Rationalizing the taxation of reorganizations and other corporate acquisitions.

In order to compare apples to apples, I assume that H sells asset X in exchange for a note that pays an amount of current interest that is equal to the current cash flow H would have received from X. I also assume that H receives in addition a principal amount of $3.125 million at the same time that X generates its terminal cash flow. (26) It is pretty obvious, as illustrated in the chart below, that the returns generated by H's modified portfolio bear little relation to the returns that H would have received had he not entered into the installment sale. To quantify the overlap of such returns in an ad hoc sort of way, note that H's return after entering into the installment sale will be within 10% of what his return would have been had he not entered into such sale only 5% of the time (i.e., for values of X between $3.025 million and $3.225 million). Thus, H receives nonrecognition treatment with respect to an investment modification that has very materially impacted his investment returns.

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Somewhat less dramatic, but along the same general lines as an installment sale (at least in terms of its effect on H's additional investment returns: increasing such returns during "bad" states of the world and decreasing them during "good" states of the world), are various investment modifications involving options. Thus, for example, H could purchase a put option that gave him the right but not the obligation to sell X at the end of three years for $3 million, in exchange for a mandatory payment, also to be made at the end of three years, in the amount of $375,000. The net effect would thus be that H would receive a return of at least $625,000 (i.e., $3 million minus $2 million debt repayment minus $375,000) on his investment. Or, H could sell a call option that gave the buyer the right but not the obligation to purchase X at the end of three years for $4 million, in exchange for a mandatory payment, also to be made at the end of three years, in the amount of $125,000. The net effect would thus be that H would be unable to receive a return in excess of $2.125 million on his investment.

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Note that H's additional investment return after purchasing the given put option will be within 10% of what such return would have been had he not purchased the put option only 5% of the time (i.e., for values of X between $2.525 million and $2.725 million). Furthermore, his additional investment return after selling the given call option will be within 10% of what such return would have been had he not sold the call option only 5% of the time (i.e., for values of X between $4.025 million and $4.225 million). As in the case of the installment sale, H has materially modified his additional investment returns. Nonetheless, he is not taxed on his unrealized gains at the time that he enters into these modifications. Indeed, in these cases, H continues to enjoy deferral with respect to his unrealized gains in X not because the Code grants him nonrecognition treatment, but rather because the Code does not even acknowledge that the investment modification is a realization event and, as such, could be taxed. That is, H legally owned asset X prior to entering in to the option transaction, and he continued to legally own asset X (although not necessarily all of the investment upside or downside of asset X) after entering into the investment modification. Thus, section 1001 has no sale or exchange or other disposition upon which to operate. (27)

The third investment modification I want to consider is a like-kind exchange that garners nonrecognition treatment by virtue of the application of section 1031. In order for H's modification to qualify for like-kind exchange treatment, X must be the right sort of asset (e.g., real estate that is either held for investment or used in the conduct of an active trade or business), and X must be exchanged for an asset (Y) that is also the right sort of asset (i.e., is of "like kind" with asset X). (28) Since under the tax regulations an exchange of undeveloped farm land in Kansas for an office building in Manhattan qualifies as a like-kind exchange, it should be apparent that, at least in the case of real property, H may engage in a wide variety of exchanges, with vastly different possible economic outcomes, and still obtain the blessings of section 1031. (29)

Why are such exchanges granted nonrecognition treatment? (30) One contributing factor is the liquidity rationale already mentioned in the context of installment sales. That is, if H realizes gain on an exchange of asset X for asset Y, he does not necessarily have any cash with which to pay the tax on his gain. Once again, however, the strength of this rationale is subject to considerable doubt, particularly since the Code goes out of its way to allow H to inflict this wound upon himself. That is, provided that H acts with dispatch, and properly dots his i's and crosses his t's, he can engage in a like-kind exchange even though the buyer of X actually pays cash for such asset! (31)

The second, and perhaps more important factor, is that a classic like-kind exchange produces no pricing information which can be used to measure gain. As a result, if H exchanges asset X for asset Y, all that can be said with certainty is that asset X and asset Y are of equal value (in the sense that two presumably informed and rational economic actors were willing to exchange them in an arms' length exchange); as to whether that value is $1 or $1 thousand or $1 million or $1 billion there is no information whatever. Again, the classic case is surely not the typical case. Often very precise valuation data exists. In cases involving three party exchanges under section 1031(a)(3), that very precise data is based on amounts of cash actually paid. Nevertheless, for a subset of cases, the valuation concern may be legitimate.

In any event, in order to compare apples to apples, I assume that H exchanges asset X, subject to its liability, for like-kind asset Y with the following characteristics. Y has a fair value of $5 million and is acquired subject to a liability in the amount of $4 million. Over the relevant time horizon, Y generates sufficient current cash flow to exactly provide both the lender and H with appropriate risk-adjusted returns, but no more. (32) At the end of the relevant time horizon, Y produces a single terminal random cash flow that with equal probability lies anywhere between $0 and $8.33 million. Thus, 48% of the time, H's initial investment and unrealized gain of $1 million will evaporate (since Y's terminal cash flow of less than or equal to $4 million will be entirely dedicated to repaying the lender). The remaining 52% of the time, H will receive an additional capital-gain-type return that with equal probability lies anywhere between -100% and +333%. H's expected additional "capital gain" is +12.5%.

Finally, for ease of mathematical exposition, I begin with the simplifying assumption that the terminal values of X and Y are uncorrelated. Under this admittedly extreme assumption, H's additional investment return after engaging in the exchange will be within 10% of what such return would have been had he not engaged in the exchange only approximately 15.3% of the time (with nearly 90% of such overlap arising in situations where one or both of X and Y has a value that is below that of its accompanying liability).

Of course, even if X and Y are very different assets--like undeveloped farm land in Kansas and an office building in Manhattan--the returns from such assets are likely to be somewhat, albeit less than perfectly, correlated by virtue of the fact that certain factors, like interest rates and the general business climate, tend to impact all asset prices in similar ways. Accordingly, and again for ease of mathematical exposition, I will make the opposite simplifying assumption, namely that the terminal values of X and Y are perfectly correlated. Under this also admittedly extreme (but polar opposite) assumption, H's additional investment return after engaging in the exchange will be within 10% of what such return would have been had he not engaged in the exchange only approximately 32.3% of the time (with nearly 85% of such overlap arising in situations where one or both of X and Y has a value that is below that of its accompanying liability).

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Given a more realistic assumption of partial but not complete correlation, a result in between those presented above would be produced. Whatever such intermediate result, however, H would receive nonrecognition treatment with respect to an investment modification that has very materially, albeit not as materially as in the installment sale context, impacted his additional investment returns.

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Just as a focus on additional investment returns makes the installment sale statute seem more generous than the like-kind exchange statute, so too does a focus on investment characteristics. That is, the like-kind exchange statute can be viewed as providing nonrecognition treatment on narrower grounds--liquidity concerns compounded by valuation concerns, as opposed to liquidity concerns standing alone--than does the installment sale statute. But there are other statutes that provide nonrecognition treatment on arguably broader grounds even than the installment sale statute. Thus, if H's asset X is "qualified small business" stock, H may defer the recognition of gain from a cash sale of X so long as H expeditiously reinvests his sales proceeds in other qualified small business stock. (33)