Tax-free reorganizations: new definition of continuity.

On Jan. 23, 1998, the IRS issued final regulations on the satisfaction of the continuity-of-shareholder-interest (COSI) and continuity-of-business-enterprise (COBE) requirements for corporate reorganizations. The final regulations basically adopt the proposed regulations with respect to the impact of post-reorganization events on the COSI and COBE requirements, but also contain several taxpayer-favorable modifications. In addition, the Service issued temporary and proposed regulations extending the new COSI rules to pre-reorganization transfers of stock. The final regulations apply to transactions occurring after Jan. 28, 1998.

Continuity of Shareholder Interest

Previously, COSI generally required the shareholders of a target corporation (Target) to maintain a continuing proprietary interest in the post-reorganization entity. Thus, COSI was satisfied when Target shareholders received stock in the acquiring corporation (Acquiror) representing a minimum percentage (e.g., 40%) of the total consideration received for their Target stock. The proposed COSI, regulations shifted the focus away from the retention of Acquiror stock and towards the exchange between Acquiror and the Target shareholders, finding COSI generally satisfied if the Target shareholders receive a proprietary interest in the Acquiror in the reorganization; what the Target shareholders did with the Acquiror stock after receiving it generally was ignored.

The final regulations now confirm that Target shareholders can sell Acquiror stock received in the reorganization third parties shortly after receiving it without causing the reorganization to fail to satisfy the COSI requirement. In addition, the final regulations largely dispel notions of "historic shareholders," and provide that sales of stock prior to a reorganization are generally disregarded. In short, sales of stock by former target shareholders to third parties are disregarded both before and after the reorganization. However, this treatment does not apply to sales of Target stock to Acquiror or persons related to Acquiror. The final regulations provide that a "sale" is a transfer of Acquiror stock for consideration other than a proprietary interest (e.g., stock) in Acquiror. Compared to the proposed regulations, the final regulations also adopt a narrower definition of a "related person," generally limiting the definition to corporations that are either members of the same affiliated group or for which the sale would be treated as a redemption of the stock under Sec. 304(a)(2).

Final COSI Regulations' Effect on Judicial Precedents 

The final regulations effectively overrule the COSI law established in cases such as McDonalds Restaurants of Illinois, Inc., 688 F2d 520 (7th Cir. 1982); Penrod, 88 TC 1415 (1987); Heintz, 25 TC 132 (1955), nonacq., 1958-2 CB 9; Estate of Christian, TC Memo 1989-413; and Rev. Rul. 66-23. The final and temporary regulations adopt and expand the holding of J.E. Seagram Corp., 104 TC 75 (1995), that sales of Target stock prior to a potential reorganization do not affect COSI if not part of the plan of reorganization. However, when a premerger acquisition of Target stock by Acquiror is not "old and cold" (i.e., can be "stepped together" with the later reorganization), COSI is not satisfied if the Target stock had been acquired for other than Acquiror's stock. Thus, the final regulations adopt the holdings in King Enterprises, Inc., 418 F2d 511 (Ct. Cl. 1969) and Yoc Heating Corp., 61 TC 168 (1973).

Redemptions of Target Stock; Extraordinary Distributions

In conjunction with the final COSI regulations, the Service also issued temporary regulations on Jan. 23, 1998, providing that COSI is not satisfied if, in connection with a reorganization, Target stock is redeemed or acquired by Target or a corporation related to Target prior to the reorganization, regardless of the source of the funding for the redemption. COSI also is not satisfied to the extent that, prior to (and in connection with) a reorganization, Target shareholders receive an extraordinary dividend with respect to their Target stock. These temporary regulations represent a significant departure from the prior treatment of redemptions.

Continuity of Business Enterprise

COBE generally requires the Acquiror to either continue a significant historic Target business or use a significant portion of Target's historic business assets in a business. The proposed and final regulations treat Acquiror as satisfying COBE if a member of the "qualified group," or in certain cases a partnership that has a member of the qualified group as a partner, conducts a Target business or owns Target assets. A "qualified group." is one or more chains of corporations connected through stock ownership with Acquiror, but only if Acquiror directly owns stock meeting the requirements of Sec. 368(c) (80% vote and 80% value) in at least one of the corporations, and stock meeting the requirements of Sec. 368(c) in each of the corporations is owned directly by one of the other corporations. Thus, the Acquiror is treated as holding all the assets, and conducting all the businesses, of its qualified group. In a Type A, B, C or G reorganization, Acquiror may transfer part or all of the acquired assets or stock to one or more members of the qualified group. Note that, while the test for membership in a "qualified group" is similar to the Sec. 1504 test for affiliation, they are not the same. Specifically, the test for membership in a "qualified group" includes ownership of "pure vanilla" preferred stock and requires direct ownership of stock.

The final COBE regulations apply to all reorganizations for which COBE is relevant. The final COBE regulations clarify that they apply only to the COBE requirement, and do not address satisfaction of the explicit statutory requirements of a reorganization. Thus, a transaction must be evaluated under other relevant provisions, including the step-transaction doctrine. For example, it would appear that a B reorganization followed by a liquidation of Target pursuant to the same plan would still be tested as an asset acquisition.