New COSI rules eased for S Corporations.

• Author: Koppel, Michael D.

In January 1998, the IRS published temporary and proposed regulations (TD 8761) dealing with the application of the continuity-of-shareholder-interest (COSI) requirement in the context of pre-reorganization redemptions and extraordinary distributions. In the November 1998 issue of The Tax Adviser, there was a discussion of the problems these regulations posed for S corporations. Problems are likely to arise because it is quite common for S corporations, in anticipation of being acquired in a reorganization, to distribute their accumulated adjustments account (AAA). The temporary regulations generally treated such distributions as part of the consideration supplied by an acquiring corporation. This treatment could cause the equity supplied by the acquiring corporation to fall below the level needed to satisfy the COSI requirement.

Commentators had requested specific relief from the hardships caused by the temporary regulations. On Aug. 31, 2000, the Service published final regulations (TD 8898) that reject specific relief (i.e., no safe harbors). The final regulations do, however, provide some relief from the virtually "automatic" linkage between pre-reorganization redemptions (and extraordinary distributions) and satisfaction of the COSI requirement.

Under the temporary regulations, a distribution was taken into account for purposes of the COSI requirement, if it were made "in connection with" a potential reorganization. Under the final regulations, a proprietary interest in a target is not preserved to the extent that consideration received before a reorganization in a redemption of (or distribution on) target stock is treated as other property or money under Sec. 356, or would be so treated if the target shareholder had also received acquiring stock in exchange for the target stock (the Sec, 356 test). To determine whether the COSI requirement is satisfied, the final regulations treat each target shareholder as receiving some acquiring stock solely for purposes of applying the Sec. 356 test (but apparently not for any other purpose). However, the "in connection with" standard is still applied to determine the effect of distributions that occur subsequent to the reorganization on satisfaction of the COSI requirement.

Unfortunately, the law in the Sec. 356 area is somewhat unclear, which makes a Sec. 356 test difficult to apply with certainty whenever pre-reorganization redemptions or distributions occur. The final regulations do not...