Corporations can often combine or be acquired without any of the parties recognizing gain or loss under the corporate reorganization provisions. One of the requirements for such treatment is that the equity owners of the target corporation continue their equity ownership via acquiring a substantial equity interest in the acquiring corporation (or a parent of the acquiring corporation) – this requirement is known as the continuity of interest requirement.
When a target corporation is insolvent, it may not be possible for the shareholders of the target to receive a substantial equity interest in the acquiring company because the value of the target is substantially held by the creditors of the target corporation. Under newly issued regulations, the IRS will now allow interests of creditors of the target that are exchanged for equity interests in the acquiring corporation to be counted as equity interests in the target corporation for purposes of the continuity of interest requirement, even if the target corporation is not in bankruptcy but is merely insolvent.
When the acquiring corporation issues consideration partly in stock, and partly with cash or other property, the new regulations provide a method of determining how much of a creditor’s interest is considered to be continuing as equity. Different rules apply for senior and junior indebtedness.
The new rules are a welcome method of both allowing for tax-free reorganizations for insolvent entities, and providing mechanical formulas for computing continuing equity for purposes of the continuity of interest test.