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"Clowns to the Left of Me, Jokers to the Right,
Here I Am, Stuck in the Middle with You": The Inconsistent Tax Treatment of Security Holders in Tax-Free Reorganizations

56 Pages Posted: 26 Feb 2008  

Meredith R. Conway

Suffolk University Law School


Congress has repeatedly advocated for long-term investments in corporations over short-term investments. This position is illustrated by the tax-free reorganization provisions, and other tax provisions such as the special long-term capital gains rate and the dividend tax cut.

The difference between the tax treatment of holders of security instruments and the tax treatment of holders of non-security instruments is incompatible with sound public policy. The reorganization provisions in the Code benefit holders of stock, and penalize holders of long-term security instruments, while allowing holders of non-security debt instruments fully taxable treatment. Congress originally enacted the tax-free reorganization provisions to avoid taxing profits that were purely on paper and to avoid interfering with normal business adjustments.

Through modifications of the tax-free reorganization provisions, however, the tax treatment of security instruments conflicts with each and every legislative policy and directly conflicts with the legislative intent behind the provisions. Although an exchange of security instruments will be a purely paper transaction, security holders are taxed on any gain and prevented from recognizing any loss. By causing the tax treatment of security holders in a tax-free reorganization to be so unfavorable, Congress is interfering with normal business readjustments. Business readjustments may be restructured to avoid these tax implications to security holders; debt holders may opt to purchase short-term investments rather than long-term investments to avoid the unfavorable tax consequences altogether, or, rather than participate in the exchange at all, security holders may simply sell their security instrument outright to guarantee more favorable tax treatment. Security holders also are forced to pay tax on gain before they have ultimately converted their interests to cash. In addition, the amount of taxable gain that security holders are required to recognize does not accurately reflect their true economic gain. Rather, it is entirely possible that a taxpayer may in fact have an economic loss but because of the outdated measurement of principal amounts that the reorganization provisions use to determine gain, even with a loss the taxpayer may actually have to pay tax on a gain.

Suggested Citation

Conway, Meredith R., "Clowns to the Left of Me, Jokers to the Right, Here I Am, Stuck in the Middle with You": The Inconsistent Tax Treatment of Security Holders in Tax-Free Reorganizations. Catholic University Law Review, Vol. 56, p. 99, 2006. Available at SSRN:

Meredith R. Conway (Contact Author)

Suffolk University Law School ( email )

120 Tremont Street
Boston, MA 02108-4977
United States

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