A Trap for the Unwary in the COI Regs.

By Rick Bailine, J.D., LL.M.

Editor: Neal A. Weber, CPA

Corporations & Shareholders

All forms of acquisitive reorganizations as defined in Sec. 368 require that there be a continuity of interest (COI) in the transaction. The doctrine was first made applicable by the courts, not by any statute, so it has been referred to as a judicial doctrine. However, for at least 50 years COI has also been firmly ensconced in the regulations. For much of its long history COI required that to qualify under Sec. 368 as a reorganization, a significant portion of the consideration to be received by the shareholders of an acquired corporation had to be stock of either the acquiring corporation or the direct parent of the acquiring corporation. A parent is a corporation that controls—as defined in Sec. 368(c)—the acquiring corporation.

The notion of what was a “significant” portion of the total consideration to be received was debated somewhat, but in the final analysis most practitioners were quite comfortable if at least 40% of the value of the total consideration to be received was stock of the acquiring corporation (see John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935)). In addition, the acquired company shareholders were required to hold the acquiring corporation stock that they received for some period of time. To the chagrin of many business people, there was no indication of just how long the acquired corporation shareholders had to hold onto the stock received. Was a year long enough? How about two years? In fact, the answer was quite vague in that it was driven by the step-transaction doctrine. In very general terms, this meant that the acquiring corporation stock had to be retained until its disposition was not related to the acquisition—that is, the acquisition and the subsequent divestiture of stock had to be unrelated events.

This vagueness about how long the stock of the acquiring corporation had to be retained after the acquisition led to a significant change to the COI regulations in 1998, which is now embodied in Regs. Sec. 1.368-1(e). These regulations changed the COI requirement by eliminating the requirement that the stock of the acquiring corporation be retained post-acquisition. COI is now satisfied even if the stock of the acquiring corporation is sold immediately after the acquisition. In fact, the shareholders of the acquired corporation can even divest the stock they receive pursuant to a binding obligation entered into before the acquisition (see Regs. Sec. 1.368-1(e)(8), Example (1)). The shareholders of the acquired corporation have thus been freed from the obligation to hold the stock they received; they can hold it, divest it, or any combination of the two.

There is but one caveat that the shareholders of the acquired company should be mindful of: They may not divest the stock they receive to a party that is related to the issuing corporation. The issuing corporation is simply the corporation whose stock was issued as consideration in the acquisition. But who is a related person? The good news is that this term is defined in Regs. Sec. 1.368-1(e)(4). Thus, any sale of the stock received to any party that falls outside the definition of a related party is fine, and such a sale will not prevent the underlying acquisition from meeting COI. On the other hand, any sale of such stock to a related party can cause the underlying acquisition to fail COI and therefore become a taxable acquisition.

Example 1: P owns all the stock of both X and Y. T is the target corporation, and its stock has a fair market value (FMV) of $1,000. T is owned 100% by A, an individual. P, X, Y, and T are all domestic corporations. Assume that under one plan T merges in a statutory merger with and into X; under the merger, A will receive $600 of X stock and $400 of cash.

At this point, this appears to be a tax-free A reorganization as defined in Sec. 368(a)(1)(A). The fact that A has received both X stock and cash is not problematic because mixed consideration is acceptable in an A reorganization, and COI is satisfied because 60% of the total consideration consists of X stock—i.e., stock of the acquiring corporation.

Example 2: A sells all the X stock received to his brother-in-law B. Other than being A’s brother-in-law, B bears no relationship to any other party to the merger. This sale of X stock by A has no impact on the determination of whether the underlying merger qualifies as a tax-free reorganization. As stated above, under the 1998 COI regulations, sales of stock by the target shareholders are immaterial unless such sales are made to a party related to the issuing corporation. Here the issuing corporation is X, and B, the buyer of the X stock, has no relation to X. Thus, this sale is simply not material to the determination.

But what if A sells the X shares received to Y for cash? Is that sale also immaterial to our analysis? The answer lies in Regs. Sec. 1.368-1(e)(4), which details who is related to the issuing corporation. The first rule to be gleaned from this regulation is that only corporations can be related to the issuing corporation. But Y is a corporation, so we need to go further. We can quickly ascertain that Y is related to X, because both X and Y are members of an affiliated group (see Regs. Sec. 1.368-1(e)(4)(i)(A)). This example illustrates the basic notion of when sales of issuing corporation stock post-acquisition will or will not affect COI. To reiterate, the general rule is that sales to parties related to the issuing corporation are taboo, while sales to parties unrelated to the issuing corporation are just fine.

But a trap for the unwary lies more deeply hidden within these rules, and it relates to when one must test to see if the party that acquires the stock of the issuing corporation is related to that corporation. Common sense might make one think that the time for testing to see if there is a prohibited relationship between the acquiring party and the issuing corporation would be just before and just after the purported reorganization. Unfortunately, as is frequently the case in corporate tax, common sense is not the correct barometer. Rather, the time for testing to see if a prohibited relationship is present is revealed in Regs. Secs. 1.368-1(e)(4)(ii)(A) and (B). As detailed in this regulation, a corporation that was wholly unrelated to the issuing corporation both immediately before and immediately after the purported reorganization may still be defined as a related party such that cash purchases by that corporation may foil COI. Again, an example illustrates the situation.

Example 3: P still owns X and Y, and all are domestic corporations. Assume that X will merge with and into Y in what appears to be an A reorganization. The business reason for this merger is that Z, also a domestic corporation, has approached P to buy stock of both X and Y, and the merger will facilitate this by combining X and Y so that post-merger P can simply sell all the stock of Y, the survivor of the merger, to Z.

Clearly there will be no issue relating to COI in the merger, because Z, the party that will be buying the stock of Y (the issuing corporation) is unrelated to Y both immediately before and immediately after the merger. In fact, because Z is totally unrelated to Y (and P and X for that matter), Z’s purchase of the Y stock will be a qualified stock purchase (QSP) as defined in Sec. 338(h)(3).

When one corporation (Z) makes a QSP of another corporation (Y), and that acquired corporation then participates in a purported reorganization after the QSP, COI is measured with reference to the buyer. This means that once Z has purchased Y, if Z then causes Y to merge with some other corporation (Q), an evaluation of COI in that merger would focus solely on Z. The fact that Z has just acquired Y would not be a concern for COI in the Y-Q merger (see Regs. Sec. 1.338-3(d)). Stated as a general rule, this means that a QSP followed by a reorganization of the acquired corporation is not problematic. However, note that in our case we will not have a QSP followed by a reorganization; we have the opposite—a reorganization followed by a QSP. Is that version of the deal also allowed?

As noted above, one would certainly think that a reorganization followed by a QSP would not present any COI issues; after all, to have a QSP the corporation making the acquisition must be unrelated to the issuing corporation. But herein lies the trap for the unwary. Regs. Sec. 1.368-1(e)(4)(ii)(B) contains the following language: “A corporation . . . will be treated as related to the issuing corporation if the relationship is created in connection with the potential reorganization.” Recall that P will cause X to merge into Y to facilitate the sale by P of the Y stock to Z. Given this fact, it would seem difficult, at best, to maintain that Z’s relationship to Y did not occur “in connection with” the merger of X and Y. Moreover, after Z has purchased 100% of the Y stock, Z and Y will certainly be related.

It thus seems clear that Z’s purchase of the Y stock after the merger with X will run afoul of the COI regulations, such that the merger will be taxable to X and X’s shareholder, P. P likely does not care, because it was P’s plan to sell Y anyway, so P would be taxed on the combined value of the X and Y stock. But it is doubtful that anyone would anticipate a corporate-level tax to X on the “sale” of its assets to Y. The tax for that sale is rightfully one that would go on X’s final tax return while X was owned by P. But if no one was aware that COI potentially failed in the merger, no tax would be reported on that final tax return. Z is now the owner of Y, and Y is the successor to X by reason of the merger. Thus, it is altogether possible that the IRS will seek tax from Z, an event that Z did not plan.

The lesson to be learned here is that a QSP followed by a reorganization presents no COI concern, but a reorganization followed by a QSP may well present significant COI concerns. Taking this lesson and applying it to our facts, what should be done is that Z should purchase the stock of both X and Y—each purchase being a QSP—and then Z will be free to merge X into Y (or vice versa) without concern under COI.


Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.

For additional information about these items, contact Mr. Weber at (202) 370-8213 or neal.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

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