CORPORATE DISTRIBUTIONS AND ADJUSTMENTS AND THE HARD ROAD TO A BROADER TAX BASE

Hugh Calkins

The starting point for seeking an answer to the Ways and Means Committee's inquiry into the possibilities for broadening the tax base in the area of corporate distributions and adjustments is a consideration of the role of corporations in shaping the base.

The income-tax base in this country is a simple enough two-tier structure. It consists of personal income taxed at steeply progressive rates and corporate income taxed primarily at the flat rate of 52 percent. All the rest of the Internal Revenue Code is by way of definition of the base, or exception to it. Some of the exceptions, of course, have become so much a part of our sense of fairness and good policy as to be indistinguishable from the base itself. Among these are modest personal exemptions and expenses deductible in determining accounting net income. I would also include some form of preferential treatment for capital gains in this group of justified exceptions and throughout this paper I am assuming that some capital gain preference remains a part of our system.

It should be said at the outset that this tax base, were it to be unrelieved by exceptions, would be an astonishingly harsh one. There are few countries in which the corporate tax rate is as high as 52 percent-although in many it is nearly that high; there are few in which the individual rates reach the levels prescribed in our code; and there are none of which I am aware in which two such heavy burdens are simply added together with as little adjustment for the double tier as our system allows.

There are three principal ways in which the financial policies of corporations and their stockholders may contract the combined individual and corporate taxable income within this tax base. In the order of their probable effect on the revenues, they are:

1. Earnings on which the corporate tax has been paid may be accumulated and "realized" by stockholders without personal income tax, or at capital gain rates, in a variety of ways. Principally, these

are

(a) By sale or by exchange, including liquidations and redemptions, and sales of stock dividends, all of which generally result in a capital gains tax being paid before realization on the earnings,

(b) By use of corporate debt. Sometimes this is a means of eliminating corporate tax (as on payment of interest on stockholder debt). Sometimes it is a means of eliminating or reducing personal tax (as on increasing the value of the equity in a corporation purchased "thin" by payment of an indebtedness incurred as a part of the purchase price),

(c) By death, which in an income tax sense permits a realization without personal tax because of the stepped-up basis than obtained, and

(d) By gift, which is a psychic realization in any event, and can be a cash realization.

2. Combinations of two corporations may have the effect of(a) Eliminating corporate tax, where a tax loss which otherwise would expire unused is made applicable against taxable income, or

(b) Permitting appreciation in the value of an incorporated business which appreciation may consist in part of accumulated earnings to be made realizable (although not actually realized) without payment of a capital gains tax. This is frequently the effect, for instance, of a merger of a small speculative company into a large, listed, blue-chip corporation.

3. Astute, or merely accidental, use of a corporation may convert ordinary income into capital gain. This is the perplexing collapsible corporation problem.

The classification of these financial policies as contractions in the tax base is not intended to suggest that they are all unjustified erosions of it. To the contrary, as will appear below, I think that many of them are justified, by the necessities of administration if not by more positive policy considerations. The classification is intended only to suggest where to look for contractions which might be eliminated were Congress to decide that a broader base with lower rates was preferable to the sharply eroded Mount Everest which our present tax system resembles.

It will be most convenient to reverse the order of the contractions in discussing them.

I. THE CONVERSION OF ORDINARY INCOME INTO CAPITAL GAIN-THE COLLAPSIBLE CORPORATION PROBLEM

Since order was brought to spinoffs and splitups in 1954 there has been no subject more properly reserved for the high priests of Federal income taxation than the collapsible corporation. Not being one of those who have wrestled with legislative draftsmanship in this area, I offer my views on it with the certain knowledge that there are technical problems of which I have not taken account.

These points, nevertheless, seem to me to be reasonably clear:

(1) The section of the 1954 code dealing with collapsible corporations (sec. 341), as amended in 1958, is verbally so complex that, whether or not it reaches a desirable end result, it is bad legislation which should be promptly changed.

(2) It is essential to prevent the blatant instances of conversion of ordinary income into capital gains through collapsible corporations. Like unreasonable accumulations in personal holding companies and the traffic in skeletal tax-loss corporations, widespread avoidance of ordinary income by this method would bring the tax system into such disrepute as to jeopardize the one really vital principle on which it is based-voluntary compliance.

(3) It is impossible to prevent avoidance by a statutory scheme which turns on intention to use a corporation for the collapsible purpose. In part, the difficulty arises from the uncertainty neces

sarily created by the vagueness of the test. More important, where the test is intention, voluntary enforcement breaks down. Because every taxpayer can with sufficient honesty to salve his conscience and avoid a fraud penalty conjure up a proper, noncollapsible intent, no taxpayer voluntarily reports a collapsible status, and the entire burden of enforcing the section rests upon audit. Unlike unreasonable accumulations of surplus and loss carryforwards, which are comparatively rare and leave distinct tracks on the face of the return, potentially collapsible situations are more common, particularly in moderate-bracket returns, and can be identified only by facts not ordinarily disclosed in the return. Enforcement of a code provision on collapsible corporations without voluntary compliance will not work. To obtain voluntary compliance, an objective test which is not unreasonably complex must be devised.

(4) The theory of our capital-gain provisions is that preferential treatment will be given to increases in the value of investment property and that appreciation in value in inventory-type property and compensation for services will be taxed as ordinary income. I see no reason to make an exception to this policy when properties are sold in bulk, and accordingly I approve the "fragmentation" principle as applied to sales of proprietorships, partnerships, and partnership interests.1

So far, I believe, the ground is firm, and the next step also seems to me to be tolerably clear.

(5) The most satisfactory solution to the collapsible corporation problem is to provide for fragmentation of gain to the holders of a significant percentage of the stock on a sale or liquidation of a corporation in which there has been substantial appreciation in the inventory-type assets. This solution is the one advocated by the Subchapter C Advisory Group.2

1 The "fragmentation" principle is to the effect that the gain will be allocated between the portion attributable to increase in value of capital assets, which will be taxed as capital gain, and the portion attributable to increase in value of noncapital assets, which will be taxed as ordinary income.

2 As appears further on in this paper, I doubt the wisdom of the advisory group's recommendation that gain on complete liquidation of a corporation should be determined with respect to the basis to the corporation of the assets distributed. Continuation of the present rule employing value as the criterion, as I believe is desirable, would necessitate minor modifications in the advisory group recommendation.

This recommendation, modified as above suggested, is subject to three principal objections, none of which seems to me to be a valid ground for rejecting it:

(a) Application of the fragmentation principle in the corporate field doubles up ordinary income taxation. In the case of the stockholder who purchases shares of a collapsible corporation from a predecessor who paid ordinary income tax, the advisory group draft properly restricts the vulnerability of the purchaser to ordinary income treatment to futher appreciation of inventory-type assets. The draft does not, however, adjust the ordinary income tax to the corporation when the appreciation is realized, and probably such an adjustment is not feasible. There are several answers to the objection. More often than not, the "significant" (5 percent?) stockholders to whom the section would be applicable could, if they wished, cause the corporation to realize the income before the stock is sold. Where the appreciation in value of ordinary-income corporate assets is not large, the proposed fragmentation rule would not be applicable; where such appreciation is large, the rule would rarely seem unfair.

(b) The holder of a significant percentage of stock of a corporation not intentionally used for a collapsible purpose will maintain that he should not have to pay a tax at ordinary income rates on the part of the gain attributable to ordinary-income assets while smaller stockholders are not so penalized. While this position is not unreasonable, the plight of the significant stockholder does not seem to me so serious as to require rejection of the suggested approach. It is more accurate to say that the small stockholder is getting a break than that the large stockholder is being penalized.

(c) If the fragmentation approach is applied to losses as well as gains, the large stockholders will get the break while the small will not. Because this seems to be bad policy, as well as because fragmentation of losses may materially reduce revenues, I would apply the fragmentation principle to net gains but not to net losses. This creates a one-way street leading to the Treasury, to be sure, but so long as secs. 1231 and 1244 remain in the law. the Government can hardly be criticized for providing one instance in which it wins whichever way the coin falls.

II. CORPORATE COMBINATIONS

Corporate combinations epitomize the difficulty of framing an income tax law which will operate fairly to the Government and to all taxpayers. In a combination of two small, speculative, undercapitalized corporations, which have shown enough promise to have appreciated substantially in value but not enough to be as yet assured, fairness demands no tax on the pooling of the businesses, and commonsense as well as the experience of most practitioners attests that were a 25 percent tax imposed on the gain to one or both of the corporations or their stockholders, there frequently would be no deal. On the other hand, a merger of a small, speculative, undercapitalized corporation which has appreciated greatly in value into a large, listed, blue-chip corporation unquestionably gives the stockholders of the former a property interest which is totally different from what they had before and is realizable in cash at will, and fairness to the Government and to other taxpayers suggests that this transaction, which in financial substance is equivalent to a sale, should be subject to a capital gains

tax.

My inquiry will seek answers to these questions:

(a) In order to include the equivalent-to-a-sale combination in the tax base, should the "business pooling" combination be deprived of tax-free status too?

(b) Is there a feasible way to include the "sale" combination and exclude the "pooling" combination?

(c) Can other changes in the reorganization provisions significantly enlarge the tax base?

(d) Is there another approach to the combination problem which would enlarge the tax base without excessive interference with desirable business transactions?

A. Should the reorganization provisions be repealed?

My answer is a clear "No." First, the genuine pooling transactions, many of which a 25-percent gains tax would prevent, are too desirable in the economy to lose. Second, the reorganization provisions are desirable for the economy because they allow moderate-sized corporations to diversify their business and thereby remain effective competitors in the markets they serve. It is a fact of business life that a new line of business is far more easily entered through acquisition of a business already so engaged than through the assembly of management, engineering, sales and production staffs, and facilities. It is also a fact of business life that (a) moderate-sized corporations frequently do not have sufficient working capital to acquire a going business for cash, and (b) the owners of smaller businesses, who, more often than not for good business reasons,3 are seeking to combine with a larger corporation, are commonly willing to deal on the basis of a tax-free reorganization or on the basis of cash, but not on the basis of a taxable transaction involving a large block of only partially marketable stock. Repeal of the tax-free provisions, in my judgment, not only would prevent certain genuine and desirable pooling transactions from taking place, but also would strengthen the bargaining position of the larger, well-financed corporations in competing against

See Lintner, "Tax Considerations Involved in Corporate Mergers": "Federal Tax Policy for Economic Growth and Stability," 84th Cong., 1st sess. 690 (1955).

their smaller competitors for available small businesses. Antitrust policy is frequently advanced as a reason for repealing the reorganization provisions. In my judgment, so long as the antitrust laws are vigorously enforced by those responsible for their enforcement, total repeal of the tax-free reorganization provisions would be more likely to curtail than to promote competition.*

B. Can "sale combinations" be distinguished from "pooling combinations"?

To my knowledge three attempts have been made to draw such a distinction. Two seem to me to be ill-starred, the third to have some promise.

The Ways and Means Committee proposed in 1954 that the reorganization rules should be tighter for "private" than for "public" companies. The proposal was criticized, I believe soundly, on the ground that the distinction between "private" and "public" bore too little relation to the difference between a "pooling" and a "sale" to be acceptable.

Mr. Jerome D. Hellerstein has suggested that tax-free treatment be withheld whenever the stock received in the reorganization exchange is marketable. I think his suggestion would impose the capital gains tax on too many transactions that should not be so taxed, and I further suggest that the gray area of limited marketability may make his suggestion unworkable.5

The American Law Institute has suggested that tax-free treatment should be denied where one participant in the transaction is more than four times as large as the other. This suggestion has the virtue of logic, since an acquiring corporation can generally finance in cash a purchase price that is not more than a small fraction of its net worth, and the stockholders of the smaller corporation in such a transaction are likely substantially to improve the realizability of their investment even if solely voting stock is received. For reasons indicated in section. A above the ratio of 4 to 1 is too low and a ratio of about 8 to 1 would be preferable; but so modified I believe this suggestion has merit as a means of modestly enlarging the tax base in this area.

C. Other changes to enlarge tax base

The distinctions which now exist between the three methods of corporate combination-statutory merger or consolidation, acquisition of assets for stock, and acquisition of stock for stock-have been widely, and I believe justifiably, criticized as differences in form not supported by any sufficient differences in substance. The difficult issue is: To what common ground should all three methods be made to conform?

The more important specific questions into which this issue resolves itself are these:

1. What proportion of the assets or stock must be transferred? Because of possible avoidance if assets are separated from a partici

4 Posniak, "Looking Around: Effectiveness of Antitrust," vol. 37, No. 2, Harvard Business Review 29 (1959); see also, Cook, "Thinking Ahead, Trends in Merger Activity," ibid. at 15.

5 See Hellerstein, "Mergers, Taxes, and Realism," 71 Harv. L. Rev. 254 (1957). It is troublesome to me that under Mr. Hellerstein's proposal taxability would turn on marketability, which is a factual issue on which the Revenue Service will not and cannot rule. See American Law Institute, "Federal Income Tax Statute," February 1954 draft, vol. 11, pp. 312-313. The Ways and Means Committee in 1954 approved this principle for privately held corporations. Refinements to take care of affiliated groups would, of course,

be necessary.