A Good Old Habit, or Just an Old One? Preferential Tax Treatment for Reorganizations

Brigham Young University Law Review, 2004 by Brauner, Yariv

I. INTRODUCTION

The Internal Revenue Code (IRC)1 contains some exceptional rules applying to corporate structural changes. These rules grant preferential tax treatment to a significant volume of merger and acquisition (M&A) transactions.2 Nevertheless, it is hard to establish a clear and comprehensive rationale for the current rules, which should be surprising but is not so to any student of the material. Oddly enough, these rules are some of the most stable foundations of the federal tax system despite their shaky normative grounds. In this Article, I propose to repeal these rules and to tax "reorganization" transactions3 like all other sales or exchanges. I reject the stated rationale for these rules-that such transactions trigger insufficient realization and, therefore, that it is both unfair and impractical to currently tax them. I further demonstrate that the preferential tax treatment of reorganizations cannot be supported on efficiency grounds.4

In certain circumstances, the reorganization rules allow some taxpayers not to recognize (and therefore not to be currently taxed on) the gain they realize in these transactions. The "price" of such nonrecognition is usually some sort of carry-over tax basis, which, in effect, results in tax deferral and a timing preference for these taxpayers. For example, consider T, an individual inventor and a 100% shareholder of InventCorp, a Delaware corporation that has developed and secured a patent on an invention. T agrees to merge InventCorp, under Delaware law, into IBM in exchange for one million dollars' worth of IBM stock. Pursuant to the reorganization rules, T will not be taxed upon the transaction. Assuming normal start-up circumstances, T's realized gain of close to one million dollars may be deferred until she disposes of the IBM stock received in the transaction, her basis in which is transferred from her InventCorp stock forgone in the merger.5 Note that if T received one million dollars in cash in the merger, or if she had developed the invention in her capacity as an individual, she would be currently taxed on her entire gain. This (deferral) preference may translate into indefinite deferral and to partial or complete avoidance of the tax.6 Nevertheless, this preference has been established over the last eighty years as a cornerstone of the federal income tax system.

In this Article, I focus only on the primary acquisitive reorganizations: the type A statutory merger, the type B stock-for-stock acquisition, and the type C assets-for-stock acquisition. The rules governing corporate structural changes include a wide variety of other transactions that have many similar features for tax policy purposes,7 but the analysis of which must be deferred for methodological and simplification purposes.

The common feature of all reorganization transactions and, as we will see shortly, the stated justification of the applicable tax rules, is that in these transactions either the core ownership group or the core business, or both, remain substantively the same but undergo a formal change that is justified by business reasons:

The traditional theory ... is that gain or loss should not be recognized on changes of form when the taxpayer's investment remains in [the] corporate solution or when "a formal distribution . . . represents merely a new form of the previous participation in an enterprise involving no change of substance in the rights and relations of interested parties one to another or to the corporate assets."8

The courts and the business community have never questioned the logic of these rules. The government has attempted, from time to time, to analyze some of their specific details, but except for a short episode in the 1930s, it has not made a serious attempt to conceptually revise, or even review the normative foundation of, these rules. The legislature has consistently concentrated on shutting down abuse potentials rather than questioning the basic premises behind this tax regime. The result is an extremely stable (but stagnant) regime that is resistant to change despite its inadequacies, which arc exposed mainly by academics.9 The resulting system, described by one scholar, consists of "a variety of patterns of taxation [that] have emerged through largely uncoordinated, ad hoc legislative and judicial development . . . containing unsupportable distinctions and inconsistencies, [which are] massively complex."10 This harsh description is not surprising to anyone exposed to this notoriously "complex and cryptic"11 regime, but general industry satisfaction has evidently been sufficient to ensure the retention of this major part of the tax law.

Part II follows with an analysis and rejection of the stated realization-based rationale for the reorganization rules. It demonstrates that the reasons for adopting the realization requirement itself-mainly liquidity concerns and valuation hardship-are either irrelevant or cannot support the argument that the tax preference to reorganizations is necessary to maintain the integrity of the realization requirement as a fundamental feature of the federal income tax.12