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I. Introduction
Since the early days of the federal income tax, corporate reorganizations have received preferential treatment.1 For example, suppose Target Corporation (T) is merged into the acquiring corporation (P) with the T shareholders receiving P stock. The transaction qualifies as a reorganization under section 368(a)(1)(A), which provides that "the term 'reorganization' means a statutory merger or consolidation."2 Under section 354, T shareholders achieve the nirvana of tax-free treatment for gain realized on their exchange of T stock for P stock. Similarly, gain realized on T's transfer of assets to P by operation of law under the applicable merger statute will qualify for nonrecognition under section 361.
The most commonly expressed reason for nonrecognition treatment is that the reorganization exchange involves a mere change in the form of ownership, or, as described by the regulations under section 368, it involves a mere readjustment of the shareholders' continuing interest in property under modified corporate form.3 The reason is less than compelling. By exchanging their T stock for P stock, the T shareholders give up a portion of their interest in T's assets and earnings in exchange for an interest in P's assets and earnings. Indeed, if the value of T is small compared to the value of P, the T shareholders' newly acquired interest in P's assets and earnings will overwhelm their retained interest in T's assets and earnings.
Suppose, for example, that prior to the merger the net worth of P is $99,000,000 and the net worth of T is $1,000,000. Following the reorganization, the T shareholders will presumably hold 1% of the P stock (worth $1,000,000), and the P shareholders will hold 99% of P stock (worth $99,000,000). The T shareholders will have exchanged their 100% indirect ownership interest in T's assets and earnings for a 1% indirect ownership interest of the combined PT assets and earnings, 99% of which are attributable to P and 1% of which are attributable to T. In other words, this "mere change in the form of ownership" really involves an exchange byT shareholders of 99% of their interest in T's assets and earnings for an interest in P's assets and earnings. Ordinarily, of course, such an exchange would be taxable. If, for example, T shareholders simply exchanged...