Academic journal article Journal of Accountancy

Small Business Tax Solutions

Academic journal article Journal of Accountancy

Small Business Tax Solutions

Article excerpt

Q To ensure that a corporate merger will be treated as a tax-free reorganization by the Internal Revenue Service, how should the continuity of interest requirement be measured under the new regulations that have been proposed by the Treasury Department?

A. To qualify as a tax-free reorganization, a merger transaction must meet various statutory and regulatory section 1.368-1(b), is known as the continuity of interest requirement. The current regulations require that the acquired company's shareholders have a continuing and substantial proprietary interest as shareholders in the acquiring company. Historically, two primary tests have been applied to determine whether the continuity of interest rules are satisfied.


The first test looks at how much of the consideration the acquired company's shareholders receive is in the form of stock; the IRS position is that at least 50% must be stock (revenue procedure 77-31, 1977-2 CB 568). The courts, however, have allowed less -- going as low as 38% -- to find continuity of interest. In John A. Nelson Co. v. Helvering (296 U.S. 374 [1935]), the court said 38% nonparticipating preferred stock was adequate to establish continuity.

Once a company is acquired, a second test is how long its shareholders have held the stock they received in the reorganization. The IRS position historically has been that continuity of interest can be thwarted by post-transaction sales if there is a "preconceived plan or arrangement" to dispose of the acquiring company's stock (revenue ruling 66-23, 1966-1 CB 67). The courts have adopted this view when a shareholder intends to dispose of his or her stock as soon as possible after the reorganization (see McDonalds Restaurants of Ill., Inc. v. Comm'r, 688 F.2d 520 [7th Cir. 1982] and Robert A. Penrod, 88 TC 1415 [1987]).

This second test has resulted in significant litigation and uncertainty in structuring reorganization transactions. In an effort to simplify transaction structuring, the IRS has proposed new regulations that would all but do away with continuity of interest problems.


The basic premise of the proposed regulations is that continuity of interest would be measured almost solely by reference to the consideration furnished by the acquiring company. As long as the portion of consideration composed of stock is substantial (50% or more, according to the IRS), post-transation sales would be disregarded -- subject to a few exceptions. The proposed regulations appear to eliminate the need to analyze post-transaction dispositions under the so-called step transaction doctrine. …

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