IRS Eases Restrictions on Tax-Free Reorganizations

2 min

Although structuring a business acquisition as a tax-free reorganization can provide substantial income tax benefits to the participants, some of the income tax law requirements impose major restrictions on the participants' post-reorganization activities. In a surprising move this winter, the IRS proposed new regulations that significantly liberalize several of the post-reorganization restrictions that affect both the acquiring corporation and the shareholders of the target corporation.

These restrictions, commonly known as the continuity of interest, the remote continuity of interest and the continuity of business enterprise doctrines, generally limit the amount of stock that target shareholders can sell after a tax-free reorganization and limit the acquiring corporation's ability to reorganize the business that it acquired. If the reorganization participants violate any of these restrictions, then the reorganization could loose its tax-free status, potentially resulting in large, unexpected income tax assessments. The proposed regulations, if adopted, would allow both selling shareholders and acquiring corporations to engage in a greater range of post reorganization activities.

Simply stated, the continuity of interest doctrine requires target corporation shareholders to retain half of the stock that they received in a tax-free reorganization for a substantial period of time (usually one year). If the proposed regulations are enacted in their current form, this holding requirement will be eliminated and, in most cases, target shareholders will be free to sell any stock that they receive immediately after the tax-free reorganization. This change should make tax-free re-organizations more attractive to target shareholders that were unwilling to hold shares in the acquiring corporation after the transaction because of potential changes in market value.

The remote continuity of interest and the continuity of business enterprise doctrines impose strict limits on an acquiring corporation's ability to transfer the stock or assets of an acquired corporation after a tax-free reorganization. These doctrines often require acquiring corporations to wait until an acquisition is "old and cold" before reorganizing the ownership or the business operations of an acquired corporation.

The proposed regulations substantially modify these rules and allow acquiring corporations to immediately transfer acquired stock or assets to certain corporate or partnership affiliates.

The proposed regulations provide much needed flexibility for tax-free reorganizations and have been well received by most practitioners and commentators. Public hearings on these regulations are scheduled to occur this spring.

For more information about the proposed regulations or tax-free reorganizations in general, call Wallace E. Christner at (202) 962-4988 or e-mail