Small business tax solutions.

This article is part of a regular series covering tax issues of special interest to small businesses based on questions from the American Institute of CPAs tax certificate of educational achievement (CEA) courses on tax planning and advising for closely held businesses. This month, tax CEA author Bryan E. Bloom, JD, LLM, a partner and tax attorney with WRH Partners, Morristown, New Jersey, discusses corporate reorganizations.

Q A number of my clients own corporations that have been acquired by public companies. The stock in their closely held businesses was exchanged for stock in the public company. In each case, the first question they ask - during the negotiations or after the transaction - is how long must they hold the stock in the new company before they can sell it.

A This common question focuses on two underlying aspects of all corporate reorganizations: continuity of interest and the "step transaction" doctrine. For a transaction to qualify as a tax-free reorganization, it must meet three threshold requirements:

* Business purpose.

* Continuity of business enterprise.

* Continuity of interest.

It is the last requirement that limits dispositions of stock acquired in a tax-free reorganization.

Treasury regulations section 1.368-1(b) requires shareholders of the acquired company to have a continuing and substantial proprietary interest as shareholders of the acquiring company. The continuity-of-interest doctrine has two important aspects, quantitative and temporal. The quantitative test looks at how much of the consideration received by shareholders must be in stock. The Internal Revenue Service position is that it must be at least 50% (revenue procedure 77-37, 1977-2 C.B. 568). The IRS says the 50% test takes into consideration redemptions and other dispositions before the reorganization.

Case law allows less than 50% of the consideration to be in stock, going as low as 38% to find continuity. In John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935), 38% of nonparticipating preferred stock was considered adequate.

Example. Adams and Barnes each own 50% of Testco. Bigco offers to acquire Testco for $1 million. In the IRS's view, the continuity-of-interest test will be met as long as Adams and Barnes receive $500,000 of Bigco stock. Under Nelson, the amount of stock required is only $380,000. (For this purpose the consideration received by Adams and Barnes is combined in testing for continuity.)

Once Adams and Barnes acquire Bigco stock, the temporal issue is how long Adams, for example, must hold her Bigco stock. The IRS view is that continuity of interest can be thwarted by posttransaction sales if there is a "preconceived plan or arrangement" for disposition of the acquiring company's stock (revenue ruling 66-23, 1966-1 C.B. 67). The courts have adopted this view when the shareholder - Adams in the above example - intended to dispose of her stock as soon as possible after the reorganization (McDonalds Restaurants of Ill., Inc. v. Commissioner, 688 F.2d 520 [7th Cir. 1982]; Robert A. Penrod, 88 T.C. 1415 [1987]).

The McDonalds and Penrod cases often are a starting point for researching this issue, because shareholders of the acquired corporations negotiated for the right to sell their stock as soon as possible. This light was found to adversely affect continuity of interest. In McDonalds, it was the taxpayer that was arguing continuity was not satisfied - in an effort to get a step-up in the basis of the acquired assets. From a practical standpoint, the right to sell stock immediately (or at least enough stock to cause the stock component to drop below the required amount) should not be a condition of the merger. A shareholder should be able to represent that he or she has no present plan or intention to dispose of the stock.

A recent Tax Court case reviewed the continuity-of-interest rules with respect to pretransaction sales and purchases. The issue was whether the shareholder receiving stock must be a historic shareholder and not someone who bought stock in anticipation of the merger. In J.E. Seagram Corp. v. Commissioner, 104 T.C. No. 4 (1995), the Tax Court held that effectively there is no pretransaction continuity-of-interest requirement. Instead, continuity is measured based on the percentage of consideration received that constitutes a continuing equity ownership interest in the acquiring company when the reorganization is completed.

Example. Adams own 70% of Testco and Barnes owns 30%. Adams wants cash and Barnes wants stock in any sale of the company. To satisfy the continuity rules, Adams sells her stock to Collins, who is willing to accept Bigco stock; Bigco then merges with Testco. Under Seagram, continuity of interest still is met.

It may be relevant that in Seagram, the taxpayer was arguing continuity was lacking. Seagram acquired a large stake in Conoco but eventually was outbid by DuPont, which acquired Conoco for cash and stock in what it thought was a tax-free reorganization. Seagram, however, had a $530 million loss on the transaction. To recognize that loss, Seagram had to argue continuity was lacking. As noted above, the Tax Court ruled against the taxpayer (see "Seagram and DuPont: Exploring Continuity," page 32, for more details).