Rev. Rul. 82-34 & the Continuity of Business Enterprise

Corporate reorganizations, such as one company acquiring another, can be structured as tax-free events for the corporations and their shareholders. This treatment allows for the deferral of taxes that would otherwise be due on the exchange of stock and assets. To achieve this status, the Internal Revenue Code requires that the transaction represents a genuine continuation of a business under a modified corporate structure, rather than a disguised sale. One of the primary requirements is a doctrine that examines the continuation of the target company’s business activities following the reorganization. Failure to satisfy this and other rules can disqualify the entire transaction from tax-free treatment, leading to immediate tax liabilities for all parties involved.

The Continuity of Business Enterprise Requirement

The Continuity of Business Enterprise (COBE) doctrine is a foundational principle for corporate reorganizations. Its purpose is to ensure a transaction qualifying for tax-free status is a legitimate business restructuring and not a method for one company to sell its assets without incurring immediate tax. The policy limits tax-free treatment to transactions that represent “readjustments of continuing interests in property under modified corporate form.”

This principle originated in court decisions and was incorporated into the Treasury Regulations. For acquisitive reorganizations, the regulation requires the acquirer to either continue the target company’s historic business or use a significant portion of the target’s historic business assets in a business. The focus is entirely on the post-reorganization use of the target’s business or assets.

However, the COBE doctrine is not a universal requirement. In Rev. Rul. 82-34, the IRS clarified that COBE does not apply to a type “E” reorganization, or recapitalization. A recapitalization is a restructuring of a single corporation’s capital structure and does not involve acquiring a separate company, so the policy concerns behind COBE are not present.

Satisfying the COBE Tests

To comply with the COBE requirement in an acquisitive reorganization, the acquiring corporation must satisfy one of two tests in the Treasury Regulations: the historic business test or the historic business assets test. These tests determine if a transaction maintains a link to the target’s pre-reorganization activities. The acquiring entity only needs to meet one of these two standards, not both.

Historic Business Test

The historic business test focuses on the operational continuity of the target company. To satisfy this test, the acquiring corporation must continue a “significant” line of the target’s historic business. A company’s “historic business” is the business it has been conducting most recently, but a business entered into as part of the reorganization plan does not count.

The determination of whether a historic business is “significant” is based on all the facts and circumstances. For example, if a target company operates three separate lines of business of roughly equal size, and the acquiring corporation continues only one of them, the test would likely be met. Consider a scenario where a target corporation manufactures computer hardware and develops software. If the acquiring corporation continues the software development business but discontinues the hardware manufacturing, it would likely satisfy the historic business test because the software division is a significant historic business.

Historic Business Assets Test

The second path to satisfying COBE is the historic business assets test. This test is met if the acquiring corporation uses a “significant portion” of the target’s historic business assets in a business. “Historic business assets” are the assets, including intangibles like goodwill and trademarks, that the target company used in its historic business. The assets do not need to be used in the same business.

The regulations provide a safe harbor for what constitutes a “significant portion,” where assets are considered “significant” if their fair market value is at least one-third of the fair market value of all the target’s historic business assets. For instance, a logistics company acquires a textile manufacturer whose assets include a factory, machinery, and inventory. If the acquirer sells the machinery but uses the factory as a distribution warehouse, the test could be satisfied. If the factory represents at least one-third of the value of the target’s historic assets, the test is met even though the textile business was discontinued.

Post-Reorganization Asset and Business Transfers

After an acquisition, an acquiring corporation may need to restructure its combined operations. The regulations under Section 368 provide guidance on how a target’s assets or business lines can be moved within the acquirer’s corporate family without jeopardizing the tax-free status of the reorganization.

The COBE regulations permit the acquiring corporation to transfer the target’s assets or businesses to other members of its “qualified group.” A qualified group is one or more chains of corporations connected through stock ownership with the acquiring corporation. To be part of this group, the acquirer must own stock meeting the control test, which requires ownership of at least 80% of the total combined voting power and 80% of the total number of shares of all other classes of stock. Each subsequent corporation in the chain must be similarly controlled by the one above it.

This rule allows for flexibility. For example, a parent company can acquire a target and then transfer the target’s assets to its wholly-owned subsidiary, which in turn could transfer them to its own subsidiary. As long as the subsidiaries are part of the qualified group, the COBE requirement is still satisfied because the regulations treat the acquiring corporation as holding all the assets and businesses of its group members.

The regulations also extend this principle to transfers involving partnerships. An acquiring corporation can transfer target assets to a partnership, and the acquirer will be treated as conducting the business of the partnership if its members, in the aggregate, own a significant interest in that partnership.

Tax Consequences of Failing to Meet COBE

When a transaction fails to meet the COBE requirement, it is disqualified from the tax-free treatment under Section 368 of the Internal Revenue Code. The transaction is recharacterized as a fully taxable sale of assets followed by a liquidation of the target corporation, triggering immediate tax liabilities.

For the target corporation, the failure means it is treated as if it sold all of its assets to the acquiring corporation at their fair market value. This deemed sale will result in the recognition of gain or loss on every asset transferred, which can lead to a substantial corporate-level tax.

The shareholders of the target corporation also face immediate tax consequences. They are treated as having exchanged their target stock for the consideration received in a taxable sale. This requires them to recognize a capital gain or loss equal to the difference between the fair market value of the consideration and their tax basis in the stock.

The acquiring corporation is also impacted. It receives a basis in the target’s assets equal to their fair market value at the time of the acquisition, rather than the target’s lower carryover basis. This can result in higher depreciation deductions, but this benefit often does not outweigh the immediate tax costs imposed on the target and its shareholders.