Proposed change to continuity-of-shareholder-interest requirement in acquisitive reorganizations.

Continuity of shareholder interest, along with continuity of business enterprise and business purpose, are the three judicial requirements for tax-free acquisitive and divisive reorganizations under Sec. 368. In an acquisitive reorganization, the continuity-of-shareholder-interest principle requires that (1) the historic shareholders of the acquired corporation receive in the acquisition a (2) sufficient (3) equity interest of the acquiring corporation (or a corporation in "control" of the acquiring corporation) with (4) no immediate plan or intention of disposing of the stock received. There are numerous cases, rulings, regulations and procedures describing and explaining these four elements.

Pre-Reorganization and Post-Reorganization Continuity

Because of their very subjective and factual nature, the first (pre-reorganization continuity) and fourth (post-reorganization continuity) elements have been the subject of litigation. Courts applying the step-transaction doctrine have struggled over such issues as:

[] Whether a sale of stock of a corporation to new shareholders, which preceded an otherwise qualifying reorganization of that corporation, was a step in the overall acquisition so as to make the old shareholders (rather than the new shareholders) the historical shareholders to be tested for continuity of shareholder interest.

[] Whether a sale by an acquired corporation's shareholders of the acquiring corporation's stock received in an otherwise qualifying reorganization was a step in the overall acquisition so as to fail the continuity-of-shareholder-interest requirement.

Many corporate tax practitioners believe the pre-reorganization and the post-reorganization continuity requirements are needlessly complicated. Because of the present requirement for pre- and post-continuity, what the holders of a significant number of shares of the acquired corporation do with their shares of the acquired corporation before the acquisition, or with their shares of the acquiring corporation after the acquisition, determines whether the acquisition qualifies as a reorganization. Thus, their actions determine the tax consequences not only to the holders themselves, but also to the acquiring and acquired corporations and to the other acquired corporation shareholders.

Post-Reorganization Continuity--Proposed Regulations

The IRS recently proposed to remedy the complexity in this area. When finalized, Sec. 368 regulations proposed Dec. 20,1996 will eliminate the post-reorganization continuity issue. Prop. Regs. Sec. 1.368-1(c) would provide that sales by a former acquired corporation shareholder of acquiring corporation stock (received in an otherwise qualifying reorganization) would not be taken into account in determining whether the continuity-of-shareholder-interest requirement is satisfied, unless the acquiring corporation has directly (or indirectly, through a related party) furnished the consideration to that shareholder. In other words, continuity of shareholder interest would be affected only to the extent that funds for the stock of the acquired corporation are furnished by the acquiring corporation or a related party. Even if, prior to an acquisition, an acquired corporation shareholder enters into a binding commitment to sell the acquiring corporation shares to be received in the acquisition to a third party unrelated to the acquiring corporation, funds received by the shareholder from that sale will not be considered in determining whether continuity of shareholder interest has been satisfied.

Pre-Reorganization Continuity

The IRS has not ignored the pre-reorganization continuity issue. The Service has announced that it is studying, and soliciting comments on, the effect of dispositions of an acquired corporation's stock before a transaction potentially qualifying as a reorganization. At least one comment has been submitted to the IRS suggesting that it apply the same rule proposed for post-reorganization continuity to pre-reorganization continuity (i.e., pre-reorganization sales of the acquired corporation's stock should be disregarded for purposes of the continuity-of-shareholder-interest requirement, unless the sales are made to the acquiring corporation or a related party).