Whether your tax-free reorganization is acquisitive or divisive in nature, it must have continuity and business purpose principles in order to avoid tainting the tax-free nature of the transaction. These principles constitute the rationale which the courts have developed over time for the nonrecognition of tax in reorganization transactions.
Business Purpose Principle
The business purpose principle relates to the non-tax purpose of the reorganization. The courts and the IRS are typically weary of transactions being carried out for tax avoidance reasons and will disqualify any tax-free organization whose purpose includes tax avoidance. A valid business purpose may include resolution of a shareholder dispute or a facilitation of a merger.
The continuity principle includes the continuity of interest and the continuity of business enterprise doctrines.
Continuity of Interest Doctrine
As the name suggests, the continuity of interest doctrine relates to the ownership role of stockholders after reorganization. Stockholders must continue to play a role in the business post-reorganization. This rule applies to all tax reorganizations except in a Recapitalization or Identity Change transaction. Continuity is preserved when the value of the target holders stock in the new corporation is at least 50% of the stock value previously held. In the event of a divisive reorganization, the stockholders of the divided corporation must hold at least 50% of the stock value of the newly formed corporation.
Continuity of Business Enterprise Doctrine
The continuity of business doctrine examines a business’ activities to determine whether they are continued or whether a significant portion of the assets are used after the reorganization. Meeting the requirements of either one of these activities will satisfy the continuity of business enterprise principle. In continuing business activities, at least one of the lines of business of the target must be continued after in the reorganization. Asset continuity is measured on a facts and circumstances basis. In general, the significance in the portion of the assets being used post-reorganization is measured by the relative importance of the asset to the operations, and not necessarily the quantity being used.
While each type of tax-free reorganization has additional statutory requirements, following these principles will help anchor your tax-free reorganizations in the future. For further information on tax reorganizations, feel free to contact me, Karen Burton at email@example.com, or one of my colleagues at CBIZ MHM Memphis.