AuthorBrown, Fred B.
  1. INTRODUCTION 427 II. OVERYIEW OF NONRECOGNITION RULES 431 A. General Nonrecognition Rules 431 1. Like Kind Exchanges 431 2. Involuntary Conversions 432 3. Wash Sales 433 B. Nonrecognition Rules Applying to Corporation-Shareholder Transactions 433 1. Corporate Formations and Transfers to Controlled Corporation 433 2. Acquisitive Corporate Reorganizations 434 a. In General 434 b. Consequences to the Parties 436 3. Corporate Divisions 437 a. In General 437 b. Consequences to the Parties 439 4. Parent-Subsidiary Corporate Liquidations 440 C. Nonrecognition Rules Applying to Partnership-Partner Transactions 440 1. Partner Contributions 440 2. Partnership Distributions 441 III. EVALUATION OF POLICIES UNDERLYING NONRECOGNITION 441 A. Overview 441 B. Efficiency 443 1. In General 443 2. Neutrality 444 a. Basic Argument for Nonrecognition 444 b. More Refined Argument for Nonrecognition 446 c. Evaluation of Argument for Nonrecognition 448 i. Determining Time Two Benefits 448 ii. Determining Time Two Costs 454 iii. Determining Time One Costs 458 iv. Efficiency Costs of Raising Revenue Lost Due to Nonrecognition 459 3. Correcting for Market Imperfections 460 a. Argument for Nonrecognition 460 b. Evaluation of Argument for Nonrecognition 461 C. Equity 464 1. Argument for Nonrecognition 465 2. Evaluation of Argument for Nonrecognition 466 D. Administrability 469 1. Valuation 469 a. Argument for Nonrecognition 469 b. Evaluation of Argument for Nonrecognition 471 2. Liquidity 474 a. Argument for Nonrecognition 474 b. Evaluation of Argument for Nonrecognition 475 E. The Effect of Other Policies 477 1. Compromise Between Accretion and Consumption Taxes 477 2. Corporate Tax Policy 478 F. Summary 480 IV. A STANDARD FOR DESIGNING NONRECOGNITION RULES 481 A. Generally Discard Similar Replacement Property Factor 481 B. Use Difficult-to-Value Property Factor 484 C. Use Illiquid Property Factor 485 D. Use Rules That Are Narrowly Tailored to Common Transactional Forms Typically Selected for Significant Non-Tax Reasons 486 E. Adhere to Corporate Tax Policies 489 F. Overall Standard for Designing Nonrecognition Rules 489 V. USING THE STANDARD TO DESIGN NONRECOGNITION RULES 490 A. Current Examples That Are Similar to the Recommended Approach for Designing Nonrecognition Rules 491 B. Revisions to Specific Nonrecognition Rules 494 1. Like Kind Exchange Rule 494 2. Corporate Formations and Transfers to Controlled Corporations 496 3. Acquisitive Corporate Reorganizations 501 a. Definition of Acquisitive Reorganizations 501 b. Shareholder Consequences 503 c. Corporation Consequences 509 4. Corporate Divisions and Distributions of Stock in Other Corporations 511 5. Parent-Subsidiary Corporate Liquidations and Other Liquidations Involving Corporate Shareholders 517 6. Partner Contributions 519 7. Partnership Distributions 520 VI. CONCLUSION 521 I. INTRODUCTION

    Under the Internal Revenue Code (Code), when a taxpayer sells, exchanges, or otherwise disposes of property, the taxpayer realizes gain equal to the excess of (1) the amount of money received plus the fair market value of the property received in the disposition over (2) the taxpayer's adjusted basis in the property disposed of; on a disposition, the taxpayer realizes loss equal to the excess of (1) the taxpayer's adjusted basis in the property disposed of over (2) the amount of money received plus the fair market value of the property received in the disposition. (1) In general, any realized gain or loss has to be recognized, (2) that is, included in income if a gain (3) (absent an applicable exclusion), and potentially deductible if a loss. (4)

    If, however, a transaction meets the requirements of a nonrec-ognition rule, the realized gain or loss is not taken into account for the year in which the disposition occurred but instead is normally deferred through the application of special rules for determining adjusted basis. (5) Included among the nonrecognition rules contained in the Code are provisions applying to like kind exchanges, corporate formations, corporate reorganizations, parent-subsidiary liquidations, and partnership formations and distributions. (6) In some way, most nonrecognition rules require that the property received by the taxpayer in the transaction be somewhat similar to the property relinquished by the taxpayer in the transaction. (7) The rationale for nonrecognition rules has always been somewhat vague, yet these rules are a prominent feature of the income tax laws and are a source of considerable complexity and tax planning. (8)

    This Article engages in an evaluation of the nonrecognition rules contained in the Code and, based on this analysis, proposes a standard for designing nonrecognition rules. The policies that arguably support the nonrecognition rules include the familiar trio of tax policy concerns--efficiency, equity, and tax administration. (9) Regarding efficiency, the view is that where a taxpayer exchanges an asset for an asset that is somewhat similar, a taxpayer may be deterred from engaging in the transaction if there was current taxation, given that the exchange may lack significance as far as changing a taxpayer's economic position.(10) The equity basis for nonrecognition is that such a taxpayer may be viewed as being similarly situated to a taxpayer who continues to hold the same property, and because the continued holder would not be taxed currently on any appreciation in the value of the property, then neither should the taxpayer who exchanges the property for similar property. (11) The tax administration policies that arguably support non-recognition are based on the perceived valuation difficulties and liquidity concerns that occur when taxing a transaction where a taxpayer receives property other than cash. (12)

    None of these policies, however, provide a strong basis for most of the nonrecognition rules as currently formulated. The efficiency case generally lacks evidentiary support, given that empirical evidence is lacking, and it is generally difficult to draw well -supported conclusions from general observations. (13) The equity case is complicated by the fact that the rules operate in a second-best world where the tax base deviates from economic income. (14) Horizontal equity comparisons are based on the ability to pay tax, and tax policy analysts usually treat economic income as the best metric to gauge ability to pay. With economic income as the basis for comparisons, horizontal equity provides no support for nonrecognition. (15) And the tax administration argument for the rules, while plausible in theory, is compromised because non-recognition frequently occurs where there are no valuation and liquidity concerns as a result of the receipt of publicly traded property or the presence of related cash sales. (16)

    This Article generally dispenses with the efficiency and equity bases for the nonrecognition rules because of the aforementioned flaws. (17) As a result, the similar replacement property factor, which is a product of these rationales for nonrecognition and currently is prominent in most nonrecognition provisions, should be generally discarded; except in limited cases, there does not appear to be a strong justification for nonrecognition based on the degree of similarity of the property received to that transferred. (18) Instead, this Article mainly focuses on the following as being the appropriate, supportable policies in designing nonrecognition rules: valuation and liquidity difficulties, which can arise in some in-kind exchanges; and minimizing the likelihood that transactions are structured to take advantage of nonrecognition rules. (19) Moreover, because nonrecognition can be inconsistent with certain policies concerning the taxation of corporations and their shareholders, such policies should also be taken into account in formulating nonrec-ognition provisions. (20)

    Thus, this Article proposes a standard for designing nonrec-ognition rules that generally ignores the similarities or differences in the relinquished and replacement properties, unless the properties are either identical or possess a very high degree of similarity, (21) and instead takes into account the following: presence of difficult-to-value property, (22) presence of illiquid property, (23) use of rules that are narrowly tailored to common transactional forms that are typically selected for significant non-tax reasons, (24) and adherence to certain corporate tax policies. (25) The Article then evaluates the current non-recognition rules in light of this standard and recommends certain reforms, which include: (1) eliminating nonrecognition for like kind exchanges; (26) (2) eliminating the control requirement for shareholders to receive nonrecognition upon transfers to corporations, but generally taxing shareholders on the transfer or receipt of publicly traded stock; (27) and (3) permitting nonrecognition in corporate reorganizations irrespective of satisfying continuity of interest or continuity of business enterprise requirements, but taxing shareholders on the receipt of publicly traded stock. (28) Overall, the recommended approach and reforms should serve to rationalize and simplify the nonrecogni-tion rules contained in the Code.

    The Article proceeds as follows. Part II provides an overview of the nonrecognition rules contained in the Code. Part III engages in a critical evaluation of the policies that arguably support nonrecognition. This Part ultimately concludes that although efficiency benefits can be presumed to support nonrecognition in limited cases, the key policies for designing nonrecognition rules should generally be the administrative concerns of valuing property and taxpayer liquidity, minimizing the structuring of transactions to take advantage of nonrecognition, and ensuring that nonrecognition is not inconsistent with certain corporate tax policies. Based on these policies, Part IV develops the aforementioned standard...

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