entered into by the parties to determine whether
the exchange involving boot had the effect of the distribution of a
dividend.  Instead, the court first addressed the abstract question
whether the determination of dividend treatment under Section
356(a)(2) must be made by applying the principles set forth in Section
302 of the Code.  That Section governs the tax treatment of
redemptions of stock in a single corporation.  It provides, inter
alia, that a redemption will be treated as an exchange if it "is not
substantially equivalent to a dividend" (Section 302(b)(1));  and it
establishes "safe harbors" under which a redemption that causes a
specified reduction in the shareholder's percentage interest in the
corporation is automatically insulated from being found to be
substantially equivalent to a dividend (Section 302(b)(2);  see note
5, supra).  Largely because of the similarity in the language of the
two sections with respect to dividend treatment, the court of appeals
concluded that Section 302 must be applied to determine when a boot
distribution has "the effect of the distribution of a dividend" under
Section 356(a)(2) (see Pet. App. 5a).

   Having concluded that Section 302 principles must be applied, the
court of appeals then needed to find a redemption to which to apply
them, since the merger transaction entered into by the parties did not
involve a redemption.  Following the path indicated by Wright v.
United States, supra, the court recast the merger transaction to
create a hypothetical redemption.  The court constructed a scenario
based upon a pure stock-for-stock reorganization in which respondent
received 425,000 shares of NL stock -- which was precisely the option
offered to and rejected by respondent in the merger negotiations --
followed by a post-merger redemption of 125,000 of those shares in
exchange for the $3,250,000 that had been distributed to respondent as
boot in the actual transaction (Pet. App. 7a-11a).  Because that
hypothetical redemption, standing alone, would have satisfied the
"safe harbor" of Section 302(b)(2) by reducing respondent's interest
in NL from 1.3% to 0.92%, it would not have been taxed as a dividend
(see Pet. App. 7a, 34a).  In the court of appeals' view, this
conclusion concerning the hypothetical redemption necessarily meant
that the boot distribution did not have "the effect of the
distribution of a dividend" under Section 356(a)(2).  The court of
appeals' analysis is flawed in several respects.

   1. Most fundamentally, the court erred in beginning its analysis by
focusing on the abstract question whether Section 302 principles
govern, and the rest of its analysis compounds this error.  Obviously,
the starting point of the analysis must be the terms of Section
356(a)(2), the section that Congress made applicable to boot
distributions.  If that section appears inadequate to its task in a
particular case, it may be appropriate to look elsewhere in the Code
for guidance, such as to Section 302 (see note 15, infra).  But in the
situation presented here, a pro rata distribution of boot to the
shareholders of the acquired corporation, Section 356(a)(2) itself
clearly indicates that the boot should be treated as a dividend to the
extent of the accumulated earnings and profits.  See point B, supra.
There was thus no reason for the court of appeals to look to Section
302.

   Second, the court of appeals further erred in concluding that
Section 302 should be imported with full effect into the
reorganization context to determine when boot should be treated as a
dividend under Section 356(a)(2).  It is true, of course, that there
is some relationship between the two sections;  both provisions
address the question whether a particular transaction should be
treated as a dividend, and they use similar language.  Nevertheless,
there are also significant differences.  Most notably, Section 302 is
addressed to a transaction between a shareholder and a single
corporation, while Section 356 deals with a reorganization transaction
frequently involving two, often unrelated, corporations.  Section
302's allowance of exchange treatment for certain redemptions is an
exception to the general rule that corporate distributions are taxable
as dividends (see United States v. Davis, 397 U.S. at 304).  There is
no reason to assume that the reasons that impelled Congress to create
that exception should apply equally in the reorganization context so
that every nuance and detail of Section 302 should be applied in
interpreting Section 356(a)(2).  See generally Samansky, supra, 31
Case W. Res. at 17-20, 29.  /14/ Thus, there is no logical reason why
the characterization of boot distributions should necessarily be
governed by Section 302 principles.

   At all events, under a proper analysis the theoretical question
whether Section 302 redemption principles should be applied to
determine the effect of boot distributions under Section 356(a)(2) is
of no practical significance in a case like this one, where the
distribution is made on a pro rata basis to the shareholders of one of
the corporations.  A pro rata redemption of stock is "essentially
equivalent to a dividend" and therefore taxable as a dividend under
Section 302(d).  That is clear from United States v. Davis, supra,
where this Court upheld dividend treatment for a pro rata redemption,
noting that whether or not the distribution is pro rata is "the
fundamental test of dividend equivalency" (397 U.S. at 306).  The
Court's conclusion in Davis that "Congress clearly mandated that pro
rata distributions be treated under the general rules laid down in
Sections 301 and 316 rather than under Section 302" (id. at 312)
applies to all pro rata distributions of cash -- whether as a formal
dividend, in exchange for the redemption of stock, or in the course of
a reorganization.  Thus, whether Section 356(a)(2) is applied directly
to the pro rata boot distribution in this case, or, alternatively,
whether reference is made to Section 302 redemption principles, should
not affect the ultimate conclusion that the pro rata distribution has
"the effect of the distribution of a dividend" under Section
356(a)(2).  /15/

   The authorities relied upon by the courts below confirm that, in
the context of a pro rata boot distribution, the abstract inquiry into
whether Section 302 principles apply is merely a theoretical diversion
that provides no basis for failing to treat the boot as a dividend.
The courts below based their incorporation of Section 302 into Section
356(a)(2) analysis primarily upon the assertion that "the courts have
consistently held that the sections should be read in pari materia"
(Pet. App. 5a, 23a).  The courts below (and respondents (see Br. in
Opp. 8)) clearly erred in reading the cases they cite as justifying
the substitution of a hypothetical redemption analysis for the
longstanding rule that pro rata boot distributions have the effect of
a dividend.  Each of the cases relied upon, except one, is a case that
held that a pro rata boot distribution should be treated as a
dividend.  /16/ As the court explained in Ross v. United States, 173
F. Supp. at 797, all that is meant in these cases by reading the two
statutes in pari materia is that in both situations it is necessary to
look at "all the facts and circumstances surrounding the
distribution." These cases clearly stand for the proposition that,
whether or not Section 302 principles are invoked, the result of this
inquiry into the "facts and circumstances" must result in dividend
treatment when the boot distribution is made on a pro rata basis to
the shareholders of the acquired corporation.  /17/

   2. In addition to the theoretical weaknesses of the court of
appeals' general importation of Section 302 principles into the
reorganization context, there are several more specific difficulties
with the court's hypothetical post-reorganization redemption analysis.
 First and foremost, the court of appeals' approach runs directly
contrary to the general principle that, "while a taxpayer is free to
organize his affairs as he chooses, nevertheless, once having done so,
he must accept the tax consequences of his choice." Commissioner v.
National Alfalfa Dehydrating and Milling Co., 417 U.S. 134, 149
(1974).  See also Don E. Williams Co. v. Commissioner, 429 U.S. 569,
579-580 (1977).  The conflict with this principle is particularly
stark in this case because the court of appeals not only has failed to
hold respondent to the tax consequences of the transaction that he
chose, it has given him the tax consequences of an option that was
offered to him by NL, and that he deliberately rejected for sound
reasons of his own.  Respondent presumably acted prudently and
according to his best judgment in deciding to take cash and stock upon
the merger of his corporation into NLAC, rather than committing
substantially all of his resources to a large corporation in which he
would be a minority shareholder (see note 2, supra).  The court below
erred in relieving him of the tax consequences of that choice and
instead giving him the tax consequences of the very option that he
declined.  /18/

   The hypothetical post-reorganization redemption analysis also
creates practical difficulties in the application of Section
356(a)(2).  A boot distribution is taxable as a dividend if it has
"the effect of the distribution of a dividend," but only to the extent
of the distributee's "ratable share of the undistributed earnings and
profits or the corporation accumulated after February 28, 1913." It is
generally recognized that, at least in the case of a reorganization
involving two unrelated corporations like that in this case, the
corporation against whose earnings and profits the boot distribution
must be measured is the acquired corporation, i.e., the corporation
whose shareholders are the recipients of the distribution.  See, e.g.,
Atlas Tool Co. v. Commissioner, 614 F.2d 860, 868 (3d Cir. 1980),
cert. denied, 449 U.S. 836 (1980);  American Mfg. Co. v. Commissioner,
55 T.C. 204, 230-231 (1970);  cf. Davant v. Commissioner, 366 F.2d
874, 887-890 (5th Cir. 1966), cert. denied, 386 U.S. 1022 (1967)
(holding that earnings and profits of both corporations can be
examined where there was commonality of ownership).  That conclusion
is plainly the most sensible reading of the statute.  The background
of Section 356(a)(2) suggests that it was passed because "Congress was
concerned with a bailout of the earnings and profits of the transferor
corporation" (American Mfg. Co. v. Commissioner, 55 T.C. at 230).
Moreover, it is difficult to conceive of a shareholder's having a
"ratable share" of the earnings and profits of a corporation in which
he held no interest prior to the reorganization.  /19/ Indeed, the
parties stipulated in this case that the amount of the dividend was to
be measured against the earnings and profits of Basin, and the courts
below did not dispute the correctness of this interpretation (see Pet.
App. 8a, 31a).

   Thus, the approach of the court below is not consistent in
identifying the cource of the distribution.  It contemplates that the
boot distribution be viewed as having been made by the acquiring
corporation (or, in this case, by its parent, NL) in a hypothetical
stock redemption for purposes of determining whether it has the effect
of a dividend under Section 356(a)(2), but then it contemplates that
the distribution be viewed as having been made by the acquired
corporation for purposes of determining whether it exceeds the
shareholders' ratable share of earnings and profits.  There is no
reason to impute to Congress an intent to establish such a perverse
approach to the basic Section 356(a)(2) determination whether a
particular boot distribution should be taxed as a dividend.

   The hypothetical redemption approach also unnecessarily introduces
an additional speculative inquiry into the Section 356(a)(2) analysis.
 This case is an unusual one in that respondent was offered a choice
between two different transactions -- a pure stock-for-stock
reorganization or one involving boot.  Hence, it was relatively easy
to construct a hypothetical redemption scenario;  it was based on the
stock-for-stock option that respondent rejected.  /20/ But in cases
that lack this unusual aspect the hypothetical redemption scenario may
require considerable speculation and guesswork.  The court of appeals'
approach requires a court to determine how many shares would have been
exchanged if the reorganization had not involved boot, but instead had
been purely stock-for-stock.  That determination is critical because
the application of the Section 302 "safe harbor" turns on the number
of shares that hypothetically would have been received instead of the
boot and then redeemed.  Determining that number of hypothetical
shares can require a difficult and complex inquiry.  It involves
problems not only of valuing the stock in market terms but also
assessing the extent to which the valuation is affected by shifting
control, factors that become particularly elusive in the case of
closely-held corporations.  /21/

   3. Finally, the court of appeals' hypothetical redemption approach
fails to comport with the terms of the statute.  As we have shown, the
boot distribution in this case had "the effect of the distribution of
a dividend" by Basin.  The court of appeals never disputes that
conclusion.  Instead, it chooses to analogize the boot distribution to
another transaction, the hypothetical stock-for-stock reorganization
followed by a partial redemption.  The most that can fairly be said
for the court of appeals' suggested analogy is that it attempts to
show that the boot distribution might also have the effect of a
transaction that would not be a dividend.  But, of course, that is not
the test that is set forth in Section 356(a)(2).  The statute says
that a boot distribution that has "the effect of the distribution of a
dividend" should be treated as a dividend to the extent of earnings
and profits;  if that condition is satisfied, there is no statutory
basis for deviating from that treatment simply because the
distribution also has the effect of a different kind of transaction
that would not qualify as a dividend.

   In any event, it is not correct to say that the boot distribution
here has the effect of the redemption hypothesized by the court of
appeals.  There is, of course, a superficial similarity between the
two transactions in that respondent ends up, before taxes, with the
same amount of cash and stock at the end of both.  But there are also
major differences between the two transactions with respect to the
basic tax accounts that are generated, and these differences vitiate
any suggestion that the hypothetical redemption can be equated with
the boot distribution.

   First, the basis of each of the NL shares received by respondent in
the reorganization is different in the two transactions.  The total
basis of those shares is transferred from respondent's basis in the
Basin stock he gave in exchange (I.R.C. Section 358(a)), and that
total basis must be allocated over the total number of shares
received.  Thus, the basis of each individual share obviously would be
different depending upon whether the total basis is allocated over the
300,000 shares received in the actual merger or over the 425,000
shares that would have been received in the transaction hypothesized
by the court of appeals.  /22/ Second, because the gain recognized in
the hypothetical transaction would have been different from the
$3,250,000 that respondent acknowledged in the Tax Court had to be
recognized on the actual transaction involving boot.  /23/

   Another difference between the two transactions is the effect on
the earnings and profits accounts.  In the actual transaction, the
earnings and profits available for distribution as a dividend were
Basin's $2,319,611 in accumulated earnings and profits.  The gain
recognized upon the boot distribution would have been applied against
that account.  That reflects the basic theory of Section 356(a)(2) --
that the shareholders of the corporation who receive a pro rata
distribution of boot are withdrawing earnings and profits from the
reorganization, subject to the limitations of the amount of their
recognized gain and ratable share of earnings and profits.  If
respondent had chosen the redemption option, on the other hand, the
gain would have been applied against and reduced the earnings and
profits of NL (a figure that is not in the record here and that, in
any event, bears no relation to Basin's or respondent's history).
Basin's earnings and profits would have remained intact and been
carried over into NLAC, the subsidiary.  Thus, the effect on the
continuing earnings and profits accounts would be substantially
different under the two transactions.

   In sum, it cannot be said that the boot distribution that actually
occurred here had the same effect as a hypothetical redemption
following a pure stock-for-stock reorganization.  It remains true,
however, that the pro rata boot distribution did have the same effect
as a dividend distribution by Basin.  Accordingly, Section 356(a)(2)
requires that the boot be treated as a dividend to the extent of
Basin's undistributed earnings and profits.

                              CONCLUSION

   The judgment of the court of appeals should be reversed.

   Respectfully submitted.

   CHARLES FRIED

      Solicitor General

   WILLIAM S. ROSE, Jr.

      Assistant Attorney General

   LAWRENCE G. WALLACE

      Deputy Solicitor General

   ALAN I. HOROWITZ

      Assistant to the Solicitor General

   ERNEST J. BROWN

      Attorney

   MAY 1988

   /1/ Respondent Peggy S. Clark is a party herein only because she
filed a joint federal income tax return for the calendar year 1979
with her husband, respondent Donald E. Clark.  References to
"respondent" in the singular will be to Donald E. Clark.

   /2/ In the Tax Court, respondent's attorney testified (and it was
agreed that, if called, respondent would testify to the same effect
(J.A. 60)) that, at the meeting at which NL made its alternative
offers, respondent had requested the NL representatives to leave the
room so that he could discuss the alternatives with his attorney.  In
that discussion, the factors that led to a tentative choice of the
latter alternative were that respondent's "whole livelihood was tied
up in his company," and that an all-stock deal would involve the risk
of serious loss if something happened to NL.  Moreover, the stock of
NL that would be received would not be registered stock, but would be
restricted letter stock, which would mean, under Securities and
Exchange Commission rules, that respondent would have to hold the
stock for two years before he could sell it and realize full value.
And, in view of respondent's complete involvement with his company,
that, in turn, would have meant that he could not immediately pay his
outstanding bills.  J.A. 56-59.

   /3/ Unless otherwise noted, all statutory references are to the
Internal Revenue Code of 1954 (26 U.S.C.), as amended (the Code or
I.R.C.).

   /4/ The closing price of NL stock on the New York Stock Exchange on
April 18, 1979, was $23 1/8 per share;  on that basis the 300,000
shares received by respondent had a value of $6,937,500.  Respondent's
cost basis in his 58 shares of Basin stock was $84,515, and he
incurred expenses of $25,013 in connection with the merger.  J.A. 28.
Thus, he realized $10,077,972 in gain on the merger.  Pursuant to
Section 356(a)(1), respondent was required to recognize this gain only
up to the amount of the cash received in the transaction, $3,250,000.
Respondents erroneously listed the amount of the gain on their return
as $3,195,294, but, in their later computation for entry of decision
by the Tax Court, respondents acknowledged that the amount of gain
recognized and reported should have been $3,250,000 (see Br. in Opp 4
n.5).  The deficiency found by the Tax Court (see J.A. 66) reflects
that acknowledged error.

   /5/ Under the "safe harbor" provisions of Section 302(b)(2), cash
received upon a "substantially disproportionate redemption" will not
be treated as a dividend.  The statute defines such a redemption as
one in which both the shareholder's percentage interest in voting
stock in the corporation following the redemption is less than 80% of
what it was before the redemption and he retains less than 50% of the
voting power in the corporation following the redemption.

   /6/ A seventh type, set forth in Section 368(a)(1)(G), was added in
1980, after the tax year at issue in this case, by Section 4(a) of the
Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, 94 Stat. 3401.

   /7/ The transaction in this case was a "triangular merger," in
which the acquired company (Basin) was merged into a subsidiary (NLAC)
of a controlling corporation (NL).  Pursuant to Section 368(a)(2)(D),
this type of transaction qualifies as an "A" reorganization -- i.e., a
reorganization under Section 368(a)(1)(A).  Pursuant to Section
368(b), the controlling corporation (NL), whose stock was exchanged
for respondent's shares of Basin, is identified as a "party to the
reorganization."

   /8/ The congressional reports on the 1924 amendment that is now
codified as Section 356(a)(2) stated that the change was necessary to
prevent "evasions" and gave the following example to demonstrate the
need for the change (H.R. Rep. 179, 68th Cong., 1st Sess. 15 (1924);
see also S. Rep. 398, 68th Cong., 1st Sess. 16 (1924)):

         Corporation A has capital stock of $100,000 and earnings and
      profits accumulated since March 1, 1913, of $50,000.  If it
      distributes the $50,000 as a dividend to its stockholders, the
      amount distributed will be taxed at the full surtax rates.

         On the other hand, corporation A may organize corporation B,
      to which it transfers all its assets, the consideration for the
      transfer being the issuance by B of all its stock and $50,000 in
      cash to the stockholders of corporation A in exchange for their
      stock in corporation A.  Under the existing law, the $50,000
      distributed with the stock of corporation B would be taxed, not
      as a dividend, but as a capital gain, subject only to the 12 1/2
      per cent rate.  The effect of such a distribution is obviously
      the same as if the corporation had declared out as a dividend
      its $50,000 earnings and profits.  If dividends are to be
      subject to the full surtax rates, then such an amount so
      distributed should also be subject to the surtax rates and not
      to the 12 1/2 per cent rate on capital gain.

   The "surtax" at that time was the graduated portion of the income
tax, which applied to dividends but not to capital gains.  See
generally United States v. Wells Fargo Bank, No. 86-1521 (Mar. 23,
1988), slip op. 5.

   /9/ See also, e.g., Metzger Trust v. Commissioner, 693 F.2d 459,
462 (5th Cir. 1982), cert. denied, 463 U.S. 1207 (1983);  Agway, Inc.
v. United States, 524 F.2d 1194, 1198 (Ct. Cl. 1975) (quoting Himmel
v. Commissioner, 338 F.2d 815, 817 (2d Cir. 1964) (emphasis in
original)) ("'The hallmarks of a dividend, then, are pro rata
distributions of earnings and profits and no change in basic
shareholder relationships.'");  Ballenger v. United States, 301 F.2d
192, 196-197 (4th Cir. 1962);  Bradbury v. Commissioner, 298 F.2d 111,
116 (1st Cir. 1962) (quoting Bittker and Redlich, Corporate
Liquidations and the Income Tax, 5 Tax L. Rev. 437, 476 (1950)) ("'the
most obvious earmark() of a dividend is the pro rata distribution of
earnings and profit(s)' (which is) the basic criterion of whether a
particular distribution more closely equates a sale or a dividend.").

   /10/ The nonrecognition rules of the reorganization provisions, of
course, operate as a limited exception to the broadly applicable
dividend provisions of Section 316.  The relevant regulations
explicitly provide that "(t)the general rule provided in section 316
that every distribution is made out of earnings or profits to the
extent thereof * * * does not apply to * * * (t)he distribution, in
pursuance of a plan of reorganization, * * * (o)f stock or securities"
of corporate parties to the reorganization (Treas. Reg. Section
1.312-11(b) (emphasis added)).  Clearly, however, the rule of Section
316 continues to apply to money or other property distributed pursuant
to the plan of reorganization.  See Treas. Reg. Section 1.356-1.

   /11/ If it were not for the nonrecognition treatment accorded by
Congress for reorganizations, of course, both the amount of the boot
and the rest of the more than $10 million of gain realized upon the
Basin-NL transaction would have been recognized and treated as capital
gain from the sale of a capital asset.  But the parties to the merger
here sought to have the transaction treated not as a sale, but as a
tax-free reorganization, and therefore it is not appropriate to regard
the boot as the proceeds of the sale of a capital asset, which would
confer a "doubt benefit of nonrecognition and capital gain" (Samansky,
Taxation of Nonqualifying Property Distributed in Reorganizations, 31
Case W. Res. 1, 27 (1980)).  See generally Kyser, supra, 39 Tax L.
Rev. at 325-326.  The premise of the nonrecognition treatment is the
continuing interest of the participating shareholders in the
reorganized entity, as opposed to a sale;  Section 356(a)(2)
recognizes that another consequence of that continuing interest is
that boot distributions in the course of the reorganization can have
the effect of dividends and should be taxed accordingly.

   /12/ All of these cases (except Wright), like the present one,
involve "A" or "C" reorganizations of corporations not under common
control.  There are many more cases requiring dividend treatment for
boot received in a "D" reorganization ("a transfer by a corporation of
all or a part of its assets to another corporation if immediately
after the transfer the transferor, or one or more of its shareholders
* * * is in control of the corporation to which the assets are
transferred," I.R.C. Section 368(a)(1)(D)).  See, e.g., DeGroff v.
Commissioner, 444 F.2d 1385 (10th Cir. 1971);  Liddon v. Commissioner,
230 F.2d 304 (6th Cir.), cert. denied, 352 U.S. 824 (1956);  Lewis v.
Commissioner, supra;  Love v. Commissioner, 113 F.2d 236 (3d Cir.
1940).

   /13/ In the course of rejecting an alternative argument made by the
estate, the Court made the statement that "a distribution, pursuant to
a reorganization, of earnings and profits 'has the effect of a
distribution of a taxable dividend'" (325 U.S. at 292).  This
statement was read by some as establishing an "automatic dividend
rule" that would accord dividend treatment to any cash received on a
reorganization, whether pro rata or not -- for example, cash
distributed to dissenters from a merger who demand appraisal of their
stock (see, e.g., United States v. Hilton Hotels Corp., 397 U.S. 580
(1970)).  This "automatic dividend rule" was heavily criticized by the
commentators (see, e.g., Shoulson, Boot Taxation:  The Blunt Toe of
the Automatic Rule, 20 Tax L. Rev. 573 (1965);  Darrell, The Scope of
Commissioner v. Bedford Estate, 24 Taxes 266, 268-275 (1946)).  The
post-Bedford cases in this area have rejected this broad reading of
this Court's decision and have concluded that this Court was not
attempting to establish a rule that would extend to cases involving a
non-pro-rata distribution, which was not involved in Bedford.  See
Shimberg v. United States, 577 F.2d at 290 and n.19;  King
Enterprises, Inc. v. United States, 418 F.2d at 520;  Hawkinson v.
Commissioner, 235 F.2d at 750-751;  Ross v. Untied States, 173 F.
Supp. at 797.  The IRS has also rejected this broad reading of
Bedford.  See Rev. Rul. 74-515, 1974-2 C.B. 118;  Rev. Rul. 74-516,
1974-2 C.B. 121.

   The court of appeals here, however, completely misunderstood the
nature of the debate over the "automatic dividend rule." The court
erroneously described the abandoned reading of Bedford as stating
"that any pro rata distribution in a reorganization must automatically
be treated as a dividend" (Pet. App. 6a) and, in the same vein, it
erroneously stated (id. at 11a) that the government's contention here
"comes close to resurrecting the abandoned automatic dividend rule of
Bedford." The "abandoned automatic dividend rule" is one that would
have required dividend treatment for any distribution, even one that
was not pro rata.  And the critics of the broad reading of Bedford did
not question the propriety of dividend treatment for pro rata
distributions.  See, e.g., Shoulson, supra, 20 Tax L. Rev. at 608;
Cohen, Surrey, Tarleau, and Warren, A Technical Revision of the
Federal Income Tax Treatment of Corporate Distributions to
Shareholders, 52 Colum. L. Rev. 1, 48 (1952) ("the possible
implication of the Bedford decision, that any boot on a reorganization
is a dividend, would not be followed, so that boot distributions which
are disproportionate to common stock holdings would not be regarded as
dividends." (footnote omitted;  emphasis added)).  The longstanding
rule for pro rata distributions has not been abandoned;  as we have
shown, it has been consistently applied by the courts of appeals since
1934 and was approved by this Court in a portion of the Bedford
opinion that has never been questioned.  Because the present case
involves a pro rata distribution, the "abandoned automatic dividend
rule" (Pet. App. 11a) is not implicated.

   /14/ Indeed, to the extent the redemption provisions were designed
to provide an opportunity for shareholders of closely held
corporations to sell their stock back to the corporation for capital
gain where there is no outside market for the stock (see, e.g.,
Pedrick, Some Latter Day Developments in the Taxation of Liquidating
Distributions, 50 Mich. L. Rev. 529, 530 (1952)), the purpose of the
redemption provisions has little relevance to the reorganization
context.  In the latter context, the shareholder does not need a
special opportunity provided by Congress to sell his shares of stock;
the reorganization demonstrates that there is a market for them.
Instead, he has deliberately chosen to transfer his stock by means of
a tax-free reorganization, which is the antithesis, for tax purposes,
of a sale, and he should not be relieved from the consequences of that
choice.

   /15/ This is not to say that Section 302 principles can never have
any relevance to the Section 356(a)(2) analysis.  On the contrary, in
the context of a non-pro-rata boot distribution, which does not have
all the earmarks of a dividend, reference to Section 302 may provide
helpful guidance in approaching the Section 356(a)(2) question.  Thus,
the court in Shimberg noted that it did not totally reject the
relevance of redemption principles in the context of a reorganization
(577 F.2d at 290).  By the same token, the Commissioner has stated
that the principles developed under Section 302 for determining
dividend equivalency may "in appropriate cases" serve as "useful
guidelines for purposes of applying section 356(a)(2)" (Rev. Rul.
74-516, 1974-2 C.B. at 122).  See also Rev. Rul. 75-83, 1975-1 C.B.
112;  H.R. Conf. Rep. 98-861, 98th Cong., 2d Sess. 845 (1984).  But
these principles become useful only in the context of a non-pro-rata
distribution.  There is no need to refer to Section 302 when the
distribution is pro rata (although looking to Section 302 would
produce the same result (see Rev. Rul. 75-83, supra));  the payment is
clearly a dividend.  Therefore, this case presents no occasion to
consider to what extent the detailed formulations of Section 302
should be applicable in the case of a non-pro-rata boot distribution
(see, e.g., Pet. App. 12a) or whether, in such circumstances, a
different result could obtain under Section 356(a)(2) than would be
indicated by Section 302.

   /16/ See Shimberg v. United States, supra;  King Enterprises, Inc.
v. United States, 418 F.2d at 521 ("little doubt" that pro rata boot
distribution should be treated as a dividend because it is a "classic
example of a transaction having the effect of the distribution of a
dividend");  Hawkinson v. Commissioner, 235 F.2d at 751 ("the
distribution had all the earmarks of a taxable dividend, i.e., a pro
rata distribution out of corporate earnings and profits");  Ross v.
United States, supra.

   Wright v. United States, supra, does lend a measure of support to
the decision below since it looked to a hypothetical
post-reorganization redemption to determine whether a boot
distribution was a dividend.  Wright, however, arose in a very
different factual context and provides little guidance for the instant
case.  In Wright, the pre-reorganization landscape was composed of
three corporations owned largely by the same two persons, but in
different proportions.  These two major shareholders sought to merge
two of the corporations to produce a new corporation that would have
the same relative ownership percentages as the third corporation.
Because of the differing ownership percentages in the original
corporations and the differing sizes of those corporations, however,
this result could not be achieved by means of a pure stock-for-stock
reorganization and therefore the transaction contained a component of
boot issued by the new corporation to the majority shareholder.
Stressing that "(t)he corporations involved did not exist separately
but were owned and controlled by the same shareholders" (482 F.2d at
607), the court of appeals concluded that the transaction should be
analyzed as if the amount of the boot had been distributed by the new
corporation in a redemption of stock hypothetically received by the
majority shareholder in a reorganization not involving boot.  Whatever
the merit of that conclusion in Wright, it should have little bearing
here.  As the Fifth Circuit noted in Shimberg, the "commonality of
ownership" of the merging corporations appeared to have played a large
part in the Eighth Circuit's decision in Wright to recast the
transaction as a redemption of stock in a single corporation;  Wright
did not purport to deal with a situation in which previously separate
and independent corporations were involved in a reorganization (see
577 F.2d at 287).  Accordingly, regardless of whether Wright was
correctly decided on its facts, cases like Shimberg and the instant
case "present() radically different facts and call() for
correspondingly different analysis" (577 F.2d at 287).

   /17/ The court in Ross noted that a particular focus of this
inquiry should be into whether the declaration of a dividend "would
have accomplished the same result" as the boot distribution.  173 F.
Supp. at 798.  That inquiry strongly confirms that dividend treatment
is appropriate here.  As the record plainly shows, the result of the
boot distribution in this case was to allow respondent to withdraw in
the form of cash some of the fruits of his labors in Basin, rather
than to have all of them tied up in the future of NL in the form of
stock (see J.A. 58-59).  Such a withdrawal is precisely the purpose of
an ordinary dividend distribution.

   /18/ Moreover, it is an unusual feature of this case that the
record shows that respondent was offered the option of a pure
stock-for-stock reorganization.  In the typical case, the hypothetical
redemption approach takes a court down a road that may never have even
been a possibility.  There is generally no basis for assuming that a
corporation that acquires another in a reorganization involving boot
would necessarily have been willing to issue a greater number of
shares in order to make a pure stock-for-stock acquisition.

   /19/ In addition, a rule measuring the dividend against the
earnings and profits of the acquiring corporation would completely
undermine the statutory purpose in some situations.  For example,
here, if NL had had no accumulated earnings and profits, respondent
would escape dividend treatment even if it were agreed that the boot
distribution had "the effect of the distribution of a dividend,"
despite the fact that he had accumulated more than $2 million in
earnings and profits in Basin prior to the reorganization.

   /20/ Even on these facts, the hypothetical redemption analysis
involves some speculation.  The court of appeals' analysis assumes
that respondent would have redeemed 125,000 shares for $3,250,000,
apparently based on a price of $26 per share.  Had he redeemed that
number of shares at the market price on the date of the
reorganization, $23 1/8 per share (see J.A. 28), he would have
received only $2,890,625 upon the redemption.

   /21/ The imprecision inherent in making his speculative
determination is significant here because of the "either-or" nature of
the inquiry.  In many tax controversies involving a valuation problem,
a small variation in valuing property will yield a correspondingly
small variation in tax consequences.  Here, however, a small variation
in the number of shares assigned to the hypothetical redemption can
change the resolution of the ultimate issue -- whether the entire boot
distribution should be treated as having the effect of a dividend.

   /22/ On the facts of the actual transaction here, respondent's
basis in each of the 300,000 shares he received was $0.3651.  Had he
received 425,000 shares as hypothesized by the court of appeals, his
basis in each share would have been $0.2577.

   /23/ Because respondent's basis in his Basin shares was so low,
this difference in the amount of gain under the two transactions is
relatively small in this case ($3,217,787.50 vs $3,250,000).  But the
difference could equally as well be quite significant under another
set of facts.  For example, suppose respondent's basis in his Basin
shares had been $4,250,000.  Under the hypothetical scenario of the
court of appeals, each of the 425,000 NL shares received by respondent
in the exchange would then have had a basis of $10.  When he redeemed
125,000 of those shares for $3,250,000, the resulting gain would be
only $2,000,000.  Applying Section 356(a)(1) to the actual
reorganization, however, would still yield a taxable gain of
$3,250,000.

   APPENDIX