Tax-free reorganizations: new definition of continuity.

• Author: Galanis, William

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...