Designing Nonrecognition Rules Under the Internal Revenue Code

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Fred B. Brown


Nonrecognition rules are a prominent feature of the income tax laws and are a source of considerable complexity and tax planning. Included among the nonrecognition rules contained in the Internal Revenue
Code are provisions applying to like kind exchanges, corporate formations, corporate reorganizations, parent-subsidiary liquidations, and partnership formations and distributions. The policies that arguably support the nonrecognition rules include the familiar trio of tax policy concerns—efficiency, equity, and tax administration. 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. 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. And the tax administration argument for the rules, while plausible in theory, is compromised because nonrecognition 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. This Article generally dispenses with the efficiency and equity bases for the nonrecognition rules because of the aforementioned flaws. 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. This Article proposes a standard for designing nonrecognition 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, and instead takes into account the following:
presence of difficult-to-value property, presence of illiquid property, use of rules that are narrowly tailored to common transactional forms that are typically selected for significant non-tax reasons, and adherence
to certain corporate tax policies. This Article then applies this standard as a basis for suggesting revisions to the current nonrecognition rules. Included among the recommended reforms are (1) eliminating nonrecognition for like kind exchanges; (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 property; 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. Overall, the recommended approach and reforms should serve to rationalize and simplify the nonrecognition rules contained in the Internal Revenue Code.

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