New COSI rules pose problems for S corporations.

The continuity of shareholder interest (COSI) requirement has long been a nonstatutory component of the reorganization rules. Generally, the COSI requirement is intended to ensure that, to qualify as a reorganization exchange, the shareholders of the acquired corporation must continue their equity investment in the acquiring corporation. The quality and quantity of that equity investment are the two basic elements of the COSI requirement. Assuming compliance with these two basic elements, there has been a further issue as to how long the former target shareholders must retain that equity investment. This additional requirement, known as "post-reorganization continuity," has been the subject of litigation over the years.

In January 1998, the Service issued final regulations on the COSI requirement, substantially liberalizing its traditional formulation (TD 8760). The new regulations no longer impose a time-sensitive post-reorganization continuity. Instead, Regs. Sec. 1.368-1 (e) (1) focuses on the reorganization exchange itself--the quality and quantity of the equity investment in the acquiring corporation obtained by the shareholders of the acquired corporation.

At the same time these final regulations were issued, the IRS also issued Prop. and Temp. Regs. Sec. 1.368-1T, covering the pre-reorganization timeframe. Although a pre-reorganization COSI requirement had long been part of the Service's ruling policy, it has not previously been an explicit part of the regulations. Under the proposed regulations, pre-reorganization redemptions of target stock and extraordinary distributions with respect to target stock will be taken into account in determining the extent to which the value of the target's equity interest has been preserved.

Example: Individual A owns 100% of Target T, worth $100. Prior to, and in connection with a merger of T into Corporation X, T makes an extraordinary distribution of its $85 note to A. In the merger, A receives X stock with a value of $15 and X assumes T's obligation on the note. As a result, the merger does not qualify as a reorganization because of a failure to preserve a substantial part of T's value in the form of X stock.

At the May 26, 1998 hearing on the proposed regulations, a former Chair of the AICPA Tax Division's S Corporation Taxation Committee testified as to the potential negative impact the proposed rule would have on S corporations. S corporations typically distribute approximately 45% of their annual income to cover their shareholders' Federal and state tax liabilities; the remaining 55% is often left to accumulate under the rules of Sec. 1368(e)(1) (accumulated adjustment accounts (AAAs)). If an S corporation is to be acquired in a tax-free reorganization, the S shareholders have an incentive to distribute the AAA balance, before it loses its tax-free character as a result of the reorganization. Under the proposed rule, such a distribution (depending on the amount) could cause the putative reorganization to fail the COSI requirement.

The witness argued that Sec. 1371(a) confers on S corporations a significant degree of immunity from the normal operation of the subchapter C rules: Subchapter C does not apply to S corporations, to the extent its application would be "inconsistent" with subchapter S. According to this argument, the proposed rule would be "inconsistent" with tax-free withdrawals from the AAA. Accordingly, the witness suggested the adoption of a special rule for S corporations, allowing for AAA distributions without implicating the COSI requirement. The IRS panelists at the hearing were not sympathetic to the unique status of S corporations, and were not persuaded by the "language of Sec. 1371 (a)" argument.

If the Service does not amend the proposed regulations, it would appear that S corporations would have to consider a change in strategy (e.g., distributing a greater portion of current earnings), to avoid a build-up of AAA that could cause problems in the event of a reorganization.

Editor's note: This department is written by the AICPA Tax Division's professional staff. It is designed to heighten awareness of the Division's work and keep readers apprised of Tax Division activities involving tax policy, technical issues and other practice support matters.

Mr. White's views, as expressed in this column, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

George L. White, CPA
Technical Manager
AICPA Tax Division
Washington, D.C.