Rationalizing the taxation of reorganizations and other corporate acquisitions.

This article examines the taxation of human shareholders in the case of mergers and acquisitions. Currently, the relevant law is extraordinarily complex, utterly inconsistent, and in many instances arguably unfair. There are really only two plausible ways to cure these ills. The first would involve moving to a tax system with more fulsome gain recognition, most likely in the form of mark-to-market taxation. This option is not in my opinion feasible (either technically or what is perhaps more important, politically). Accordingly, the second potential cure, moving to a tax system with less gain recognition, merits attention.

In this article, I propose such a tax system. In particular, under my proposal, a human shareholder whose stock is sold or exchanged pursuant to a merger or acquisition would be entitled to nonrecognition treatment so long as either (1) he receives stock in the acquiring corporation or (2) he involuntarily receives consideration other than stock in the acquiring corporation but promptly and appropriately reinvests such consideration.

I. INTRODUCTION

The law governing the tax treatment of shareholders involved in corporate mergers and acquisitions has been relatively stable for the better part of the federal income tax's history. This is remarkable if for no other reason than that Congress generally tinkers with the Internal Revenue Code (Code) at least once a year, and enacts significant tax changes every two or three years. But it is doubly remarkable given the quirky, excessively complex, and utterly inconsistent nature of the applicable "corporate reorganization" rules. Could quirkiness, excessive complexity, and utter inconsistency possibly be a virtue?

What are the benefits of quirkiness, excessive complexity, and utter inconsistency (other than providing employment for tax professionals)? The answer is that these features, taken together, make it possible for shareholders, as a group, to choose how they will be taxed when they "sell" their corporation. Thus, if shareholders, as a group, are not averse to recognition, they can choose a taxable transaction structure. But if enough shareholders are averse to recognition, they can choose a largely economically equivalent transaction structure that has the signal difference that it has been statutorily blessed with nonrecognition treatment. It is surely the desirability (from the shareholder viewpoint) of this barely hidden "electivity" that underlies the historic stability of the corporate reorganization rules. (2) But alas, this electivity is now under attack, at least in the public company context.

Electivity still operates in the context of mergers and acquisitions of closely held corporations. In that context, shareholders tend to have a large degree of common interest. Thus, even if certain shareholders do not have a loathing of recognition, perhaps because they desire nothing other than a complete cashing-out to fund a trip around the world, they tend to appreciate that a like lack of loathing may not be prevalent among their fellow shareholders (who are not infrequently beneficiaries of their largesse). Thus, the "selling" shareholders generally will be willing to accommodate transaction structures that allow their fellows desiring nonrecognition to achieve it. Obviously, the corporate reorganization rules aid and abet the successful search for such structures.

Electivity is no longer the rule in the public company context. In that context, shareholders tend to have much less common interest. Increasingly, a large majority of public company shareholders are indifferent to gain recognition. These include tax exempt organizations and foreigners, neither of which generally pays any tax on capital gains. These also include many mutual funds and hedge funds. Such funds do not themselves pay any tax on capital gains, and while they must "distribute" all such gains to shareholders who may pay tax on them, the possibility of somewhat remote taxation tends not to be too troubling to many fund managers. Finally, these also include dealers in securities, who must pay tax on gains whether such gains are technically recognized or not. These various tax indifferent shareholders tend to prefer receiving cash consideration when they "sell" their shares in a public company, primarily because cash consideration has an unvarying value. Unfortunately, unlike "selling" shareholders in the closely held corporations' context, tax indifferent shareholders in the public company context are generally unwilling to accommodate the tax planning of their non-tax-indifferent human brethren. Thus, increasingly, human shareholders of public companies are having unwelcome gain recognition events thrust upon them. (3)

This article takes the current increased exposure of human shareholders to unwelcome recognition events as an excuse to reexamine the taxation of corporate mergers and acquisitions in general. It is divided into eight parts. Part II motivates the discussion by detailing two corporate transactions and describing the current wholly irrational and inconsistent taxation of each. It also sets forth the possibilities for taxing such transactions consistently. Part III examines nonrecognition transactions in noncorporate settings, in the hope of finding an economic or perhaps other robust basis for the grant of nonrecognition treatment. Alas, no economic or other robust basis is found. However, several ad hoc noneconomic bases are discussed. Part IV contains an economic analysis of the two corporate transactions detailed in Part II, in order to see how such transactions compare to the nonrecognition transactions described in Part III. It concludes that the corporate transactions are at least as worthy of nonrecognition treatment as the noncorporate transactions.

Part V briefly examines the history of the corporate reorganization provisions of the Code in order to determine whether an earlier Congress believed there was anything unique about the corporate context that justifies either a less or a more liberal nonrecognition regime than is found in non-corporate contexts. The short answer is that no enlightenment is to be found in such history. Part VI begins to tackle the question of rationalizing the tax treatment of corporate mergers and acquisitions. It does this by describing three proposals: one from the early 1980s by the American Law Institute (ALI), one from the late 1980s by David Shakow, and one from the very recent past by Yariv Brauner. Part VII is the heart of the enterprise. It sets forth a menu of consistent tax alternatives and debates the pros and cons of each. It ultimately (and to an academic reader perhaps surprisingly) extols the virtues of a tax regime of expanded nonrecognition treatment. In particular, I propose a tax regime in which shareholders would receive nonrecognition treatment in the context of a merger or acquisition whenever they either (1) exchange their stock for the stock of some other corporate party to the merger or acquisition, or (2) involuntarily exchange their stock for consideration other than stock but promptly and appropriately reinvest such consideration. Part VIII is a brief conclusion.

II. A TALE OF TWO CORPORATE ACQUISITIONS

I will begin my discussion with two corporate acquisitions, each quite different from the other. I make no claim that either of these acquisitions is in any way typical of the larger run of corporate acquisitions. Each is in fact quite unusual. Nonetheless, each is possible, and the tax law must therefore be able to deal with both. How the tax law currently deals with them, and how it should ideally deal with them, is the subject of this article.

A. Acquisition #1, Variant A

Suppose an individual (H) owns all of the stock of a corporation (X) with a tax basis of essentially $0. X is in the oil exploration business; it borrows money, purchases real estate with promising geological markers, and drills for oil. It currently has borrowings of $2 million. Happily, it has just successfully drilled its first well. The well is not a very big one. Still, with a parcel of land and a successful well, X's assets have an estimated fair value of $3 million. Perhaps more importantly, X's parcel of land is situated on property that General Electric Corporation (GE) believes would be an ideal location for a new factory. Thus, GE approaches H about the possibility of acquiring X.

Following some back and forth, H agrees to sell X to GE in exchange for $1 million worth of GE's publicly traded common stock. Accordingly, GE organizes a transitory subsidiary (S) and transfers $1 million of newly issued GE common stock to S in exchange for all of S's stock. Immediately thereafter, S merges with and into X, with X surviving. Pursuant to the terms of the merger agreement, H's X stock is exchanged for the GE common stock owned by S and GE's S stock is converted into all of the outstanding stock of X. Thus, H walks away with a block of GE common stock and X becomes a wholly owned subsidiary of GE.