In January 1998, the IRS published temporary and proposed regulations (TD 8761) dealing with the application of the continuity-of-shareholder-interest (COSI) requirement in the context of pre-reorganization redemptions and extraordinary distributions. In the November 1998 issue of The Tax Adviser, there was a discussion of the problems these regulations posed for S corporations. Problems are likely to arise because it is quite common for S corporations, in anticipation of being acquired in a reorganization, to distribute their accumulated adjustments account (AAA). The temporary regulations generally treated such distributions as part of the consideration supplied by an acquiring corporation. This treatment could cause the equity supplied by the acquiring corporation to fall below the level needed to satisfy the COSI requirement.

Commentators had requested specific relief from the hardships caused by the temporary regulations. On Aug. 31, 2000, the Service published final regulations (TD 8898) that reject specific relief (i.e., no safe harbors). The final regulations do, however, provide some relief from the virtually "automatic" linkage between pre-reorganization redemptions (and extraordinary distributions) and satisfaction of the COSI requirement.

Under the temporary regulations, a distribution was taken into account for purposes of the COSI requirement, if it were made "in connection with" a potential reorganization. Under the final regulations, a proprietary interest in a target is not preserved to the extent that consideration received before a reorganization in a redemption of (or distribution on) target stock is treated as other property or money under Sec. 356, or would be so treated if the target shareholder had also received acquiring stock in exchange for the target stock (the Sec. 356 test). To determine whether the COSI requirement is satisfied, the final regulations treat each target shareholder as receiving some acquiring stock solely for purposes of applying the Sec. 356 test (but apparently not for any other purpose). However, the "in connection with" standard is still applied to determine the effect of distributions that occur subsequent to the reorganization on satisfaction of the COSI requirement.

Unfortunately, the law in the Sec. 356 area is somewhat unclear, which makes a Sec. 356 test difficult to apply with certainty whenever pre-reorganization redemptions or distributions occur. The final regulations do not elaborate on applying the Sec. 356 test, other than stating in the preamble that "taxpayers should consider all facts, circumstances and relevant legal authorities." In the stock acquisition context, the solely-for-voting-stock authorities (such as Rev. Ruls. 75-360, 68-285 and 55-440, and McDonald, 52 TC 82 (1969)) are helpful in applying the Sec. 356 test. In the asset acquisition context, the law is unclear; see Rev. Rul. 71-364 (distribution by a target corporation of excess cash not needed to satisfy liabilities was part of a Sec. 356 exchange that did not violate the "solely for voting stock" requirement for a Sec. 368(a)(1)(C) reorganization).

The "de-linking" is illustrated in the following example taken from the final regulations.

Example: Target T has two shareholders, A and B. Corporation P expresses an interest in acquiring T. A does not want to receive any P stock. T redeems all of A's stock for cash. None of the funds used to redeem A were or will be furnished by P. P subsequently acquires all of B's stock in T solely for voting stock in P. The COSI requirement is satisfied because B's proprietary interest in T was preserved in the reorganization.

This example is deceptively simple. Consider the following elements:

• The relative ownership interests of A and B are not given. A may own more than 50% of T. Under the temporary regulations, a cash payout of that size, if linked to the potential reorganization exchange, would probably violate the COSI requirement.
• P announces its interest in acquiring T. In response, A indicates he wants no part of P stock and instead wants to be bought out. Under the temporary regulations, that linkage between the redemption and the potential reorganization would probably have resulted in counting the redemption against COSI (Temp. Regs. Sec. 1.368-1T(e)(1)(ii)(A)).
• None of the funds used to buy out A came from P. This factual statement is the key to the principal change made in the final regulations. It allows taxpayers to set aside a distribution, regardless of its size or connection with the potential reorganization. It immediately raises the question as to how taxpayers can establish this fact. As noted, the preamble to the final regulations advises taxpayers to "consider all facts and circumstances, and relevant legal authorities." By so advising taxpayers, the IRS is sanctioning an inquiry into the source of funding for the redemption. The Service in the preamble to the temporary regulations explicitly rejected this "tracking approach," because it "would be extremely difficult to administer." Even though considerably less beneficial than the safe harbors requested by commentators, a "tracking approach" is an improvement over the temporary regulations.
• The reorganization consists of a stock-for-stock exchange. If the redemption payout were too large, a stock-for-assets type of deal might violate the "substantially all" requirement of certain reorganization definitions (i.e., Sec. 368(a)(1)(C)), and forward or reverse triangular mergers under Sec. 368(a)(2)(D) or (E). As a stock-for-stock exchange, the size of the redemption payout does not preclude qualification as a Type B reorganization (so long as P is not the source of funding for the payout); see Rev. Rul. 55-440. However, because nonvoting stock consideration is not permitted in a Type B reorganization, it is unclear how to apply the Sec. 356 test.

The final regulations are generally effective for transactions occurring after Aug. 30, 2000, unless a transaction is pursuant to a written agreement binding on that date. Taxpayers who entered into a binding agreement in the period between Jan. 28, 1998 (the effective date of the temporary regulations) and Aug. 30, 2000 (the effective date of the final regulations) may request a letter ruling permitting them to apply the final regulations. A condition for issuing such a ruling will be that the Service must be satisfied that it will not be "whipsawed" (i.e., that different parties to the transaction are not taking inconsistent positions in applying the final regulations).

In devising a strategy to satisfy the final regulations, taxpayers must be careful about using a note to distribute AAA; see Waterman S.S. Corp, 430 F2d 1185 (5th Cir. 1970). If the subsequent reorganization is in the form of a merger in which the acquiring corporation assumes the S corporation's liabilities, the IRS might argue that the acquiring corporation is supplying nonequity consideration for the reorganization, thus possibly violating the COSI requirement. The deemed dividend technique of Regs. Sec. 1.1368-1(f)(3) (to the extent of subchapter C earnings and profits) may help avoid the potential problem.

S corporations that may eventually be sold tax-free should make current distributions of their AAA. If a company needs working capital, a capital contribution could be made.

From Stewart S. Karlinsky, Ph.D., CPA, San Jose State University, San Jose, CA, Robert J. Mason, J.D., Ernst & Young LLP, Washington, DC, and George L. White, CPA, Technical Manager, AICPA Tax Division, Washington, DC. Messrs. Karlinsky and Mason are members of the AICPA Tax Division's Corporations and Shareholders Technical Resource Panel.