Rationalizing the taxation of reorganizations and other corporate acquisitions.

But what if the corporations involved in the business combination have multiple classes of stock outstanding, each with different entitlements? In this case, Shakow's apparently objective focus on group ownership becomes problematic for at least two reasons. The first is that such focus does not, in fact, eradicate the relevance of transactional form. The second is that it may make valuation questions, which are all but unanswerable, determine the tax outcome.

To see how transactional form could change the tax results in Acquisition #2, suppose that the transaction proceeds essentially as in Variant 2B, but with the following changes. First, X does not borrow any money from Bank, and accordingly does not engage in a recapitalization. However, X does amend its charter to provide that the Class A and the Class B stock will henceforth each be entitled to only a single vote per share. Thus, at the time of the merger of RUC with and into X, X continues to have 500,000 shares of Class A Common Stock (now having one vote per share) and 500,000 shares of Class B Common Stock outstanding. The merger takes place as before, with each share of RUC being exchanged for one share of X's Class B Common Stock. Thus, after the merger, X's original shareholders own all 500,000 shares of X's Class A Common Stock and 500,000 out of 1.5 million shares of X's Class B Common Stock. Note that so long as the Class A Common Stock's liquidation preference stays "in the money," there is no significant difference between the economics of this transaction and the economics of the original Acquisition #2. For example, after waiting a suitable period of time, X's Class A Common Stock could be recapitalized as in the original Acquisition #2, thus exactly restoring the economics of the original structure.

How would Shakow's scheme tax this new variant? Let me stipulate that the post-combination fair values of the Class A and Class B Common Stock are $50 per share and $10 per share, respectively. If so, then X's original shareholders own 75% of the post-merger corporation, and RUC's original shareholders own the remaining 25%. In other words, X has become the purchasing corporation and RUC has become the target corporation. Accordingly, Shakow would not tax the original shareholders of X, but would tax the original shareholders RUC. Form, it turns out, matters very much indeed!

The second problem, which is admittedly not a problem of theory but merely of administration, arises from the difficulty of valuing stock in the absence of public equity markets. For example, consider the following variation of Acquisition #2. Suppose that X has among its assets the rights to drill for oil on a patch of land called Parcel V. X's shareholders believe that Parcel V will be particularly lucrative, but RUC's shareholders are somewhat skeptical. Further, suppose that RUC has among its assets the rights to drill for oil on a patch of land called Parcel W. RUC's shareholders believe that Parcel W will be particularly lucrative, but X's shareholders are somewhat skeptical.

Under these facts, a business combination between X and RUC (which might still make an extraordinary amount of sense due to factors such as cost savings, diversification of projects, etc.) might proceed along the general lines of Acquisition #2A, but with the following modifications. RUC amends its charter to provide for two classes of common stock. The first class, called Class W, entitles its owners to a modest preferred return based on a fraction of the net cash generated by Parcel W, and otherwise entitles them to participate equally with owners of all other classes of RUC common stock in all other distributions and liquidation proceeds. The second class, called Class V, entitles its owners to a modest preferred return based on a fraction of the net cash generated by Parcel V, and otherwise entitles them to participate equally with owners of all other classes of RUC common stock in all other distributions and liquidation proceeds. Once the charter has been amended, X merges with and into RUC. The original owners of RUC's common stock exchange each share for one new share of Class W Common Stock. Finally, X's Class A Common Stock owners exchange each share for $40 in cash and one new share of Class V Common Stock; X's Class B Common Stock owners exchange each share for one new share of Class V Common Stock.

Confronted with these facts, how would Shakow's tax regime respond? Is X the purchasing corporation? Its original shareholders clearly think so. But RUC's original shareholders just as clearly think that X is the target corporation. The Commissioner, predictably, will argue that X and RUC are each target corporations. Intractable valuation questions have thus been elevated to tax outcome determinative status. That can't be good.

Two questions must be answered before surrendering all hope in intermediate options. First, are the infirmities identified above likely to be sufficiently important to matter? Second, are there ways to modify the Shakow-style intermediate option that do not suffer from the same infirmities?

The first question is largely empirical. As an empirical matter, I concede that the problem, at least in the public company context, is unlikely to be significant. In that context, which admittedly is Shakow's focus (in large part because it is the only context in which valuation issues are not insuperable), corporations with multiple classes of stock exist, but are in the distinct minority. Moreover, in vanishingly few of the corporate combinations involving corporations with multiple classes of stock are such multiple classes likely to cast any doubt on the identity of the target corporation and the purchasing corporation.

Nonetheless, a robust tax regime should be concerned not only with the public company context, but also with the private company context. Anecdotal evidence based on my prior life in practice suggests that multiple classes of stock are quite common in the context of private companies. Moreover, the same anecdotal evidence suggests that shareholders transacting in the private company context are far more amenable to complicating their corporate capital structures with multiple classes of stock if such complications produce desired tax savings. Perhaps this is as it should be. Perhaps it is socially desirable to allow private company shareholders a wider latitude for avoiding recognition than public company shareholders. After all, these are the fabled small businessmen, the principals of venture capital and private equity firms, and so on, who are surely the actors in the economy who are the most responsive to tax incentives. These are also the same individuals who so disproportionately populate the upper classes. It therefore seems to me that a policy debate beyond the scope of this article (and beyond the scope of Shakow's article as well) is necessary before pronouncing that a problem of multiple classes of stock is insignificant.

But suppose one takes the other position: that the problem of multiple classes of stock is both empirically and conceptually unimportant. After all, even if private company shareholders can manipulate the preferences of different classes of stock and thus designate either party to a corporate combination to be the purchasing corporation, their machinations will (in all but the rarest cases) leave the other party to the combination as the target corporation. As a result, exactly one set of shareholders will (almost) always still be taxed. Does this mean that all is well in a Shakow-style world?

Alas it does not. The Shakow-style tax regime has another and considerably more important conceptual flaw. What determines taxation under Shakow is the presence or absence of an ownership change. For example, in Acquisition #2, Shakow would not tax H because H is one of X's original shareholders and such shareholders as a group own 50% of the surviving corporation (whether RUC as in Variant 2A or X as in Variant 2B). This is nothing more than a type of continuity-of-interest inquiry, and thus must succumb to all of the problems that plague such an inquiry. In particular (and exactly as under current law), H's taxation would depend not on the economic characteristics of his own exchange, but on the economic characteristics of the aggregation of the exchanges of all of X's shareholders.

To see how this may matter under specific facts, consider yet another variant of Acquisition #2. The combination will follow the general outlines of Variant 2A, but with the following differences. Suppose that the Class A shareholders of X do not merely want $40 per share of cash consideration, but actually want to be cashed out entirely. Thus, RUC must find an additional $5 million of cash beyond the $20 million it will in any event borrow from Bank. To raise this cash, RUC seeks an additional equity investment from its original shareholders. Some subscribe and some don't. But in the end, RUC's capitalization increases to 1.5 million shares of common stock and its war chest increases to $25 million of cash.