Rationalizing the taxation of reorganizations and other corporate acquisitions.

This is hardly a ringing endorsement for granting Acquisitions #1 and #2 nonrecognition treatment. It would arguably be best to simply eliminate such treatment for all of the listed transactions. (36) However, if nonrecognition treatment for the installment sale and the like-kind exchange (and the qualified stock rollover) are not going to be eliminated (and my belief is that it is not going to be eliminated any time soon), then, unless one has no qualms about incrementally discriminating against the more common run of investments made in corporate form in favor primarily of investments made in noncorporate form (and one should have such qualms since the entire apparatus of double taxation already discriminates against investments made in corporate form), some other justification must be found to exclude one or both of Acquisitions #1 and #2 from the nonrecognition club.

Fortunately (or perhaps unfortunately), the traditional justifications for granting nonrecognition treatment to a transaction apply with about as much force to Acquisitions #1 and #2 as they apply to noncorporate nonrecognition transactions. This is illustrated in Table 4 below. Based on those justifications, Acquisition #2 makes a strong case for nonrecognition treatment, very much in line with the case made by a classic like-kind exchange. Further, while Acquisition #1's case for nonrecognition treatment is quite weak, it is no weaker (and in Variant 1A marginally stronger, since H never actually has cash in his hands) than the case made by a qualified stock rollover.

I am not unmindful of one possibly vocal objection to the premises underlying the foregoing Table 4. Is it not the case that what is and what is not blessed in the Code is largely or even purely a question of political whim? Put differently, is not the political clout of the real estate industry the best explanation for why like-kind exchanges receive nonrecognition treatment, or at least for why it is so much easier to qualify real estate exchanges under section 1031 than it is to qualify exchanges of personal property? And is not the political clout of the investment community, or perhaps Congress' sincere desire to help spur small business formation, the best explanation for the qualified stock rollover provision?

While I agree that these observations have some (perhaps even considerable) explanatory power in delineating the contours of various nonrecognition provisions, I think they provide little of the philosophical justification for the actual existence of such provisions. Thus, "the principal congressional objective in allowing [the installment] method is to provide relief from the harshness of an obligation to pay taxes when the taxpayer has not received cash with which to pay those taxes." (37) Furthermore, the congressional concerns leading to enactment and retention of the like-kind exchange provision were squarely valuation-based: "If all exchanges were made taxable, it would be necessary to [value] the property received in exchange in thousands of horse trades and similar barter transactions each year." (38)

Since nonrecognition treatment can be justified for certain classes of corporate reorganizations and other acquisitions along these same philosophical lines, and as will become clear below, not only along these lines but along other lines as well, it follows that absent some particularly good (political or other) reason to exclude such classes of corporate reorganizations and other acquisitions from nonrecognition treatment, they should be granted such treatment.

V. THE HISTORIC RATIONALES FOR THE NONTAXATION OF CORPORATE REORGANIZATIONS

The corporate reorganization provisions, broadly defined as Part III of Subchapter C of the Code, bestow nonrecognition treatment upon certain parties to certain mergers, acquisitions, and other corporate transactions, and of particular relevance to this article, delineate the extent of nonrecognition treatment to be enjoyed by a human shareholder H who exchanges his X corporation stock for stock, securities, or other consideration as a result of a merger, acquisition, or similar transaction involving X. They entered the Code by way of the Revenue Act of 1918. (39) Although the legislative history of the original statute is sparse, what there is of it indicates a desire on the part of Congress to provide nonrecognition treatment in circumstances involving "purely paper transactions." (40) Unfortunately, it was as unclear in 1918 as it is today what exactly is meant by the phrase "purely paper transaction." (41)

Congress immediately (42) and frequently (43) set to work clarifying the corporate reorganization definition. It ultimately succeeded only in making the definition incredibly and most (including me) would argue pointlessly complicated. But it never did much in the way of providing a raison d'etre. Thus, notably, the most famous elaboration of a raison d'etre is one official's unofficial pronouncement, famously broadcast in the New York Times. A.W. Gregg, a special assistant to Treasury Secretary Andrew Mellon, stated that the purpose of the reorganization provisions was to ensure that exchanges involving "merely changes in form and not in substance" should not be taxed. (44)

Both the "purely paper transactions" language and the "merely changes in form and not in substance" language are open to a very natural and very narrow interpretation. Under this interpretation, Congress did not intend to add any taxpayer benefit not already provided by the underlying constitutional tax law (as understood by Congress). That constitutional tax law limited income taxation to income that was realized. Congress may have believed, but may have feared that the Commissioner and the courts would not similarly believe, that some purely paper transactions and mere changes in form did not amount to realization. Accordingly, it enacted the reorganization provisions as a sort of insurance policy, a backstop to the Constitution. (45) Was Congress just being paranoid? As it turns out, it was not. The Commissioner and certain Justices on the Supreme Court did indeed ultimately take a much narrower view of what did and what did not amount to realization.

For example, in Eisner v. Macomber, Justices Brandeis and Holmes attempted, unsuccessfully, to persuade their colleagues that the ultimate purely paper transaction, the mere splitting of a corporation's stock, should constitute a (taxable) realization event. (46) And in Marr v. United States, Justice Brandeis, now writing for the majority, stated that a New Jersey corporation's reincorporation as a Delaware corporation was a (taxable) realization event because "a corporation organized under the laws of Delaware does not have the same rights and powers as one organized under the laws of New Jersey." (47) I very much doubt that he could have found a single human shareholder, then or now, who would characterize such a reincorporation as anything other than the merest change in form. (48)

But while the genesis of the reorganization provisions may well have been simply to bolster the realization principal, their effect was always much more. Thus, they have always applied to a wide swath of transactions that, while they may solely involve exchanges of paper and thus linguistically constitute "purely paper transactions," are surely much more than "merely changes in form and not in substance." (49) If there is a valid principal, economic or otherwise, that unites these favored transactions, Congress has never seen fit to announce it. And that has left it up to commentators and courts to fill the breach. Not surprisingly, many of these have posited the justifications, briefly discussed in the prior part, that also apply in noncorporate acquisition contexts.

The first justification, adapted from the like-kind exchange context, is valuation difficulty. (50) In certain corporate acquisitions, such as Acquisition #2, such difficulty may actually exist. But for many acquisitions that fall squarely within the corporate reorganization definition, including Acquisition #1, the notion of valuation difficulty is a joke. The second, adapted from the installment sale context, is insufficient liquidity to allow the taxpayer to pay his tax. (51) Again, in certain corporate acquisitions, such as Acquisition #2, such difficulty may actually exist. But for many acquisitions that fall squarely within the corporate reorganization definition, including Acquisition #1, there is no illiquidity. Moreover, even where liquidity is a valid concern, mechanisms could be enacted to allow the Treasury to effectively lend the taxpayer the cash with which to pay his tax. (52)

A third justification, adapted to the reorganization context from the realization context, and thus arguably more in tune with the genesis of the reorganization provisions, is that most taxpayers think it is grossly unfair to be taxed on gain from an investment prior to their disposition of such investment. (53) In large part this is because what goes up may also come down: an unrealized gain might evaporate prior to the asset's disposition. Of course, the very same argument can be made in a reinvestment context (and would need to be made to provide Acquisition #1B with nonrecognition treatment): if H sells X for cash and reinvests his proceeds in Y (or GE), he might suffer a loss in Y (or GE) that offsets some or all of his prior (taxed) gain in X. However, while perceptions of unfairness are strong against imposing a tax in the investment context, they are not generally similarly strong against imposing a tax in the reinvestment context.