In order for a transaction to be given non-recognition treatment under the reorganization provisions, it must meet certain requirements.
• The reorganization must meet certain tests in the Regulations regarding “continuity of interest” and “continuity of business enterprise.”
• The reorganization must be conducted according to one of seven patterns eligible for non-recognition.
• The reorganization must meet the judicially imposed condition requiring a “business purpose” for the transaction
• A plan of reorganization must exist and be adopted by each corporation involved in the transaction.
Continuity of Interest
Continuity of interest means that the shareholders retain a substantial proprietary interest in the continuing business. This concept was first developed by the court in Cortland Specialty Co. I, and is now contained in the Regulations:
1. The purpose of the continuity of interest requirement is to prevent transactions that resemble sales from qualifying for non-recognition of gain or loss available to corporate reorganizations. Continuity of interest requires that in substance a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization.’
2. To qualify for favorable treatment, the consideration package must contain stock of the acquiring corporation so that the target’s shareholders have an equity interest in the acquiring corporation. The IRS has indicated that for ruling purposes, at least 50 percent of the consideration should be stock of the acquiring corporation. This does not mean half of what each shareholder receives must be stock. Instead, the test is applied to the target’s shareholders as a group. As a result, an acquiring corporation has great flexibility in designing the package of consideration that the target’s owners will receive.
Continuity of Business Enterprise
Reorganization is classified as a nontaxable transaction because it results in a continuation of the business in modified form. To ensure that the business is continued, the Regulations contain a continuity of business enterprise requirement. To meet this requirement the acquiring corporation must either continue the target corporation’s historic business or use a significant portion of the target corporation’s assets in a business.