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C. Rudolf Peterson

The status of corporations and their shareholders as separate taxable entities, capable of dealing with each other, has led to the development of what is often regarded as the most complicated of all branches of the tax law. Other branches may now be catching up. The provisions on trusts and estates and partnerships are scarcely models of simplicity, but they lack any real potential such as that which is to be found'in the field of corporation-shareholder relationships. Basic principles are easy to state. Their use and abuse is another matter. So long as we continue our system of taxing corporations and shareholders separately, giving effect to many transactions between them as though they were strangers, and so long as we have anything but minimal tax rates, and so long as the distinction between ordinary income and capital gains persists, we cannot have a simple statute. Since it is idle to assume that the system stands any chance of repudiation, our primary object should be to recognize the problems and to reexamine the methods presently employed to solve them, placing initial emphasis on principle. As is well known, much detailed work has already been done in this field, both by and for the committee. The purpose of this paper is largely to provide a frame of reference.

Under our system of taxation, except for the recently enacted subchapter S, a corporation is not a mere income-computing entity, like a partnership, with its income taxed directly to its proprietors, but is a taxpayer in its own right. Its income is not taxed to its shareholders until it is distributed to them in the form of dividends, at which time, generally speaking, if the shareholders are individuals, the full normal and surtax rates are applied. But the shareholder can also sell his stock and, if he does so, he will be taxed at capital-gains rates, regardless of the fact that his gain may consist in whole or in part of accumulated corporate income, which, if distributed to him in ordinary course, would be taxable to him as dividends, and, indeed, will be so taxed upon distribution to the purchaser of the stock even though they formed part of the purchase price. Such a sale can be made not only to third parties but also to the corporation itself. For this purpose, the receipt of a liquidating distribution is treated as a species of sale to the corporation.

Under this broad statutory scheme, obviously the first problem is whether there must not be some refinement of the sale concept in dealing with transactions between a shareholder and his corporation. The so-called sale may be nothing more than the receipt of a disguised dividend—a bailout, as the saying goes. The sole shareholder of a corporation with $100,000 of capital and $100,000 of accumulated earnings, for example, instead of taking down'a $50,000 dividend, taxable at full normal and surtax rates, turns in one-quarter of his stock for $50,000 and claims that he is taxable on only a $25,000 capital gain, i.e., that he has sold for $50,000 stock costing him $25,000. And so there has been developed the concept of redemptions equivalent to dividends, for, barring the question of whether some provision should not be made for tax-free returns of capital before distributions are taxed as dividends, no one quarrels with refusing to allow sales treatment in the case described. The difficulty lies in providing standards.

Until the 1954 code, only the judgment test of dividend equivalence or nonequivalence was set forth in the statute. Today we find in addition two highly articulated sets of provisions on the subject. One set of rules tests dividend equivalence or nonequivalence from the shareholder point of view, the question being, has there been a substantial change in the shareholder's position vis-a-vis his investment? Specifically, has his percentage of stock ownership been reduced by at least 20 percent and, if he had control before the redemption, has he lost it? Elaborate rules of constructive ownership are applied in this connection. The other set of rules tests dividend equivalence or nonequivalence from the corporate point of view—has there been a partial liquidation of the business? If one of several businesses is terminated, the shareholder is in the clear. Even if the shareholder cannot meet the mechanical rules of either test of dividend nonequivalence, he can still fall back on the judgment test.

From the standpoint of complexity, the statute may be defended on the ground that only by extreme particularization can there be any approach to certainty both from the Government's and from the taxpayer's point of view. One important question in this area has been whether attribution of stock ownership has not been overdone. Another important policy question has been the relevance of any corporate level test to determine dividend treatment to shareholders and particularly whether the termination of a business test has any validity. This is not to overlook the broader question of whether there ought not to be a revision of our fundamental approach to corporate distributions which provides that, so long as a shareholder's proprietary interest continues, distributions are regarded as first out of earnings. It has been suggested that a shareholder ought first to be allowed to get his capital

back, at least if it takes the form of an investment in preferred stock.

Another aspect of the bailout problem that has led to extreme complication in the statute is the once valid device of issuing a nontaxable preferred stock dividend followed by its sale to outsiders, usually an insurance company, from whom it is ultimately redeemed. Few would argue in favor of permitting this. But how to prevent it? Barring the drastic device, which might not be constitutional in any event and would certainly be challenged on economic grounds, of making such stock dividends taxable in the first instance, any method would involve complications and, once enacted, would have to undergo the test of experience. Section 306, the engine which was developed in 1954, is just such a provision and, while it is easy to be critical in detail, we should make haste slowly in any attempt to make changes at this

No survey of the field of corporate distributions and adjustments to uncover sore spots can fail to refer to the treatment of collapsible corporations. The provisions covering this subject had their origin in the attempt to stop the practice which became popular in the 1920's of seeking to convert what was essentially ordinary income into capital gain by the use of temporary corporations. The classic example involved the organization of a motion picture company to produce one picture, or a real estate company to engage in a single development, following the completion of which, before any income had been realized, the corporation would be liquidated or its stock sold, thereby converting the ordinary income potential of the motion picture or the real estate development into à capital gain. As the law was enacted and now stands, however, particularly if the courts' language in some bad cases can be taken at its face value, the statute's reach is far broader than the original intent. Capital gain can often be converted into ordinary income. Shareholders may sometimes be caught though the corporations are not in fact collapsed. There is no attempt to fragment gain. Motive may have been reduced to a mere play on words. On the other hand, arbitrary dividing lines may make manipulation too easy. All in all, and in spite of the fact that some effort was made to ease the situation by section 20 of the Technical Amendments Act of 1958, this area should be reexamined, both from the point of view of what we are trying to do and from the point of view of how we are doing it.

Coming now to the subject of corporate reorganizations, we are confronted with a series of questions. Are the applicable provisions broad enough to accomplish their objective of providing maximum flexibility for business to effect corporate adjustments that amount to changes in form rather than substance without tax penalties? Are they both broad enough and narrow enough to prevent tax avoidance? Are they consistent within themselves and with other parts of the code? Are they realistic in concept? Should tax policy be influenced by other elements of public policy-antitrust policy, foreign trade policy, and so forth?

The corporate reorganization provisions are in mitigation of the concept of a corporation as entirely separate from its shareholders, or, more accurately, from any other corporation by which it may be acquired or into which it may be converted and in which its shareholders continue their proprietary interest. They recognize that in some contexts a corporation is more a matter of form than of substance. Strict adherence to the entity theory might regard a mere corporate migration, as, for example, the reincorporation of a New Jersey corporation in Delaware, as a sale by the New Jersey corporation of its assets for the stock of the Delaware corporation and a taxable exchange by the shareholders of their New Jersey stock for the Delaware stock. But this would be pushing things too far. Not only is it unrealistic, but it would place a virtual embargo on normal and often economically desirable business transactions. It could also in many instances lead to tax avoidance by permitting basis stepups or assets to be withdrawn at capital gains rates under circumstances where the overall effect is no more than the receipt of taxable dividends.

Elaborate provision has therefore been made for the special treatment of corporate adjustments, known as reorganizations, the general

effect of which is that, within defined limits, no gain or loss will be recognized, but the status quo will be preserved, on the transfer of assets of one corporation for the stock or securities of another corporation and the exchange of stock for stock or securities for securities of the same corporation or a successor corporation in a reorganization. If the shareholders bail out assets in the process the general intent is to accord the same treatment as though the bailout had occurred without the formality of a reorganization.

Much has been written and many an argument has taken place on the subject of the corporate reorganization provisions over the years. As already suggested, it was early felt that some special treatment had to be provided by statute because of early court decisions and technical concepts of realization of income which would prevent business adjustments which amounted to no more than changes in form. The modern era of highly articulated provisions began in 1924. This type of approach, that is, a spelling out of rules in detail, frequently has the disadvantage of permitting literal compliance and therefore sometimes amounts to a blueprint for tax avoidance. By 1934 considerable dissatisfaction had developed on the subject. It was even seriously suggested that the reorganization provisions be completely eliminated from the statute, on the ground that they were both complicated and productive of tax avoidance. Careful consideration by the committees of Congress and the Treasury, however, led to the conviction that this would not be sound policy.

It was pointed out that reorganizations were then being consummated in the majority of cases to reduce the capital structure and to strengthen the financial condition of the participating corporations, and that to eliminate the reorganization provisions would enable many stockholders and bondholders to take large losses without substantially changing their former interests in the enterprise. It was also felt that such a procedure would result in a severe handicap upon legitimate exchanges and reorganizations. The committees therefore decided that the wiser policy was to amend the provisions drastically to stop the known cases of tax avoidance, rather than to eliminate the sections completely.

The thorough revision which was undertaken in 1934 still forms the basis for the present provisions on the subject of reorganizations. In the meantime a body of judicial decisions which had just begun to develop around the time of the 1934 act has greatly reduced the dangers of tax avoidance through an overliteral application of precise rules. The doctrines of continuity of proprietary interest and compliance with the basic purposes rather than merely the form of the statute, the business purpose test, recognition of dividend equivalence in many disguises, though sometimes complained of on the ground of uncertaintly, are indispensable adjuncts to the statute. In addition, as new problems have developed and experience has accumulated further legislation has been enacted. But there has not been time for a thorough reconsideration of the structure as a whole, with a view to possible improvement both in draftsmanship and in concept, though an attempt was made on the House side in 1954.

Six types of reorganization are specified in present law: (A) statutory mergers or consolidations; (B) exchanges of stock of one corporation solely for voting stock of another if the second corporation is in control of the first following the transaction; (C) acquisition of substantially all the assets of one corporation by another, if at least 80 percent of the consideration therefor is voting stock of the acquiring corporation; (D) certain transfers of assets by one corporation to another corporation controlled by the transferor corporation's shareholders; (E) recapitalizations; and (F) a mere change in identity, place, or form of organization.

While the definitional list is fresh in mind, reference should be made to the first problem that is worthy of consideration in connection with any possible revision—that of internal consistency. The (A), (C), and (D) types of reorganization all three involve asset acquisitions. The so-called continuity of proprietary interest requirement in (C) is that at least 80 percent of the consideration received by the transferors be in the form of voting stock of the acquiring corporation. In (D) it is continuing control. In (A) nothing is said. Though a continuity of interest requirement has been developed in merger cases by judicial decision, it does not approach the standards laid down by Congress in the (C) and (D) cases. While the absence of any stock will defeat the transaction, just what proportion is required is not wholly clear; it probably does not exceed 50 percent. And it can be any kind of stock, not just voting stock.

It is believed that some consideration should be given to providing a uniform set of rules. In the course of such consideration it will be found that habits of thought, particularly among lawyers, will have developed a kind of reverence for statutory mergers or consolidations that may becloud the issue. Of course, if consistency is desired, it can be achieved by conforming (A) to (C), or by conforming (C) to (A), or by settling on some middle ground. Arguably (C) is unduly strict in laying down an 80-percent test and may be overemphasizing a wholly irrelevant factor in insisting that the stock be voting stock. Again, it is a question of what we want to achieve, what we want to encourage and what we want to discourage, how far we can go before we come to what would generally be regarded as a sale. It should also be remembered that a broad definition may work in the interests of preventing tax avoidance by preventing bailouts at capital gains rates. At the same time it may increase the pressure for a separate set of rules at the corporate level, since acquiring corporations often fail to see the justice of being stuck with a carryover basis on assets which in their view they have really purchased. On the subject of importing the control test of (D) into the merger concept, it need only be said that this would be only an alternative of limited application to cover certain cases which should be allowed even though the quantum test is not met. Perhaps they would be covered anywaywhich reduces the problem to one of symmetry in draftmanship.

Another problem in the reorganization area which is deserving of reconsideration is the problem of reincorporation, which also embraces the question of the splitup which fails. In the course of the 1954 revision the possibilities of tax avoidance in this area were rendered much more acute than they had been before. To take an extreme case, What is the tax treatment of the following transaction? Sixty percent of the assets of the X corporation are business assets and 40 percent consist of an investment portfolio. If the investment portfolio were distributed to shareholders, assuming adequate earnings

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