FLORIDA TAX REVIEW
VOLUME 3 1996 NUMBER 5

The Devolution and Inevitable Extinction
of the Continuity of Interest Doctrine

David S. Miller"

I. INTRODUCTION ................................ 189

II. THE PURE PAST BUT SORDID HISTORY OF THE

CONTINUITY OF INTEREST DOCTRINE ................ 191
A. The Birth of the Reorganization Provisions ....... 192
B. The Original Continuity of Interest Doctrine ...... 195

C. The Statuton' Continuiti, of Interest Doctrine ...... 198
D. The Deadwood Decisions: Post- 1934 Cases

Interpreting Pre-1934 Law .................... 201
E. Resurrection: The Emergence of a New Judicial

Continuity of Iterest Doctrine ................ 205

III. THE NEW JUDICIAL CONTINUITY OF INTEREST DOCTRINE

IN FULL BLOOM ............................... 207

A. Expansion of the Continuity Doctrine Beyond

the Original Parenthetical ................... 208
1. D Reorganizations ................... 209
2. Section 355 ........................ 210

3. F Reorganizations ................... 212
B. Remote Continuity.......................... 214

C. Post-Reorganization Target Shareholder Conduct . .. 218
D. Double Duty-The Application of the Continuity of

Interest Doctrine to Integrated Asset Purchases .... 222
E. The Specter of Historic Shareholder Continuity .... 226

IV. THE DECLINE OF THE CONTINUITY OF INTEREST

DOCTRINE .................................... 230
A. Limitations on Remote Continuit. ............... 230

* Associate, Cadwalader, Wickersham & Taft. New York, New York; B.A., 1986,

University of Pennsylvania; J.D., 1989, Columbia University: LL.M. (Taxation). 1994. New
York University School of Law. The author thanks David W. Feeney for his comments on a
previous draft of this article.



Florida Tax Review

B. The All But Elimination of Continuity From
Section 338 Integrated Transactions ............ 231

C. Continuity Without Stock .................... 239

V. THE END OF CONTINUITY AS WE KNOW IT ........... 241
A. The Consequences of Continuity ............... 241

1. Abuse Potential ..................... 241
2. Unadministrability ................... 243
3. Economic Inefficiency ................. 243
4. Unfairness ......................... 244
5. Uncertainty ........................ 244
6. Inconsistent and Anomalous Treatment ..... 245
7. Inconsistency With the Tax Policies of

Nonrecognition ..................... 246
B. Constructing a Valid Policy for a Strong Form

of Continuity ............................. 248
C. Alternative Conceptions of Continuity ........... 250

1. The Corporate Lawyers' Approach of
Ginsburg & Levin ................... 250

2. Continuity as an Anti-Abuse Rule ......... 251
3. Bifurcation ........................ 252
4. Restricted Scope .................... 252
5. Objective Continuity Test Determined

Exclusively at the Corporate Level ........ 254

VI. CONCLUSION .................................. 257

[Vol. 3:5



1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 189

I. INTRODUCTION

The continuity of interest doctrine, in its present form, is the extra-
statutory requirement that the historic shareholders of a target company must
retain a quantum of equity interest in the acquiror in order for an acquisition
to qualify as a reorganization entitled to tax-free treatment. If sufficient stock
of the acquiror is not retained by the target's shareholders for a long enough
period, the transaction is not a tax-free reorganization, and the target corpora-
tion and target shareholders (including those that did retain the acquiror's
stock) are subject to tax on their gains. On the other hand, because the
doctrine is not an anti-abuse rule, if the continuity of interest requirement is
not met, the target and its shareholders are entitled to recognize any loss on
the transaction.

This summary of the doctrine and its consequences is, of course,
greatly simplified. Every aspect of the continuity of interest doctrine carries
with it a formidable array of complex issues. For example, for how long must
the target's shareholders have held their stock to be considered "historic"
shareholders? What types of interests in the target qualify as equity for
purposes of the test? What type and quantum of continuing interest in the
acquiror is required, and for how long and in what form must it be retained?'
Some of these questions have recently attracted significant attention as a
result of a Tax Court case, J.E. Seagram Corp. v. Commissioner,2 newly
issued regulations under section 338,' and an announcement that the Internal
Revenue Service is considering a comprehensive reassessment of the
doctrine.4

This article does not attempt to answer these metaphysical questions
or purport to assert what the law should be (although a few suggestions are
made along the way).5 Instead, the article makes a simple prediction: The

1. This list should not be regarded as exclusive. A fair measure of the number and
extent of the issues raised by the continuity of interest doctrine is § 610 of Martin D. Ginsburg
& Jack S. Levin, Mergers, Acquisitions and Buyouts (1995). a comprehensive study, which
devotes 75 pages (divided into 15 separate sub-sections) and over 80 examples to the topic.

2. 104 T.C. 75 (1995). The case was appealed to the Second Circuit Court of
Appeals, but was settled before that court made its decision.

3. 60 Fed. Reg. 54942 (1995).
4. Juliann Avakian Martin, IRS Considers Guidance on Postreorganization Sales and

Continuity of Interest, 96 TNT 55-9 (Mar. 19, 1996) (LEXIS, FEDTAX library, TNT file);
'Seagram' Could Lead to Re-Evaluation of Continuity of Interest. Solomon Says, Daily Tax
Report (BNA) (Nov. 6, 1995) (LEXIS, FEDTAX library. BNADTR file).

5. One could fill a small public library with articles and treatise chapters devoted
to either or both of these objectives. A small sampling: Boris 1. Bittker & James S. Eustice,
Federal Income Taxation of Corporations and Shareholders (6th ed. 1994); Peter L. Faber,
Postreorganization Sales and Continuity of Interest, 68 Tax Notes 863 (Aug. 14. 1995); Peter
L. Faber, Continuity of Interest and Business Enterprise: Is It Time to Bury Some Sacred



Florida Tax Review

continuity of interest doctrine in its present form will not survive for long.
Crystal balls aside, this forecast is not as radical as it might first appear. The
continuity doctrine, which was developed by courts before the enactment of
the statutory "solely for voting stock" requirement of C reorganizations, was-
intended to prevent corporations from receiving tax-free treatment on sales
of substantially all of their assets for cash and short-term notes of the
acquiror. In 1934, Congress codified this expression of the doctrine for B and
C reorganizations in the solely for voting stock requirement, and with that
statutory change, the judicial rule should have died. Instead, subsequent
courts, failing to recognize the original purpose of the judicial doctrine or the
significance of the statutory amendment, began to apply it to statutory
mergers. And the Service, flush with victory and blind to the evils of the
double-edged doctrine it was forging, implied in the representations required
for favorable private letter rulings that the continuity of interest doctrine
requires the former shareholders of a target to maintain a relationship with
each other as shareholders in the combined entity after the acquiror's tax-free
acquisition of target.

Today, the doctrine is wielded to break otherwise valid tax-free reor-
ganizations with equal vigor by the Service (which asserts it against taxpayers
to cause gain recognition) and taxpayers (who, by failing to meet the
continuity requirement, can claim a loss). Not surprisingly, this double duty
has not left the doctrine unscathed. Most recently, the Tax Court in Seagram
took pains to limit further expansion of the doctrine when it was asserted by
a target shareholder seeking to claim a loss. On the other hand, the doctrine
has acquired new meaning as the mechanism to cause taxable gain only for
the historic minority shareholders who receive and retain acquiror's stock in
a merger following a qualified stock purchase under section 338.

This article advances what should be an unremarkable proposition-a
doctrine whose policy basis evaporated over 60 years ago and exists without
any express or implicit basis in the statutes, which is as often invoked by
taxpayers to recognize loss as by the Service to impose tax on gain, which
in its present form is the source of significant instability and uncertainty, and
which leads to results that are as inequitable and counterintuitive as they are
economically inefficient-cannot survive for long. In the course of develop-
ing this argument, the article explores how this wayward doctrine went astray
and how its course might be corrected.

Cows? 34 Tax Law. 239 (1981); William T. Hutton, Musings on Continuity of Inter-
est-Recent Developments, 56 Taxes 904 (1979); Jere D. McGaffey & Kenneth C. Hunt,
Continuity of Shareholder Interest in Acquisitive Corporate Reorganizations, 59 Taxes 659
(1981); Robert A. Rizzi, Continuity of Interest and Reorganizations: Toward a Unified Theory,
17 J. Corp Tax'n 362 (1991); Bernard Wolfman, Continuity of Interest and the American Law
Institute Study, 57 Taxes 840 (1979).

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1996] Devolution & Inevitable Ertinction of the Continuir" of Interest Doctrine 191

The article is divided into five Parts. Part II presents the history of
the doctrine, from its sensible judicial origins to its legislative codification in
1934, and explains the subsequent judicial decisions that freed the doctrine
from its statutory mooring and permitted it to drift, untethered, into a new,
modem form. Part M explores the fullest expression of the doctrine, which
today is perhaps most brashly reflected in the "anti-Yoc Heating" regulations
promulgated under section 338. Part IV identifies the doctrine's vulnerability.
In the face of significant contrary policies, the doctrine is subject to
legislative, judicial, and regulatory constriction, and Part IV describes some
of the limitations that tenderly rein continuity's strongest form. Finally, Part
V examines some of the unfortunate aspects of the doctrine that remain
today-abuse potential, unadministerability, inefficiency, unfairness, and
inconsistency-and pauses to reexamine the doctrine in its best light and
glean from its strongest form a defensible policy rationale. Part V asserts that
any justification for the doctrine's strong form is inconsistent with our
modem tax system and argues that the doctrine's strength will continue its
ebb to a modified form that is more consistent with its original purpose. Part
V presents some alternative conceptions of the doctrine that might replace its
current form.

II. THE PURE PAST BUT SORDID HISTORY OF THE
CONTINUITY OF INTEREST DOCTRINE

The modem continuity of interest doctrine is really the result of a big
mistake. This Part makes the point by tracing the doctrine's development
through four stages. First, following the birth of the reorganization provisions,
the doctrine was sensibly developed by the Second Circuit in Cortland
Specialty Co. v. Commissioner,6 and the Supreme Court in Pinellas Ice &
Cold Storage Co. v. Commissioner,7 to interpret a parenthetical clause in the
fledgling definition of reorganization and exclude from that definition asset
sales for cash and short-term notes. In the second stage, Congress intervened
in 1934 to replace the judicial continuity doctrine established in Cortland and
Pinellas with its own more restrictive statutory rule-the "solely for voting
stock" requirement-which disallowed tax-free treatment for certain
acquisitions that would have passed the Cortland-Pinellas test. In the third
stage of the doctrine's adolescence, courts continued to apply the old judicial
doctrine of Cortland and Pinellas to pre-1934 tax years. These cases were
consistent with the teachings of Cortland and Pinellas that an asset sale
should qualify as a tax-free reorganization only if the consideration is
consistent with that of a state-law merger.

6. 60 F.2d 937 (2d Cir. 1932). cert. denied, 288 U.S. 599 (1933).
7. 287 U.S. 462 (1933).



Florida Tax Review

In its fourth and final stage of development, the judicial continuity
doctrine was reborn in Roebling v. Commissioner,8 which ignored the 1934
legislation and revived the doctrine, applying it even to statutory mergers
(which were the model for tax-free reorganization treatment in the first place),
Once resurrected, the new judicial doctrine flourished, germinating from a test
that distinguished merger-like tax-free reorganizations from taxable asset sales
to an incipient basis for denying tax-free treatment as a result of the pre- and
post-acquisition conduct of the acquiror, the target, and even the target's
former shareholders.

A. The Birth of the Reorganization Provisions

The Revenue Act of 1918 contained the first reorganization provision,
providing that no taxable gain or loss occurs when, "in connection with the
reorganization, merger, or consolidation of a corporation," a person receives
"in place of stock or securities owned by him new stock or securities of no
greater aggregate par or face value."9 Mergers and consolidations were terms
of art under state law, requiring compliance with restrictive conditions (or the
grant of legislative approval) and giving rise to specific consequences.
Among the requirements were that the acquiror and target carry on the same
or similar businesses, the shareholders of the target acquire an equity (or
other permanent) interest in the acquiror, and, after the merger, the target
dissolve.'0 The most significant consequence of a state law merger was the
acquiror's liability for the target's legal obligations." The term "reorganiza-
tion," on the other hand, was not generally defined under state law and was
not generally applied to transactions with multiple corporations. In regula-
tions, Treasury defined "reorganization" broadly, but maintained the state law

8. 143 F.2d 810 (3d Cir. 1944), cert. denied, 323 U.S. 773 (1944).
9. Revenue Act of 1918, § 202(b), 40 Stat. 1057, 1060. One serious deficiency of

the 1918 Act was that the target was subject to tax even as a result of a reorganization. This
failing was remedied in 1924. See Revenue Act of 1924, §§ 203(b)(3), (e), (f), (g), 43 Stat.
253, 256-57.

10. See, e.g, Del. Laws c. 241 (1833); Pa. Laws No. 1 (1837); N.J. Acts c. 90
(1853); Mass. Laws c. 74 § 1 (1827); Mass. Laws c. 50 § 1 (1840). See generally Comment,
Statutory Merger and Consolidation of Corporations, 45 Yale L.J. 105, 106 & n.4, 109 &
nn.16-18 (1935) (citing cases).

11. See, e.g., State v. Jefferson Lake Sulphur Co., 36 N.J. 577, 178 A.2d 329
(1962), cert. denied, 370 U.S. 158 (1962); Camben Safe-Deposit & Trust Co. v. Burlington
Carpet Co., 33 A. 479, 480 (N.J. Ch. 1895); La Porta v. Enten Corp., 125 A.D. 2d 367, 509
N.Y.S. 2d 91 (2d Dep't 1986); Greene v. Woodland Ave. & West Side St. R.R., 62 Ohio St.
67, 79, 56 N.E. 642, 646-47 (1900); see also Eldon Bisbee, Consolidation and Merger, 6
N.Y.U. L. Rev. 404, 414 (1929); Comment, Statutory Merger and Consolidation of Corpora-
tions, 45 Yale L.J. 105, 122 n.90 (1935) (citing statutes and cases prior to 1918).

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19961 Devolution & hevitable Errinction of the ContinuitY of Interest Doctrine 193

merger and consolidation requirement that the target be dissolved and, in the
case of an upstream merger, required that both companies be affiliated.'-

In 1921, Congress significantly broadened the definition of reorgani-
zation by including a B-type stock acquisition with a majority threshold (as
opposed to the 80% requirement under current law) and a C-type asset
acquisition. Section 202(c)(2) of the 1921 Act provided:

The word "reorganization," as used in this paragraph, includes [A] a
merger or consolidation (including the acquisition by one corporation
[B] of at least a majority of the voting stock and at least a majority
of the total number of shares of all other classes of stock of another
corporation, or [C] of substantially all the properties of another
corporation), [E] recapitalization, or [F] mere change in identity,
form, or place of organization of a corporation.' 3

The decision to include a stock acquisition as a reorganization was
the subject of heated debate in the Senate,14 but the addition of the paren-
thetical clause "to include" an asset acquisition does not appear to have been

12. In general, where two (or more) corporations unitc their properties, by
either (a) the dissolution of corporation B and the sale of its assets to
corporation A, or (b) the sale of its property by B to A and the dissolution
of B, or (c) the sale of the stock of B to A and the dissolution of B...
The term "reorganization," as used in section 202 of the statute, includes
cases of corporate readjustment where stockholders exchange their stock
for the stock of a holding corporation, provided the holding corporation
and the original corporation, in which it holds stock, are so closely related
that the two corporations.., are thus required to file consolidated returns.

Regs. 45, art. 1567 (1921).
13. Revenue Act of 1921, § 202(c)(2), 42 Stat. 227. 230 (1921) (emphasis added).

The predecessor paragraphs to modem § 368(a)(1) are bracketed and the key C reorganization
phrase is italicized.

The relevant language was reenacted without substantive change in 1924, 1926,
1928, and 1932. See Revenue Act of 1924, § 203(h)(1), 43 Stat. 253. 257; Revenue Act of
1926, § 203(h)(1), 44 Stat. 9, 14; Revenue Act of 1928. § 112(i). 45 Stat. 791, 818: Revenue
Act of 1932, § 112(i), 47 Stat. 169, 198. As described below in note 18, D reorganizations
were added in 1924.

14. One senator argued that the exchange of a majority interest in a target
corporation for stock in a corporate conglomerate was the equivalent of a sale and should be
taxed as such. 61 Cong. Rec. 6560, 6566 (1921). The majority nevertheless voted for a broad
definition of a tax-free stock acquisition for two reasons. First. in a "country-wide"
corporation, it was often impossible to coordinate an exchange offer with more than a majority
of the shareholders. See id. at 6564 (Senator Watson). Second, in the absence of the provision,
a shareholder with a depreciated majority interest could contribute his interest to a newly-
formed holding company in exchange for stock and claim a loss. See id. (Senator Smoot). This
was probably not an unusual transaction in 1921 during the economic downturn that followed
the end of World War I.



Florida Tax Review

discussed at all. Nevertheless, contemporaneous sources indicate that asset
acquisitions were included because some states had not yet passed statutes
authorizing mergers and consolidations and other states prohibited mergers
and consolidations with out-of-state corporations.

Therefore, in drafting the Revenue Act of 1921 and subse-
quent acts, Congress sought to provide for the situation
presented where an attempt was made to effectuate a practi-
cal merger or consolidation without compliance with the
technical requirements of state laws, or where there is no
state law, covering the readjustment which has taken
place.15

However, in expanding the definition of reorganization to cover the
merger-like acquisition of substantially all the assets of a target corporation,
Congress neglected to include the requirement of state merger laws at that
time: the consideration had to include acquiror stock. 16 (Incidentally, it took

15. Mark Eisner, Taxation Affecting Corporate Reorganizations, in Some Legal
Phases of Corporate Financing Reorganization and Regulation 403, 419 (1931). These reasons
were still present in 1934, when the House of Representatives proposed a repeal of the B and
C reorganizations, and the Senate convinced the House to retain them (in restricted form) for
the same reasons. See Part II.C.

16. See, e.g., Outwater v. Public Service Corp., 103 N.J. Eq. 461, 143 A. 729
(1928), aff'd, 104 N.J. Eq. 490, 146 A. 916 (1929) (putative merger whereby shareholders of
target would receive preferred stock of acquiror that was redeemable at option of acquiror after
three years was invalid under state law; target shareholders must obtain equity or other
permanent or perpetual interest in target). In Ounvater, the court held:

Continued membership, until dissolution, is an inherent property right in
corporate existence. A merger is but fusion of corporate assets and fran-
chises and an allocation of stock in the merged company, and works a
conversion not a destruction of that right. In the ordinary case of merging
going concerns and the conversion of share for share upon parity of value,
all rights, including voting rights, are reserved to the stockholders.

Id. at 465; see also Moore v. Splitdorf Elec. Co., 114 N.J. Eq. 358, 168 A. 741 (1933). See
generally William L. Clark & William L. Marshall, A Treatise On the Law of Private
Corporations § 359 at 1089 (1903) ("[tlhe statute or the agreement, or both, generally provide
that the consolidated corporation shall issue shares of its stock to the stockholders of the
consolidating corporations..."); Walter Chadwick Noyes, A Treatise on The Law of Inter-
corporate Relations § 64 at 105 (1902) (same); Ernest L. Folk, III, et al., Folk on the Delaware
General Corporation Law 14 n.13 (2d ed. 1990) (Delaware did not permit cash consideration
until at least 1941); Homer Hendricks, Developments in The Taxation of Reorganizations, 34
Colum L. Rev. 1198, 1220 (1934) ("[i]n the usual form of strict merger or consolidation, the
corporation which acquires the properties of another issues some stock or securities of its own.
In this way the interests of the owners of the merging or consolidating corporations are
continued in the enterprise, but the former owners may or may not control the resulting
organization"). See also Pinellas Ice & Cold Storage Co. v. Commissioner, 57 F.2d 188, 190

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1996] Devolution & Inevitable -rtinction of the ContinuitY of Interest Doctrine 195

Congress until 1968, when it enacted section 368(a)(2)(D), to require
explicitly that for certain statutory mergers, the consideration must include
stock to qualify as a reorganization.)

B. The Original Continuity of Interest Doctrine

The continuity doctrine developed as a sensible judicial interpretation
of a poorly-drafted statute that expanded the definition of tax-free reorgani-
zation to include merger-like asset transfers without specifying the requisite
consideration. The cases to first invoke the doctrine involved corporate tax-
payers that transferred substantially all of their assets in exchange for cash
and short-term notes of the acquirors in transactions that failed to qualify as
statutory mergers or consolidations. Invariably, the taxpayer claimed that the
asset sale was a reorganization as defined in the statute, and not a taxable
sale.7

Under the 1926 Act (the earliest Revenue Act to be interpreted on
this issue), tax-free treatment was available to a target only to the extent that
(1) the transaction was pursuant to a plan of "reorganization" (i.e., "a merger
or consolidation (including the acquisition by one corporation of ... substan-
tially all of the properties of another corporation)"),18 and (2) the consider-

(5th Cir. 1932), affd, 287 U.S. 462 (1933) ("As applied to corporations, the terms 'merger'
and 'consolidation' have well known legal meanings .... In either event, the resulting corpo-
ration acquires all the property, rights and franchises of the dissolv ed corporations, and their
stockholders become its stockholders" (emphasis added)).

Congress also declined to address whether the target must liquidate after the
transaction, as would generally be the case in a statutory merger or consolidation under 192 1
law, and was in fact required under existing regulations. See supra note 12. In Helvering v.
Minnesota Tea Co., 296 U.S. 378 (1935). the Supreme Court held that dissolution of the target
was not required by the statute. See also Watts v. Commissioner, 75 F.2d 981 (2d Cir. 1935,
aff'd, Helvering v. Watts, 296 U.S. 387 (1935). In 1984, however. the liquidation requirement
for a C-type asset acquisition was reimposed by Congress. Deficit Reduction Act of 1984. Pub.
L. No. 98-369, § 63(a), 98 Stat. 494, 583 (adding IRC § 368(a)t2)(G)).

17. See, e.g., Pinellas Ice & Cold Storage Co. v. Commissioner, 21 B.T.A. 425
(1930), aff'd, 57 F.2d 188 (5th Cir. 1932), aff'd. 287 U.S. 462 (1933): Cortland Specialty Co.
v. Commissioner, 60 F.2d 937 (2d Cir. 1932); Sarther Grocery Co. v. Commissioner, 63 F.2d
68 (7th Cir. 1933); Prairie Oil & Gas Co. v. Motter. 66 F.2d 309 (10th Cir. 1933): Worchester
Salt Co. v. Commissioner, 75 F.2d 251 (2d Cir. 1935): Le Tulle v. Scofield. 308 U.S. 415
(1940).

18. Section 203(h) of the 1926 Act provided:
[t]he term "reorganization" means (A) a merger or consolidation (including
the acquisition by one corporation of [B] at least a majority of the voting
stock and at least a majority of the total number of shares of all other
classes of stock of another corporation or [C] substantiall all the proper-
ties of another corporation), or [D] a transfer by a corporation of all or
part of its assets to another corporation if immediately after the transfer the



Florida Tax Review

ation for the transaction consisted of "stock or securities" of the acquiror (or
another corporate party to the transaction). 9 In each of the transactions, the
taxpayer undoubtedly satisfied the literal definition of reorganization. More-
over, since the term "securities" was undefined by Congress for purposes of
the reorganization provisions (as it has remained to this day), but had been
defined broadly in other contexts,20 the taxpayers had good reason to feel
optimistic.

Nevertheless, in Pinellas Ice Co. and Cortland Specialty Co., the first
two cases to consider the issue, the Supreme Court and Second Circuit
concluded that both conditions were failed. In each case, the consideration
consisted of cash and notes (which, in Cortland, matured serially, with the
longest having a 14-month term, were unsecured, and were "doubtless readily
marketable," and in Pinellas had a 4-month term and were well-secured).l

Each court concluded that although Congress failed to define "security," it
could not have intended the word to include instruments, such as the notes,
that were effectively cash equivalents. Although this rationale was sufficient
to dispose of the cases, the courts also concluded that the transactions failed
to qualify as "reorganizations."

Acknowledging that the literal language of the reorganization
definition included all asset transfers, regardless of the consideration, the
courts concluded that the parenthetical language of the phrase, "merger or

transferor or its stockholders or both are in control of the corporation to
which the assets are transferred, or [E] a recapitalization, or [F] a mere
change in identity, form, or place of organization, however, effected.

(Emphasis added). The bracketed letters correspond to the analogous provisions of modem law.
Clause [D] (which was (B) in the statute) was added in 1924 to enlarge the scope of the
definition of reorganization. See Revenue Act of 1924, § 203(h), 43 Stat. 253, 257; House
Comm. on Ways and Means, 68th Cong., Ist Sess., reprinted in J.S. Seidman, Seidman's
Legislative History of Federal Income Tax Laws 697 (1953).

19. Section 203(b)(3) of the 1924 Act provided for nonrecognition "if a corporation
a party to a reorganization exchanges property, in pursuance of the plan of reorganization,
solely for stock or securities in another corporation a party to the reorganization." Section
203(e) of the 1924 Act subjected the target to tax on any gain to the extent the consideration
consisted of money or property other than stock or securities (boot).

20. See Schedule A of Title XI of the 1918 Act, Revenue Act of 1918, 40 Stat.
1057, 1135 (imposing stamp tax on "all instruments, however termed, issued by any
corporation with interest coupons or in registered form, known generally as corporate
securities"). Section 23(k)(3) of the 1938 Act used substantially the same definition to
distinguish debt instruments that give rise to capital losses from bad debts, which permit
ordinary deductions. Revenue Act of 1938, 52 Stat. 447, 462.

Thus, it was unclear whether short-term debt instruments could be securities or
whether the holder's interest had to be secured. See Neville Coke & Chemical Co. v.
Commissioner, 148 F.2d 599, 601-02 (3d Cir. 1945), cert. denied, 326 U.S. 726 (1945)
(discussion of confusion over whether time or some other factor is crucial).

21. Cortland, 60 F.2d at 940; Pinellas, 287 U.S. at 464.

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 197

consolidation (including the acquisition by one corporation of... substantial-
ly all of the properties of another corporation)," must be read in the context
of the words "merger or consolidation" that precede it.Y Since "the general
purpose of [all state merger and consolidation statutes] has been to continue
the interests of those owning enterprises, which have been merged or consoli-
dated, in another corporate form,"' the courts held that an asset transfer is
a reorganization only if the target corporation receives consideration of a type
that is consistent with statutory mergers and consolidations (i.e., stock or
securities);2' otherwise, the transfer is indistinguishable from a mere sale.
It is this second rationale for denying reorganization treatment that became

known as the continuity of interest doctrine.
The Pinellas and Cortland courts nicely wove the "stock or

securities" requirement of the statute into the continuity-based distinction
between a merger-like reorganization and a taxable asset sale. Thus, the
C7ortland court suggested that reorganization treatment might have been

available had the consideration received by the target been "securities,'
though not stock, [that] created such obligations as to give creditors or others
some assured participation in the properties of the transferee corporation,"2' 6

and the Supreme Court in Pinellas noted that Cortland's interpretation
"harmonizes with the underlying purposes of the provisions in respect of
exemptions and gives some effect to all the words employed."'- This inter-
dependency between the reorganization definition and the stock or securities

22. See also Le Tulle v. Scofield, 308 U.S. 415, 420 (1940) ("the section is not to
be read literally, as denominating the transfer of all the assets of one company for what
amounts to a cash consideration given by the other a reorganization").

23. Cortland, 60 F.2d at 939.
24. See id. at 939-40; Pinellas, 287 U.S. at 469-70 (citing Cortland, 60 F.2d at 937,

939, 940).
25. Had the taxpayers in Pinellas, Cortland. and the other early continuity cases

consulted a sufficiently wily tax advisor before embarking on their respective transactions,
their problems could have been ameliorated by first liquidating the target by distributing its
assets to its shareholders and then having the shareholders sell the assets. Under regulations
dating back to the 1918 Act, in kind liquidating distributions were tax-free to the dissolving
company. See Regs. 69, art. 548 (1926); Regs. 45, art. 547 (1918): Hellebush v. Commission-
er, 24 B.T.A. 660, 667 (1931), aff'd, 65 F.2d 902 (6th Cir. 1933). The shareholders would
have been taxed on the liquidating distribution, but this would not have been a significant
acceleration of the income they recognized upon the maturity of the short-term debt
obligations. See Koppers Coal Co. v. Commissioner, 6 T.C. 1209 (1946). Section 337 of the
1954 Code effectively overruled Cortland and Pinellas by permitting a tax-free sale of assets
prior to a liquidation. It was not until General Utilities was repealed in 1986 that Cortland and
Pinellas were restored as good substantive law.

26. Cortland, 60 F.2d at 940.
27. Pinellas, 287 U.S. at 470.



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requirement was later (and still remains in part) reflected in the regulations28

and was maintained by case law through 1939, when the Second Circuit held
in Commissioner v. Tyng29 that because 20- and 40-year convertible bonds
were clearly "securities," the transaction necessarily satisfied the continuity
of interest requirement for tax-free treatment under the 1928 Act. 30

The Cortland and Pinellas courts, having decided that the transactions
at issue failed to qualify as reorganizations because the consideration failed
to include any stock or securities of the acquiror, left open the question of
whether any specific quantity of acquiror's stock or securities must be
received by the target. Contemporaneous commentators assumed that "[tihe
issuance of any substantial amount of stock or securities should be sufficient
to bring the transaction within the parenthetical language." 3'

C. The Statutory Continuity of Interest Doctrine

In 1933, following the Cortland and Pinellas decisions and facing the
prospect that the existing definition of reorganization might nevertheless
permit corporate taxpayers to claim tax-free treatment on a sale of assets for
short-term debt instruments, a subcommittee of the House Ways and Means
Committee recommended a wholesale repeal of the tax-free reorganization
provisions until "a more desirable method of treatment could be built up."32

The Treasury opposed the repeal on the grounds that tax-free treatment was

28. See, e.g., Regs. 101, § 112(g)-I (1934) ("[alccordingly, under the Act, a short-
term purchase money note is not a security of a party to a reorganization, . . . and a sale is
nevertheless to be treated as a sale, even though the mechanics of a reorganization have been
set up"); Regs. § 1.368-2(a) ("[i]f the properties are transferred for cash and deferred payment
obligations of the transferee evidenced by short-term notes, the transaction is a sale and not
an exchange in which gain or loss is not recognized").

29. 106 F.2d 55 (2d Cir. 1939), rev'd, Helvering v. Tyng, 308 U.S. 527 (1940). See
infra text accompanying notes 54 to 58, which discusses how the divorce of the stock or
securities requirement from the judicial continuity of interest doctrine under pre-1934 law was
a prelude to the judicial resurrection of the doctrine under post-1934 law.

30. Tyng, 106 F.2d at 59 ("[live different Circuit Courts of Appeal, besides our
own, and the Court of Claims as well, have decided that the receipt of 'securities' results in
the retention of a continuity of interest necessary for a reorganization").

Ultimately, the Supreme Court held that the target or its shareholders must receive
some equity in the acquiror. See Le Tulle v. Scofield, 308 U.S. 415 (1940), discussed infra
Parts III.B and IV.A.

31. Hendricks, supra note 16, at 1220 (emphasis added); see also Cortland, 60 F.2d
at 940 ("even if the transfer to Deyo was an exchange in pursuance of a 'plan of reorganiza-
tion,' the property received by Cortland had to include some 'stock or securities'" (emphasis
added)).

32. See Subcomm. of House Comm. on Ways and Means, 73rd Cong., 2d Sess. 8-9,
37-42 (1934), reprinted in J.S. Seidman, Seidman's Legislative History of Federal Income Tax
Laws 332 (1953); see also H.R. Rep. No. 704, 73rd Cong., 2d Sess. 13 (1934), reprinted in
1939-1 C.B. 554, 563.

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appropriate for legitimate reorganizations in which only "paper gains" were
realized and, because the economic tide was turning, several reorganizations
in progress at the time would give rise to the recognition of losses if they
were taxable.33 The full Ways and Means Committee was persuaded by the
Treasury's arguments and proposed to retain the basic concept of tax-free
reorganizations but to deny tax-free treatment for asset acquisitions of the
type that were the subject of Cortland and Pinellas. Under the Ways and
Means proposal, the definition of reorganization would have been confined
to "(1) statutory mergers and consolidations; (2) transfers to a controlled
corporation, 'control' being defined as an 80-percent ownership; and (3)
changes in the capital structure or form of an organization."' u These
amendments were approved by the full House.

The Senate Finance Committee applauded the policies behind the
House's proposal but, with respect to asset acquisitions, made the following
observation:

Not all of the States have adopted statutes providing for
mergers and consolidations; and, moreover, a corporation of
one State can not ordinarily merge with a corporation of
another State. The committee believes that it is desirable to
permit reorganizations in such cases, with restrictions
designed to prevent tax avoidance. t

The Finance Committee proposed an expansion to the House's definition by
permitting C-type asset acquisitions but requiring that the consideration
consist "solely" of acquiror's "voting stock." The Committee also restricted
tax-free "mergers and consolidations" to those specifically provided for under
state "statutory" law (as opposed to those pursuant to private legislation, as
had also been common). Congress passed the bill, as modified by the Senate
Finance Committee:

The term "reorganization" means [A] a statutory merger or
consolidation, or [B] the acquisition by one corporation in
exchange solely for all or a part of its voting stock: of at
least 80 percentum of the voting stock and at least 80 percen-

33. 78 Cong. Rec. 2512 (1934).
34. H.R. Rep. No. 704, supra note 32, reprinted in 1939-1 C.B. 564.
35. Id. at 598. See George S. Hills, Definition-"Reorganization" Under the Revenue

Act of 1934, 12 Tax Magazine 411, 411 (1934) ("a cursor), examination of the business
corporation laws of the forty-eight states discloses that fifteen states have no statutory
provision for 'merger' or 'consolidation,' sixteen states have statutory provisions limited to
domestic corporations, and seventeen states have statutory provisions covering domestic
corporations and foreign corporations").



Florida Tax Review

tum of the total number of shares of all other classes of stock
of another corporation; or [C] of substantially all the proper-
ties of another corporation, or [D] a transfer by a corporation
of all or a part of its assets to another corporation if immedi-
ately after the transfer the transferor or its shareholders or
both are in control of the corporation to which the assets are
transferred, or [E] a recapitalization, or [F] a mere change in
identity, form, or place of organization, however effected.36

With these changes, Congress replaced the judicial continuity of
interest doctrine with a more explicit-and restrictive-statutory version.37

These amendments met the House's original concerns by preempting any
attempt of taxpayers to obtain tax-free treatment for a Pinellas-type
transaction and met the Treasury's and the Senate's objective of permitting
tax-free asset acquisitions that were "sufficiently similar to mergers and
consolidations as to be entitled to similar treatment."38 Additionally, voting
stock consideration was not made a condition of tax-free treatment for
statutory mergers or consolidations, even though in 1934, under the laws of
various states, there was no requirement that a plan of merger or consolida-
tion provide for solely voting stock consideration and, in fact, some "modern"
state statutes permitted mergers without any equity consideration.39 Thus,

36. Revenue Act of 1934, § 112(g)(1), 48 Stat. 683, 705. The letters in brackets are
redesignated to correspond to current law.

37. See Helvering v. Southwest Corp., 315 U.S. 194, 198 (1942) ("[tlhe continuity
of interest test is made much stricter [by the 1934 Act]"); Comment, Corporate Reorganization
to Avoid Payment of Income Tax, 45 Yale L.J. 134, 140-41 (1935); Hugh Satterlee, The
Income Tax Definition of Reorganization, 12 Tax Magazine 639 (1934); Hills, supra note 35,
at 412; Hendricks, supra note 16, at 1202 ("[tlhe intent of Congress is thus made plain
... [F]or future transactions, the views of the Board of Tax Appeals ... regarding the
interpretation to be given to Section 112(i)(1)(A) of the 1932 and prior acts are made
inapplicable"); Erwin N. Griswold, Securities and Continuity of Interest, 58 Harv. L. Rev. 705,
711 (1945) (since "the definition of reorganization in the statute has now been changed so as
to include only a 'statutory merger or consolidation,' or an exchange of property 'solely for
voting stock,'" the definition of securities is "no longer of any particular importance" in
determining whether a "reorganization" has taken place).

38. H.R. Rep. No. 704, supra note 32, reprinted in 1939-1 C.B. 598.
39. See, e.g., Ark. Dig. Stat. § 170112 (Crawford & Moses, Supp. 1931) ("[tlhe

agreement may provide for the distribution of cash, notes or bonds in whole or in part, in lieu
of stock to the stockholders of the constituent corporations or any of them"); see also Cal. Civ.
Code § 361 (Deering 1931); Fla. Comp. Gen. Laws Ann. § 6562 (Skillman 1927); Nev. Comp.
Laws § 1638 (Hillyer 1930); Ohio Gen. Code § 8623-67 (Page, Supp. 1935); Tenn. Code Ann.
§ 3750 (Williams 1934); Ill. Rev. Stat. c. 32 § 62 (Cahill & Moore 1935) (permitting distribu-
tion of "shares or other securities or obligations of the new corporation"). See generally Henry
Winthrop Ballantine, Ballantine on Corporations § 291 at 686 (1946); Comment, Corporate
Reorganization To Avoid Payment of Income Tax, 45 Yale L.J. 134, 141 & n.48 (1935).

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1996] Devolution & Ievitable Extinction of the Contbiuity of Interest Doctrine 201

Congress confirmed that for statutory mergers and consolidations, the state
requirements, such as a formal plan of merger, shareholder vote, and
dissenters' rights, and the consequences-such as liability for the target's
legal obligations-were sufficient to distinguish those transactions from sales,
and that any requirements as to the nature of the consideration would be
defined by state law.40

D. Deadwood Decisions: Post-1934 Cases Interpreting Pre-1934 Law

Following the 1934 Act and until at least 1940, the judicial continuity
of interest doctrine continued to be applied as cases involving tax years
before 1934 advanced through the courts. These cases were entirely faithful
to three principles deriving from the Cortland and Pinellas decisions. First,
although the literal language of the parenthetical describing B and C
reorganizations would permit tax-free treatment to a target upon a "sale" of
substantially all of its assets-regardless of the consideration-the parentheti-
cal should be read to require consideration that is consistent with a statutory
merger or consolidation.4'

Second, the cases were consistent with the view that the continuity
of interest required for transactions described in the parenthetical describing
B and C reorganizations was not required for other reorganization transac-
tions. For example, in Schoo i. Commissioner,2 the court held that the
exchange of preferred stock for 25-year bonds in a recapitalization was a
reorganization, even though the shareholder's continuity of interest was
broken by the transaction. The court made clear that the continuity of interest
requirement was relevant only in determining whether a C-type asset transfer
was sufficiently similar to a merger to deserve like treatment."

Courts have long recognized that the receipt of voting stock is not necessary in a
statutory merger. See, e.g., John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935).

40. See Satterlee, supra note 37, at 688 ("the history and structure of the
reorganization provisions prior to the Revenue Act of 1934 indicate that any requirement of
a continuity of interest was consciously and advisedly omitted from the definition of
reorganization in clause A").

41. Helvering v. Minnesota Tea Co., 296 U.S. 378, 385 (1935) (target or its
shareholders must acquire a "definite" and "material" interest in acquiror "in order that the
result accomplished may genuinely partake of the nature of merger or consolidation");
Coleman v. Commissioner, 81 F.2d 455, 457 (10th Cir. 1936) ("[dlid the transaction smack
enough of a 'merger or consolidation' that it can fairly be said to fall within the parenthetical
phrase?"); Worcester Salt Co. v. Commissioner, 75 F.2d 251, 252 (2d Cir. 1935) (-the
transaction must at least 'partake of the nature of a merger or consolidation' "); see John A.
Nelson Co. v. Helvering, 296 U.S. 374 (1935) (nonvoting preferred stock is adequate
consideration for a tax-free C-type asset acquisition).

42. 47 B.T.A. 459 (1942).
43. Id. at 461; see also Commissioner v. Neustadt's Trust, 131 F.2d 528 (2d Cir.

1942) (1936 Act); Crofoot v. Commissioner, 4 T.C. Memo (CCH) 97. T.C. Memo (P-H)



Florida Tax Review

Finally, courts continued to emphasize that the parenthetical clause
was intended to expand the definition of reorganization and should be
construed liberally, so long as it did not allow tax-free treatment for disguised
asset sales. For example, in John A. Nelson Co. v. Helvering,44 the Court
held that the target need not receive voting securities; in Nelson and in
Helvering v. Minnesota Tea Co.,45 the Court held that even though a
statutory merger or consolidation would generally require the target to
dissolve, no such requirement was imposed by the parenthetical; 46 and in
Helvering v. Alabama Asphaltic Limestone Co.,47 the Court held that the sale
by a bankrupt corporation of all its assets to a committee of its creditors for
cash and stock of a newly-organized corporation owned by the creditors,
which the bankrupt corporation, in turn, distributed to its creditors in
satisfaction of its debts, constituted a tax-free reorganization. In Alabama
Asphaltic, the Court disabused the view, "followed by some courts," that "a
substantial ownership interest in the transferee company must be retained by
the holders of the ownership interest in the transferor., 48 Stressing once
again that reorganizations include "transactions which are beyond the ordinary
and commonly accepted meanings of [merger and consolidation]," the Court
held that the insolvent target's distribution of the acquiror stock to its
bondholders was sufficiently similar to the analogous distribution by a solvent
target to its shareholders to warrant tax-free treatment for the target on the
transfer of its assets.

Nevertheless, three deadwood Supreme Court decisions, while
consistent with the narrow purposes of the judicial doctrine as applied under
the pre-1934 statute, were subsequently-and unfortunately-interpreted as
dramatically expanding the continuity of interest requirement and sparking
resurrection of the judicial doctrine under post-1934 law.

45,036 (1945); Annis Furs, Inc. v. Commissioner, 2 T.C. 1096 (1943) (1934 Act); Kirby v.
Commissioner, 35 B.T.A. 578 (1937) (1926 Act and 1928 Act), modified on other grounds,
102 F.2d 115 (1939). As discussed below, the judicial continuity doctrine was not applied to
D reorganizations under post-1934 law. See infra notes 73-74 and accompanying text.

44. 296 U.S. 374 (1935). See also United States v. Adkins-Phelps, Inc., 400 F.2d
737 (8th Cir. 1968) (continuity satisfied notwithstanding acquiror's right of first refusal to
purchase its shares from target shareholder at par); Schweitzer & Conrad, Inc. v. Commission-
er, 41 B.T.A. 533 (1940) (nonconvertible preferred stock with no right to vote, redeemable at
any time and mandatorily redeemable after six months if a certain level of earnings was
achieved; held, sufficient).

45. 296 U.S. 378, 385 (1935).
46. However, in 1984 Congress legislatively imposed a liquidation requirement on

targets in C reorganizations. Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 63(a), 98
Stat. 494, 583 (adding IRC § 368(a)(2)(G)).

47. 315 U.S. 179 (1942).
48. Id. at 183.

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1996] Devolution & Inevitable Frtinction of the Continui" of Interest Doctrine 203

Groinan v. Comnnzissioner49 and Hehvering %,. Bashford each
involved a B-type acquisition of a target's stock by a newly-formed
subsidiary of a parent corporation. In each case, the acquisition was
immediately followed by the target's liquidation into the subsidiary. The
consideration for the transfer was cash, parent stock, and stock of the
subsidiary. It was clear in each case that the transaction qualified as a
reorganization, and the sole issue was whether the parent's stock was stock
of a "party to the reorganization" so that the target shareholders would not
have to recognize on receipt of it.

In Gronan, the Court approached the question quite logically by
starting with section 112(i)(2) of the 1928 Act, which defined "party to a
reorganization" as "including" a corporation resulting from a reorganization
and "both" corporations in a stock acquisition. After concluding that
subsidiary and target were parties to the reorganization, the Court held that
the parent was not encompassed by the statutory definition or any other
ordinary meaning of the term "a party to the reorganization."

The Groman Court next considered whether the subsidiary could be
ignored or otherwise regarded as the parent's alter ego. To answer this
question, the Court delved into the purposes of the reorganization provisions,
stating that the statute permitted tax-free treatment to target shareholders only
if their interest "continues to be definitely represented in a substantial
measure in a new or different [corporation, and] then to the extent, but only
to the extent, of that continuit., of interest .. In light of this require-
ment of a close relationship between target shareholders and acquirors, the
Court held that the statute did not permit the actual acquiror (the subsidiary)
to be ignored or the acquiror's parent otherwise to be deemed the "other"
party to the reorganization. This conclusion was also reached in Bashford,
where the target shareholders dealt exclusively with parent, which contributed
the target stock to its subsidiary in exchange for subsidiary stock that it
transferred to the target shareholders. (In Groman, the subsidiary had received
parent stock and the subsidiary dealt exclusively with the target shareholders.)

Groman and Bashford are stinted and formalistic interpretations of the
"party to a reorganization" definition, but they adhere to the statutory
language and have nothing to do with the extra-statutory continuity of interest
doctrine. In context, it is clear that by referring to "continuity of interest," the
Court was not referring to the continuity of interest doctrine used to
distinguish merger-like transactions from taxable sales and whose failure
disqualifies the entire reorganization. Instead, the Court was explaining the

49. 302 U.S. 82 (1937).
50. 302 U.S. 454 (1938).
51. Groman, 302 U.S. at 89 (emphasis added).



Florida Tax Review

statutory mechanism that permits tax-free treatment to target shareholders
only to the extent they receive stock or securities-representing a "continuity"
of their former proprietary interest-of the true acquiror, and not in some
other corporation. Nevertheless, the Court's reference to "continuity of
interest" has caused Groman and Bashford to be misunderstood as being
more than cases interpreting the term "a party to a reorganization" and as
announcing, instead, an expansion of the judicial continuity of interest
doctrine whose failure (at least under pre-1934 law) disqualified an otherwise
valid reorganization. 2 This view inexplicably persists today despite their
double legislative repeal: first in 1934 when Congress undercut the decisions
by requiring that the consideration in B-type stock acquisitions consist solely
of acquiror voting stock (and not parent stock as well), thereby legislatively
foreclosing Groman and Bashford transactions, and, again, when Congress
expressly permitted triangular reorganizations in piecemeal legislation enacted
over the 17 years from 1954 to 1971. 

The third deadwood decision that eventually helped resurrect judicial
continuity was Le Tulle v. Scofield.4 In Le Tulle, the Supreme Court
interpreted pre-1934 law to require that, in a tax-free C-type asset acquisition,
the consideration must consist of equity of the acquiror. The acquiror in the
case obtained the target's assets solely for acquiror bonds payable serially
over 11 years. Although the Court did not specifically hold that the bonds
were "securities," that much seemed clear. Nevertheless, the Court held that
the transaction failed to qualify as a reorganization.

Le Tulle was faithful to the Court's consistent view that the 1921 Act
parenthetical was intended to expand the definition of reorganization to
include, among other transactions, asset acquisitions that sufficiently resem-
bled state mergers and consolidations. However, by requiring the considera-
tion in a tax-free C-type asset acquisition to include at least some acquiror
equity, Le Tulle effectively limited tax-free asset acquisitions to transactions
that could have qualified as statutory mergers in 1921, when the tax-free
reorganization provision was first enacted and state merger and consolidation
laws generally required at least some acquiror stock consideration. 55

However, state merger law evolved considerably after the 1921 Act, and by
1931, when the Le Tulle transaction took place, many states permitted the
acquiror's consideration to consist of non-equity securities, and some states

52. See, e.g., G.C.M. 35117 (Nov. 15, 1972) ("[t]he concept of remote continuity
originated" in Groman and Bashford); G.C.M. 39150 (Mar. 1, 1984). General Counsel
Memoranda 35117 and 39150 are discussed infra Part III.B.

53. The legislative repeal of Groman and Bashford is discussed infra Part IV.A.
54. 308 U.S. 415 (1940).
55. See supra note 16 and accompanying text.

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19961 Devolution & Inevitable Extinction of the ContinuirY of Interest Doctrine 205

even permitted all-cash consideration. 6 Thus, the Le Tulle transaction could
have been consummated as a statutory merger under the laws of these states.

Since the purpose of the parenthetical clause was to permit transac-
tions that did not qualify as statutory mergers to be treated as tax-free
reorganizations, it is odd that the Supreme Court would deny reorganization
status to a transaction that could have been completed as a statutory merger.
In addition, by requiring that the target receive acquiror stock, the Court
severed continuity's moorings in the statutory "stock or securities" require-
ment that Judge Hand had been so careful to preserve in Cortland and
Tyng and which had been extolled in Pinellas.58 Thus, for the first time,
the Supreme Court implied that the continuity of interest doctrine might be
regarded as a requirement wholly independent of the statutory language. Even
a transaction that satisfied every literal requirement of the 1921 Act and
satisfied the Cortland and Pinellas test because the acquiror received
substantially all of the assets of the target in exchange for acquiror's "stock
or securities" might nevertheless fail to qualify as a tax-free reorganization
unless target received stock of the acquiror.

E. Resurrection: The Emergence of a New Judicial Continuity of Interest
Doctrine

Roebling v. Commissioner 9 is the first case to hold that the judicial
continuity of interest doctrine survived the 1934 Act. No less significantly,
the court held for the first time that, despite the clear statutory language to
the contrary, a statutory merger failed to qualify as a reorganization.' In

56. See supra note 39 and accompanying text. Oddly, the Treasury had recognized
that legal advance in a 1927 published ruling, which treated a three-corporation consolidation
as a reorganization, even as to a corporation whose shareholders were entirely cashed out. 1.T.
2364, VI-1 C.B. 13. See infra note 61 for a discussion on this ruling.

57. Prior to Le Tulle, circuit court decisions were unanimous that if the target
received securities of the acquiror, a sufficient continuity of interest would necessarily be
retained. See Commissioner v. Tyng, 106 F.2d 55, 59 (2d Cir. 1939) (citing cases), rev'd.
Helvering v. Tyng, 308 U.S. 527 (1940).

58. See Pinellas, 287 U.S. at 470 (Cortland "harmonizes with the underlying
purpose of the provisions in respect of the exemptions and gives some effect to all the words
employed" (emphasis added)).

59. 143 F.2d 810 (3d Cir. 1944), cert. denied, 323 U.S. 773 (1944).
60. In Morgan Mfg. Co. v. Commissioner, 124 F.2d 602 (4th Cir. 1941). two corpo-

rations agreed that if the acquiror paid the liabilities of the target to its shareholders, the target
would merge into the acquiror under state law, and the target's shares would be canceled. The
court held that even though the merger qualified as such under local law, it was not a tax-free
reorganization. However, the decision was not based on continuity of interest, but on the
authority of Gregory v. Helvering, 293 U.S. 465 (1935), the court finding that the substance
of the transaction was a sale of the target's assets for the amount of liabilities owed to its



Florida Tax Review

Roebling, the South Jersey Gas, Electric and Traction Co. (South Jersey) was
merged under New Jersey law into the Public Service Electric and Gas
Company (PSE&G), with PSE&G surviving and the former shareholders of
South Jersey receiving 100-year bonds of PSE&G in exchange for their South
Jersey stock. The court held that the judicial continuity of interest doctrine
survived passage of the 1934 Act and, on the authority of Le Tulle v.
Scofield, also held that continuity was relevant in a statutory merger.

Each of these conclusions was clearly wrong. Under the 1918 Act and
every subsequent Revenue Act, the paragon for reorganization treatment was
the statutory merger. In 1921, Congress expanded the definition of reorgani-
zation to additionally include similar transactions that failed to qualify as
mergers under state law. From Cortland and Pinellas, courts had identified
acquiror stock consideration as the salient characteristic of those transactions.
However, until Roebling, it was clear that a statutory merger or consolidation
was a tax-free reorganization, even if the consideration was cash.6 In
Roebling, the court turned seven Revenue Acts and twelve years of case law
on their collective heads, and held that the very model of a tax-free
reorganization-a statutory merger in which the target's shareholders received
securities of acquiror-failed to qualify as a reorganization.62

The Roebling court compounded its error by ignoring the Revenue
Act of 1934, by which Congress had entirely replaced the judicial continuity
of interest doctrine with a solely for voting stock requirement that was
applicable only to B and C reorganizations. The 1934 Act further affirmed
that statutory mergers and consolidations were exempt from any continuity
requirement by setting those transactions apart from asset and stock
acquisitions in a separate clause that contained no voting stock requirement.

The court's decision also finds no support in Le Tulle, which
construed the C reorganization definition to require that the target's
shareholders receive acquiror stock, despite the subsequent liberalization of
state merger law that permitted a statutory merger solely for debt (or even
cash) consideration. Le Tulle did not disqualify a statutory merger from

shareholders. The court also indicated that the terms of the merger agreement, which required
the target shareholders to receive stock in the surviving corporation, were not in fact met.

61. See I.T. 2364, VI-I C.B. 13, declared obsolete in Rev. Rul. 69-44, 1969-1 C.B.
312, which involved a consolidation of three corporations, M, N, and 0, into a new corporation
P. The ruling holds that the transaction is a reorganization with respect to each corporation,
even though 0 received only cash, which it distributed to its shareholders. Since the
consideration received and distributed by 0 was not stock or securities, 0 and its shareholders
recognized gain or loss.

62. See Satterlee, supra note 37, at 688 ("the history and structure of the
reorganization provisions prior to the Revenue Act of 1934 indicate that any requirement of
a continuity of interest was consciously and advisedly omitted from the definition of
reorganization in clause A").

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1996] Devolution & Inevitable Ertinciion of the Continityi of Interest Doctrine 207

reorganization treatment. Moreover, even if Le Tulle was correct under pre-
1934 law, when Congress revisited the definition of reorganization in 1934,
placing "statutory mergers or consolidations" in a separate clause, many
contemporary state merger statutes permitted target shareholders to receive
only nonequity securities of the acquiror."

Finally, in citing for support the regulations, which provided in a
general "purpose" clause (as they do to this day) that continuity of interest
is "requisite to a reorganization,"' the court ignored several aspects of the
regulations. First, the regulations were in fact satisfied in Roebling because
they reflected (and to some extent still reflect) Judge Hand's pre-Le Tulle
opinion in Commissioner v. Tyng that while short-term notes indicate a sale,
a debt security of the acquiror is sufficient to establish continuity.' - These
regulations made clear that compliance with the specific requirements of
clauses (A) through (E) of section 112(g)(1) would satisfy continuity because
the transactions described in those clauses are, by definition, sufficiently
distinguishable from a mere sale.66 Thus, under the regulations, a statutory
merger in which the target shareholders received only acquiror nonequity
securities qualified as a reorganization.

IH. THE NEW JUDICIAL CONTINUITY OF INTEREST DOCTRINE
IN FULL BLOOM

If Le Tulle supplied the breeze that loosened the continuity of interest
doctrine from its statutory roots in the "stock or securities" requirement, and
Gromnan and Bashford the gust that floated the doctrine into fertile soil,
Roebling is the thunderstorm that allowed the new judicial doctrine to sprout.
This Part summarily describes the doctrine in its fullest bloom, a Technicolor

63. See supra note 39 and accompanying text.
64. Regs. 86, § 112(g)-I (1934).
65. Regs. 101, § 112(g)-I (1938) ("Purpose") ("there is not a reorganization if the

holders of the stock and securities of the old corporation are merely the holders of short-term
notes in the new corporation.... Accordingly, under the Act, a short-term purchase money
note is not a security of a party to a reorganization. . .. and a sale is nevertheless to be treated
as a sale, even though the mechanics of a reorganization have been set up").

66. The regulations stated:
The application of the term "reorganization" is to be strictly limited to the
specific transaction set forth in section 112(g)t{). The term does not
embrace the mere purchase by one corporation of the properties of another
corporation, for it imports a continuity of interest on the part of the
transferor or its stockholders in the properties transferred. If the properties
are transferred for cash and deferred payment obligations of the transferee
evidenced by short-term notes, the transaction is a sale and not an
exchange.

Regs. 101, § 112(g)-2 (1938) (emphasis added).



Florida Tax Review

spectacle that retains its color in the recent "anti-Yoc Heating" regulations
issued under section 338.

The discussion is divided into five topics. First, this Part describes the
application of the doctrine to D and F reorganizations and even section 355
divisive transactions. The use of continuity to disqualify a transaction from
these provisions is surprising because the early continuity cases stress that it
was applicable only to the stock and asset acquisitions described in the
original parenthetical clause. Second, this Part examines the remote continuity
doctrine, which unexpectedly developed from Groman and Bashford, cases
that had nothing to do with the continuity of interest doctrine and in which
the Court found that the transactions at issue were reorganizations. Third, this
Part discusses the controversial expansion of continuity to disqualify
otherwise valid reorganizations based on post-reorganization conduct of the
target's shareholders. Fourth, this Part examines the use of the continuity
doctrine as an alternative basis for finding that an acquiror that purchases
stock of a target and then merges the target into a subsidiary as part of single
integrated transaction is entitled to a stepped-up basis in the target's assets.
Finally, this Part discusses the possible expansion of continuity to disqualify
otherwise valid reorganizations based on target shareholders' preacquisition
conduct.

A. Expansion of the Continuity Doctrine Beyond the Original Parenthetical

The original purpose of the continuity of interest doctrine, to
distinguish a merger-like stock or asset acquisition from a cash purchase of
the target's assets, had no application to the other types of reorganizations,
as early case law recognized.67 Nevertheless, the doctrine is now said to be
an extra-statutory requirement of D68 and F reorganizations (where a
virtually 100% continuity requirement is imposed), 69 and even section 355
divisive transactions.7" The application of continuity to D reorganizations,
while perhaps justifiable on policy grounds in a few situations,7 is not
supported by the statute or the original case law. In contrast, the application

67. See, e.g., Hickok v. Commissioner, 32 T.C. 80 (1959) (holding continuity
inapplicable to E reorganizations (recapitalizations)); Microdot, Inc. v. United States, 728 F.2d
593 (2d Cir. 1984); Golden Nugget, Inc. v. Commissioner, 83 T.C. 28 (1984). The Service
now acknowledges that the continuity of interest doctrine does not apply to E reorganizations.
See Rev. Rul. 77-479, 1977-2 C.B. 119; Rev. Rul. 77-415, 1977-2 C.B. 311.

68. See Bittker & Eustice, supra note 5, 12.26 at 12-92 to 12-93.
69. See Rev. Rul. 79-289, 1979-2 C.B. 145; Rev. Rul. 79-250, 1979-2 C.B. 156;

Rev. Rul. 78-441, 1978-2 C.B. 152; Rev. Rul. 75-561, 1975-2 C.B. 129.
70. See Regs. § 1.355-2(c)(1), (2).
71. This topic is discussed below in Part V.C.4.

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 209

of continuity to F reorganizations and corporate divisions should be under-
stood as an example of evolutionary convergence: the appearance of a
concept analogous to the historic continuity requirement of Pinellas and
Cortland, but unrelated as a matter of pedigree.

1. D Reorganizations.-D reorganizations have their genesis in
section 203(h)(1)(B) of the 1924 Act, which included as a reorganization "a
transfer by a corporation of all or a part of its assets to another corporation
if immediately after the transfer the transferor or its stockholders or both are
in control of the corporation to which the assets are transferred." ' - The
original continuity cases were inapplicable because Cortland and Pinellas
interpreted the parenthetical clause describing B and C reorganizations and
D reorganizations were not included in that clause or intended as surrogates
for statutory mergers. The "control" requirement of modem section
368(a)(1)(D) provided the closest analogy, and at times it was referred to by
the courts as the continuity requirement of D reorganizations. The courts
made clear, however, that the statutory definition of control, while similar to
the continuity concept of Cortland and Pinellas, superseded it.

This point is made in Weicker v. Howbert," where assets of a
distributing corporation were transferred to its newly-organized subsidiary and
the subsidiary was split-off, with a shareholder of the distributing company
exchanging all but one of her shares for a 73% stake in the split-off
subsidiary and another exchanging some of his shares for the remainder of
the former subsidiary's stock. The court ruled that the transaction did not
qualify as a D reorganization under the 1928 Act because, after the split-off,
the distributing company's shareholders did not together control the former
subsidiary (the single share retained by one of the shareholders being
ignored): "In order to [be a D reorganization], there must be a continuity of
interest on the part of the transferor corporation or its stockholders in the
transferee corporation amounting to a control by the former of the latter."7

In 1954, Congress relaxed the control requirement of D reorganiza-
tions by permitting it to be met if former shareholders of the distributing
corporation were in control of the controlled corporation after the trans-
action.75 The current regulations insist that the judicial continuity test is a

72. Revenue Act of 1924, 203(h)(1)(B). 43 Stat. 253.
73. 103 F.2d 105 (10th Cir. 1939).
74. Id. at 109. See also Williamson v. Commissioner, 27 T.C. 647, 660 (1957)

("The transaction, therefore, fails to qualify as a corporate [D] reorganization because it fails
to comply with the provisions of the statute intended to result in a continuity of interest by the
transferor corporation or its stockholders, or both, in the transferee corporation-).

75. IRC § 368(a)(1)(D) (1954). See S. Rep. No. 1622, 83d Cong., 2d Sess. 273-74
(1954), reprinted in 1954 U.S.C.C.A.N. 4785, 4912.



Florida Tax Review

condition of all reorganizations but also appear to acknowledge that, for D
reorganizations, the statutory control test has replaced it.76

Nevertheless, issues continue to exist as to whether a transaction that
otherwise qualifies as a D reorganization is disqualified if the acquiror's
consideration consists of some of its stock but not a sufficient amount to
satisfy traditional continuity thresholds, 77 and whether the remote continuity
doctrine (discussed below in Part III.B) disqualifies a D reorganization if the
target's assets are dropped into a subsidiary before or after the acquisition.78

2. Section 355.79 -The current regulations under section 355 pro-
vide that judicial continuity is a requirement of tax-free divisive transactions,
independent from the statutory control and business purpose tests.8" This
requirement is especially surprising since section 355 sprouted from D reor-
ganizations, which historically were not required to meet judicial continuity,
and since the provision permitting tax-free divisive transactions was in 1954
plucked from its place as an addendum to the reorganization provisions and
placed in section 355. Section 355 lists several requirements for tax-free
treatment but conspicuously omits to include a continuity requirement.

Nonrecognition for corporate divisions was first granted by the 1924
Act,81 which permitted a tax-free distribution, "in pursuance of a plan of
reorganization," of the stock or securities of a corporate party to a reorgani-
zation to a shareholder of that (or another) corporate party. This provision
disappeared and reappeared in the statute, and finally was revamped in 1954
and moved to its present location in section 355. The 1924 Act also
introduced the D reorganization, and it was understood that divisions could
be D reorganizations.

8 2

Section 355 of the 1954 Code set out the conditions for tax-free
treatment under that provision and eliminated the requirement that a tax-free
division be a reorganization. This change severed all ties with the continuity
of interest doctrine. Nevertheless, while it does not appear that any court

76. Regs. § 1.368-1(b) provides: "Requisite to a reorganization under the Code are
... (except as provided in section 368(a)(1)(D)) a continuity of interest .... (emphasis
added).

77. See Bittker & Eustice, supra note 5, 12.26[21 at 12-92 to 12-93.
78. See Ginsburg & Levin, supra note 1, § 702.2 at 662-65.
79. For a discussion of the continuity requirement under the § 355 regulations, see

Benjamin G. Wells, Continuity of Interest Under the New Section 355 Regulations, 16 J. Corp.
Tax'n 203 (1989).

80. Regs. § 1.355-2(c).
81. Revenue Act of 1924, 203(c), 43 Stat. 253.
82. See generally Charles S. Whitman, III, Draining the Serbonian Bog: A New

Approach to Corporate Separations Under the 1954 Code, 81 Harv. L. Rev. 1194, 1199-1200
n.25 (1968) (providing an excellent review of the history of § 355).

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19961 Devolution & Inevitable Ertinction of the Continui" of Interest Doctrine 211

flunked an otherwise valid section 355 transaction for lack of continuity, the
Seventh Circuit in Redding v. Commissioner3 suggested (without any
apparent authority) that an otherwise valid section 355 distribution might be
rendered taxable by a prearranged sale by the shareholders of more than 50%
of the stock received in the controlled company.84

Subsequent to the 1986 amendments to section 355 that helped
effectuate a repeal of the General Utilities doctrine, but prior to the issuance
of final regulations under section 355, government officials recognized the
difficulty of importing a continuity doctrine into section 355 and struggled to
find a statutory basis for such a requirement. 5 The regulations by fiat
require continuity as a separate element of a section 355 transaction, in
addition to the statutory "business purpose" and "device" tests, despite the
absence of any statutory basis.8 6

Quite apart from this separate continuity requirement, a transaction
or series of transactions in which the shareholders of a distributing company
are able to cash-out their newly received stock tends to indicate a device for
the distribution of earnings and profits or the lack of a valid business
purpose, either of which is sufficient grounds for denying tax-free treatment.
In light of Congress' broad grant of regulatory authority, the section 355 con-
tinuity requirement should be viewed as an element of those statutory tests.'s

83. 630 F.2d 1169 (7th Cir. 1980).
84. Id. at 1180 n. 22. See also Pamela B. Gann, Taxation of Stock Rights and Other

Options: Another Look at the Persistence of Pahner r. Commissioner, 1979 Duke L J. 911.
975 (1979) (discussing possible applicability of continuity test to § 355 transactions, and cited
by the Redding court).

The reference to 50% was an apparent allusion to Rev. Proc. 77-37. 1977-2 C.B.
568, modified by Rev. Proc. 86-42, 1986-2 C.B. 722, discussed infra Part Ill.E.

85. See Prop. Regs. § 1.355-2(b) (1977) (stating that continuity is an aspect of
business purpose); Lee A. Sheppard, Section 355 and Continuity of Interest. 39 Tax Notes 911,
912 (May 23, 1988) (quoting then-Tax Legislative Counsel Dana Trier -Continuity of interest
is an aspect of device, but that's not the whole point ... Continuity of interest comes from
the business purpose clause, not the device clause, which has its o%% n continuity of interest
aspect").

86. Regs. § 1.355-2(c)(1) ("This continuity of interest requirement is independent
of the other requirements under section 355").

87. A recent legislative proposal would in effect add a statutory continuity
requirement to § 355. In March 1996, the Clinton Administration announced a proposal that
would subject the distributing company to tax on the appreciated value of the controlled
company unless the "historic" shareholders of the distributing company (generally, those
shareholders that owned stock continuously for the two years preceding the distribution)
maintain a 50% interest in the vote and value of each of the distributing and controlled
companies for a continuous two-year period immediately after the distribution. See Department
of the Treasury, General Explanations of the Administration's Revenue Proposals (Mar. 1996);
Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's
Fiscal Year 1997 Budget Proposal (released on Mar. 19, 1996) (JCS-2-96) (Mar. 27. 1996).



Florida Tax Review

3. F Reorganizations.-The use of continuity to bust putative F
reorganizations had nothing to do with preventing tax-free treatment for in-
substance asset sales, as did Cortland and Pinellas, but instead was the
courts' attempt to corral a rampant section 368(a)(1)(F), which was unloosed
by the Service as a weapon against liquidation-reincorporation transactions
but before long had turned on its master.88

In 1961, after Congress failed to pass legislation curbing tax-free
liquidation-reincorporations, the Service asserted the F reorganization as a
means to attack transactions in which an operating company was liquidated
and reincorporated with shareholders receiving cash and/or notes but
maintaining the same proportionate equity interests in the new corporation.8

If the form of the transaction was respected, the shareholders could claim
capital gain or loss on the liquidation. If the transaction was recast as a
reorganization, no loss would be recognized, and the liquidation proceeds
were taxable as boot (typically, as a dividend).

Although an F reorganization must be "a mere change in identity,
form or place of organization, '' "° the Service's argument that it should also
encompass multiple operating company transactions was wildly successful.
In Davant v. Commissioner,9 a group of shareholders with parallel owner-
ship of two operating companies caused one to purchase the assets of the
other and then liquidated the transferor. The Service argued in the Tax Court
that the transaction was not only a D but also an F reorganization. The
Service later realized the evils that would result from such a holding and
attempted to bag its own errant theory by abandoning the F reorganization
argument when it went before the Fifth Circuit. However, the effort was in
vain. All on its own, the court held that the transaction was both a D and an
F reorganization.92

Almost immediately, taxpayers claimed the spoils of the Service's
pyrrhic victory in Davant. An F reorganization is the only acquisitive trans-
action that permits the acquiror to carryback a net operating loss from a year
after the acquisition to offset income of the target in a preacquisition year.93

Thus, if after an F reorganization, the acquiror operates at a loss in a post-

88. The rise of the F reorganization is recounted in Patricia Ann Metzer, An
Effective Use of Plain English-The Evolution and Impact of Section 368(a)(l)(F), 32 Tax
Law. 703 (1979) and Richard Crawford Pugh, The F Reorganization: Reveille for a Sleeping
Giant? 24 Tax L. Rev. 437 (1969).

89. See Rev. Rul. 61-156, 1961-2 C.B. 62.
90. IRC § 368(a)(1)(F).
91. 366 F.2d 874 (5th Cir. 1966), cert. denied, 386 U.S. 1022 (1967).
92. Davant's litigation history is recounted in Rev. Rul. 69-185, 1969-1 C.B. 108.
93. IRC § 381(b) (flush language), (b)(3). Also enjoying this benefit is a single

corporation undergoing an E-type recapitalization. See IRC § 381(a)(2). Also, the taxable year
does not terminate as a result of an E or F reorganization.

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 213

acquisition year, it may use the losses to offset the target's preacquisition
income and obtain a refund. If the reorganization is not an F, any tax benefit
from the net operating loss might be delayed or lost altogether.

Now sensitive to the revenue loss that the unleashed F reorganization
could wreak on the fisc, the Service attempted first to claim the desirable
aspects of F reorganizations only for itself, arguing that they should continue
to be liquidation-reincorporation busters but denying the loss carryback
benefits to taxpayers engaging in multiple operating company acquisitions.
These arguments failed to convince the courts.'

Ultimately, the Service conceded universal application of the desirable
aspects of F reorganizations, but proposed a narrow interpretation of the
definition of an F reorganization. Under Revenue Ruling 75-561,9 the
Service required for F reorganizations of multiple operating companies that
(1) both corporations be engaged in the same or an integrated business, (2)
the businesses remain unchanged after the acquisition and, most relevant to
this discussion, (3) there must be a "complete identity of shareholders and
their proprietary interests in the transferor corporations and acquiring corpora-
tions." With that ruling, a "super continuity" requirement for F reorganiza-
tions was born. The courts accepted these strictures (with a de minintis excep-
tion),96 and they appear to remain the law notwithstanding Congress' ulti-
mate (but, alas, probably incomplete) solution to the F reorganization mess:
to limit the application of section 368(a)(1)(F) to a single corporation.9

94. See, e.g., Rev. Rul. 69-185, 1969-1 C.B. 108 (describing the Service's litigation
position and listing the courts that rejected it).

95. 1975-2 C.B. 129.
96. See, e.g., Romy Hammes, Inc. v. Commissioner. 68 T.C. 900 (1977): Berger

Machine Products, Inc. v. Commissioner, 68 T.C. 358 (1977); Rev. Rul. 78-441. 1978-2 C.B.
152 (permitting an F reorganization with a less than 1% ownership shift).

97. See Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248.
§ 225(a), 96 Stat. 324, 490.

With this change, one might hope that F reorganizations, like E recapitalizations,
might entirely escape a continuity requirement. See Rev. Rul. 77415, 1977-2 C.B. 311 (no
continuity requirement for recapitalizations, which involve only one corporation). The Service
seems to be moving slowly towards that conclusion. See Rev. Rul. 96-29. 1996-24 I.R.B. 5

(stating that the step transaction doctrine is not applied to disqualify an F reorganization that
is part of a series of transactions that ultimately results in a change in shareholder ownership).

However, at least two factors suggest that the Service is unlikely to entirely
relinquish its F reorganization continuity requirement. Notwithstanding the unambiguous
statutory language, the legislative history indicates that Congress intended to prohibit only F

reorganizations involving multiple operating companies, leaving the door ajar for multi-
corporate F reorganizations. H.R. Rep. No. 760, 97th Cong.. 2d Sess. 541 (1982). reprinted
in 1982 U.S.C.C.A.N. 781, 1315 (stating that the new limitation "does not preclude the use

of more than one entity to consummate the transaction provided only one operating company
is involved"). Moreover, treating all mergers into shell companies as F reorganizations might



Florida Tax Review

Although this F reorganization continuity requirement is lumped
together with the requirement of A, B, and C reorganizations, it does not
share their common ancestry in Cortland and Pinellas; instead, it should be
regarded as an interpretation of the statutory language that limits F reorgani-
zations to the "mere change in identity, form, or place of organization,' 98

which arguably does not occur when such a change is part of a bigger plan
to change stock ownership. Nevertheless, it is worth noting that some of the
most famous of the continuity cases involve F-reorganizations, and their
holdings have been adopted as generally applicable continuity lore.99

B. Remote Continuity

As discussed above in Part II.E, the Supreme Court held in Groman
and Bashford that, where the consideration consists of stock or securities of
two corporations, one of the corporations may be not be a "party to the
reorganization," with the result that its consideration is boot. Within a few

have broader consequences. For example, the forward subsidiary merger of a target company
into a newly-formed subsidiary of a corporate parent would be an F reorganization and a sale
of stock if the merger failed to qualify under § 368(a)(2)(D) (or as an A, B, or C reorganiza-
tion), rather than (1) a taxable sale of the target's assets, (2) a contribution by parent of
target's assets to the newly-formed subsidiary, and (3) a liquidating distribution by the target
of the consideration. Cf. Revenue Ruling 69-6, 1969-1 C.B. 104 (a merger not qualifying as
a reorganization is treated as the sale of target's assets and a liquidating distribution of the
consideration received). Treatment as an F reorganization and a sale of stock would subject
the transaction to only a shareholder level of tax, exempting the target from corporate tax.

The Tax Section of the New York State Bar Association has recommended (as part
of the Yoc Heating report discussed infra Part IV.B) that the continuity requirement for F
reorganizations be abrogated for the second step of a two-part transaction in which a parent
company makes a qualified stock purchase of target and then merges the target into the
parent's newly-formed subsidiary. (It would probably exceed the Service's good graces to
allow target minority shareholders to receive parent stock in the merger.)

This recommendation is the sensible result for an innocuous transaction that is
consistent with the original purpose of the F reorganization. It recognizes that, after the 1982
amendment, the strict continuity requirement of F reorganizations is no longer necessary to
prevent taxpayers from capitalizing on the ability of the acquiror in an F reorganization to
carry post-acquisition net operating losses to preacquisition years, and it also highlights that
the historical continuity requirement of Cortland and Pinellas has no application to F
reorganizations, which are governed by rules specific to the purpose behind § 368(a)(l)(F).

98. IRC § 368(a)(1)(F).
99. See, e.g., Yoc Heating Corp. v. Commissioner, 61 T.C. 168 (1973). The Yoc

Heating court was careful to cite only F reorganization cases as authority for its continuity
holding, thus retaining (if only theoretically) the distinction between F reorganizations' special
continuity requirement and the more generally applicable judicial continuity of interest
doctrine. See id. at 178 (citing Helvering v. Southwest Corp., 315 U.S. 194 (1942) and
Berghash v. Commissioner, 43 T.C. 743 (1965), aff'd, 361 F.2d 257 (2d Cir. 1966)).

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1996] Devolution & Inevitable Ertinction of Mhe Continuity of lInterest Doctrine 215

years, those decisions were expanded beyond situations where the target
received consideration from two corporations.

For example, in Anheuser-Busch, Inc. v. Helvering,"5 ' the target's

shareholder received only acquiror stock, but the acquiror subsequently
transferred the target's assets to a subsidiary. The court held that the parent
stock was "other property" received in a reorganization. This holding was not
a necessary consequence of Groman and Bashford. The Anheuser-Busch court
could certainly have concluded that where the consideration consists of stock
or securities of one corporation, that party is the true acquiror, and any
subsequent transfer is independent of the reorganization. Nevertheless,
Anheuser-Busch is not inconsistent with a reading of Bashford that determines
the true acquiror by following target's assets and therefore denies "party"
status to the parent of an ultimate operating company.

And, Anheuser-Busch remained true to the basic issue in Groman and
Bashford: Was the putative acquiror a party to the reorganization, or should
its stock or securities be treated as "'other property" (boot)? The transaction
in Anheuser-Busch was recharacterized as a tax-free reorganization of target
into subsidiary in which target's shareholder received "other property." This
holding confirms that the parent's stock supplied the requisite continuity,
even though it was not stock of a party to the reorganization. Had the trans-
action failed continuity, it would not have been a reorganization, and the
parent stock received by target's shareholder would have been sales proceeds
and not "other property."

The Service no longer treats Groman and Bashford as "party" cases
that cause certain consideration to be treated as "other property," but instead
as the foundations of a "remote continuity" doctrine that entirely disqualifies
a reorganization (including a statutory merger) if the target's assets are
separated from the acquiror's consideration by an intervening impermissible
entity. "' Presumably, the theory behind this view is that continuity requires
that a quantum of the consideration must consist of stock of the true acquiror,
and if all of the consideration received by target shareholders is stock of a
nonparty, none of the consideration counts for continuity purposes. However,
this interpretation is entirely inconsistent with the Groman, Bashford, and
Anheuser-Busch decisions, which all acknowledge that the acquisitions

100. 115 F.2d 662 (8th Cir. 1940).
101. See, e.g., G.C.M. 35117 (Nov. 15, 1972) ("the transaction will not qualify as

a tax-free reorganization under Code § 368(a)(1)(A) ... unless S is a 'party to the
reorganization' .... "); G.C.M. 35486 (Sept. 20. 1973) ("The term 'continuity of interest' has
come to be employed by the courts, the service. and the commentators as a reference to the
various litmus-like qualifications imposed on tax-free reorganizations."): G.C.M. 39150 (Mar.
1, 1984). See also Ginsburg & Levin. supra note 1. §§ 610.11.1. 610.11.2, at 630-37.



Florida Tax Review

considered in those cases qualified as reorganizations.102 This interpretation
is also inconsistent with the original purpose of the continuity of interest
doctrine to distinguish merger-like asset acquisitions from sales, based on the
nature of the consideration. Anheuser-Busch, in particular, could certainly
have been accomplished as a state law merger solely for acquiror stock,
followed by the drop down, without invoking the concern in Pinellas and
Cortland that the target (or even its shareholders) get cashed out. And, while
early merger statutes did not permit third-party consideration, there is no
suggestion that the form in Bashford would not have been respected as a
valid state law merger. In any event, some liberal merger statutes that were
in place by 1934 expressly permitted stock or securities of a subsidiary or
parent of the acquiror to serve as consideration.

Moreover, there is nothing inconsistent with the parent's stock
providing sufficient equity interest to satisfy the continuity doctrine, but at the
same time not being stock of a party to the reorganization. 0 3 Cortland and
Pinellas were concerned with the treatment of a target that received cash
equivalents in a putative reorganization; Le Tulle further required that the
target receive consideration assuring some continued participation in target's
former business. The Anheuser-Busch transaction satisfied that test. Although
the target's shareholder received equity in a holding company, the economic
effect was no different than had an operating acquiror obtained target's assets
directly.

The distinction between Groman and Bashford as "party" cases or as
establishing a remote continuity doctrine is subtle but important. Consider the
alternative consequences to the target in a transaction in which the target
merges into a second-tier subsidiary of the acquiror, and the target share-
holders' consideration consists 10% of the second-tier subsidiary's stock and
90% of grandparent stock.'°4 If Groman and Bashford are about continuity
of interest, a finding of "discontinuity" would cause a transaction that
otherwise qualifies as a reorganization to be a taxable sale. The second-tier

102. See, e.g., Anheuser-Busch, 115 F.2d at 666 ("the Board concluded ... 'the
subsidiary and not the parent was a party to the reorganization.' We agree with the Board's
conclusion").

103. An analogous issue is likely to arise if the Clinton Administration's current
proposal to treat certain preferred stock as boot becomes law. Under Nelson, preferred stock
is good consideration for continuity purposes, but under the Administration's proposal, it
would be boot. For the reasons discussed in the text, there is nothing inconsistent with this
result.

104. Cf. G.C.M. 39150 (Mar. 1, 1984) (dropping less than all of target's assets into
a partnership owned 99% by acquiror may defeat reorganization status, depending on facts and
circumstances).

It is important that target shareholders receive some stock or securities of a party to
the reorganization in order to fit within the statutory requirements of § 361(a) and (b).

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 217

subsidiary would not accede to target's tax attributes or its asset bases; the
target would recognize gain or loss equal to the difference between the value
of its assets and their bases; and the acquiror's consideration (second-tier
subsidiary and grandparent stock) would be received by the target's share-
holders in liquidation of the target. If, on the other hand, Gronan and
Bashford are "other property" cases, the transaction would be a reorganiza-
tion, and the second-tier subsidiary would take the target's attributes
(including its net operating losses) and asset bases (increased by any gain
recognized by the target); if the target distributes all of the consideration to
its shareholders, it would recognize no gain or loss, and its shareholders
would recognize gain (but not loss) only to the extent of the "other property"
(grandparent stock).05

The Service's dogmatic adherence to remote continuity is perhaps
best revealed in its approach to partnership drop-downs. The Service treats
a drop-down of the target's assets to a 99%-owned partnership as an action
that breaks the continuity of a contemporaneous merger, notwithstanding the
legislative repeal of Gromnan and Bashford discussed below in Part IV.A."
Dropping fewer than all of the target's assets into a 99%-owned general
partnership makes or breaks continuity, based on a "facts and circumstances"
test.107 This position renders the reorganization provisions of the Code
almost entirely elective for intra-group transactions (subject perhaps to the
partnership anti-abuse regulations),1rs a conclusion confirmed by the
Service's enforcement of the remote continuity doctrine even for reorgani-
zations among wholly-owned entities of a single corporate parent.t
Moreover, it appears that the Service continues to insist that grandparent
stock may not be used as consideration in a statutory merger, but that

105. See IRC § 361(b) (no gain or loss to target on the exchange): § 361(c) (target
recognizes gain with respect to appreciated property that is distributed): § 354(a) (target
shareholders do not recognize gain or loss with respect to acquiror stock): § 356(a), (c) (target
shareholders recognize gain, but not loss, with respect to parent stock); § 362(b) (basis to
acquiror).

106. See G.C.M. 39150 (Mar. 1, 1984); G.C.M. 35117 (Nov. 15. 1972). See
generally Alfred D. Youngwood & Deborah B. Weiss, Partners and Partnerships-Aggregate
vs. Entity Outside of Subchapter K, 48 Tax Law., 39, 57-60 (1994).

A Service official recently stated that G.C.M. 39150 and 35177 are under
reconsideration. See Juliann Avakian Martin, IRS Considers Guidance on Post Reorganization
Sales and Continuity of Interest, 96 TNT 55-9 (Mar. 19, 1996) (LEXIS, FEDTAX library,
TNT file) (quoting Nelson F. Crouch, Chief of Branch 1: "The GCMs are out there... and
we don't like them anymore").

107. G.C.M. 39150 (Mar. 1, 1984).
108. Regs. § 1.702-1.
109. See G.C.M. 39150 (Mar. 1, 1984) (discussing continuity in the context of a

partnership whose partners are the corporate subsidiaries of a single parent).



Florida Tax Review

sections 368(a)(2)(C) and 368(a)(2)(D) can be used concurrently to achieve
tax-free treatment." 10

In addition, the Service regards pre-transaction drop-downs by a
target as analytically indistinguishable from the post-transaction drop-down
at issue in Anheuser-Busch. Arguably, pre-transaction drop-downs are a step
removed from Anheuser-Busch, and two steps away from Bashford, because
there is no doubt that the acquiror is the true acquiror and not a broker for
its subsidiary, as the Court found in Bashford. However, if one accepts the
Anheuser-Busch expansion of Groman-Bashford, treating parent stock as
other property in a post-reorganization drop-down of the target's assets to a
subsidiary, there is some merit to the Service's conclusion that the same
result should obtain in a pre-transaction drop-down. As a conceptual matter,
however, in keeping with Gromnan and Bashford, the issue should be whether
the target or target's partnership is the true "party to the reorganization," and
not whether the transaction lacks continuity. 1' The original continuity of
interest doctrine, as expressed in Pinellas and Cortland, is singularly
concerned with the nature of the consideration and not with its spacial
relationship to target's assets.

C. Post-Reorganization Target Shareholder Conduct

Perhaps the most significant expansion of the continuity of interest
doctrine is its use to disqualify a reorganization based on target shareholders'
intent and subsequent conduct. Heintz v. Commissioner' 2 was apparently
the earliest decision to take this uneasy step, and the principle was firmly

110. See, e.g., Rev. Rul. 74-564, 1974-2 C.B. 124 (use of grandparent stock does
not qualify under § 368(a)(2)(E); transaction nevertheless qualifies as a B reorganization); Rev.
Rul. 74-565, 1974-2 C.B. 125 (same). See generally James A. Nitsche, Asset Remoteness
Problems Persist in Affiliated Group Acquisitive Reorganizations, 83 J. Tax'n 94 (1995);
Robert A. Rizzi, Continuity of Interest and Reorganizations: Toward a Unified Theory, 17 J.
Corp. Tax'n 362, 366-68 (1991). Thus, apparently, a direct merger of the target into a second-
tier subsidiary for grandparent stock may be taxable, but a merger of the target into a first-tier
subsidiary for parent stock, followed by a drop-down of target assets into a second-tier
subsidiary, is generally tax-free. See, e.g., Rev. Rul. 64-73, 1964-1 C.B. 142. Cf. Rev. Rul.
83-34, 1983-1 C.B. 79 (successive § 351 drop-downs are permissible); Rev. Rul. 77-449, 1977-
2 C.B. 110 (same).

111. In Commissioner v. First Nat'l Bank, 104 F.2d 865 (3d Cir. 1939), the target
transferred 86% of its assets to a newly-formed acquiror in exchange for acquiror stock and,
pursuant to a plan, transferred that acquiror stock to the shareholders of acquiror's parent
corporation for parent stock. The court held that the target had engaged in a reorganization but,
under Groman and Bashford, the parent was not a party to that reorganization and was subject
to tax. See Ballwood Co. v. Commissioner, 84 F.2d 733 (3d Cir. 1936) (predating Groman and
Bashford); Electrical Sec. Corp. v. Commissioner, 92 F.2d 593 (2d Cir. 1937) (predating
Groman and Bashford).

112. 25 T.C. 132 (1955).

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1996] Devolution & Inevitable Ertinction of the Continuirv of Interest Doctrine 219

planted in McDonald's Restaurants of Illinois r. Commissioner."'
Heintz and McDonald's involved similar facts: Target shareholders,

desiring cash for their shares, accepted acquiror stock on the condition that
the acquiror assist them in selling the stock to unrelated investors shortly
thereafter." 4 The taxpayers in each case drew the continuity sword and
argued that the side agreement severed continuity and caused the transaction
to be a taxable sale."15 In each case, the taxpayers prevailed."'

These "shareholder conduct" cases are expansions-rather than neces-
sary consequences-of the original continuity cases, for several reasons. First,
the analysis in the original decisions was directed solely at the corporate
level, and examined only the nature of the consideration given by the acquir-
or in order to determine whether the transaction was more like a merger or
a sale. In Heintz and McDonald's, the inquiry was focused at the shareholder
level, and continuity was found lacking even though the target and its share-
holders indisputably received acquiror stock in form and in substance. Target
shareholders were under no compulsion to sell the acquiror's stock, they bore
the risk of market fluctuations in the price of the stock, and there was no
assertion that the stock should not be treated as equity for federal income tax
purposes as a result of the side agreement between target shareholders and the
acquiror. 17 Thus, the acquiror's stock quite clearly conferred, first in the

113. 688 F.2d 520 (7th Cir. 1982), rev'g McDonald's of Zion v. Commissioner. 76
T.C. 972 (1981).

114. In Heintz, the transactions were structured as a stock exchange follow ed
immediately by a liquidation of the subsidiary: in McDonahl's. the target merged into the
acquiror under a state statute.

115. In Heintz, target shareholders argued for sale treatment to recognize capital
gains rather than ordinary "boot" income. In McDonald's, the acquiror sought sale treatment
to achieve a stepped-up basis in the target's assets.

116. In contrast, in United States v. Adkins-Phelps. Inc., 400 F.2d 737 t8th Cir.
1968), the acquiror prevailed in asserting that a statutory merger was a reorganization.
notwithstanding the agreement of the target's sole shareholder not to sell acquiror stock
without offering it first to the acquiror at par value and the subsequent sale of acquiror stock
back to acquiror at par. To similar effect are Commissioner v. Fifth Ave. Bank of New York.
84 F.2d 787 (3d Cir. 1936) (an option exercised by 99% of target shareholders to sell their
acquiror stock for cash to acquiror's subsidiary did not defeat continuity); Daisy M. Ward v.
Commissioner, 29 B.T.A. 1251 (1934), nonacq. 1934-1 C.B. 31. aff'd sub nom Helvering v.
Ward, 79 F.2d 381 (8th Cir. 1935) (where target shareholders had. and exercised, an option
to resell their acquiror stock back to acquiror. reorganization respected as separate from salej.

117. Compare Farr v. Commissioner, 24 T.C. 350 (1955, where the court found
continuity to be met in a split-off under § 112(g)l1)tD) (1939). even though its purpose was
to permit sale of distributing company stock to a third party (which was accomplished). The
court stressed that "petitioner remained free to retain her entire interest in [the distributing
company], [the buyer] was under no obligation to purchase any interest, and the petitioner
alone had the risks and the benefits of [the distributing company'sl continuing operations."
Farr, 24 T.C. at 367.



Florida Tax Review

target and then in its shareholders, a "proprietary stake" in the acquiror that
was "definite and material,"'" 8 and certainly exceeded the equity risk that
is sufficient to establish continuity under established case law." 9

Second, in contrast to the historical continuity cases, the cash
ultimately received by target shareholders in Heintz and McDonald's came
not from the acquiror, but from unrelated secondary purchasers of target
shareholders' acquiror stock. Unless these public shareholders are treated as
the true acquirors of the target's assets, which is difficult to understand given
the interposition of the acquiror, these shareholder conduct cases are clearly
distinguishable from the asset sales in Pinellas and Cortland. In addition,
since target shareholders bore the risk of market fluctuations in the value of
the acquiror stock, the transaction was economically dissimilar from a direct
sale of target stock for a cash equivalent. 2

The fact that the historic roles of the litigants were reversed
(taxpayers were asserting the absence of continuity) should have alerted the
courts to the possibility that something was essentially different about these
cases. Suddenly, the parties to a transaction that satisfied the statutory
elements of a reorganization could, through side agreements, escape the
package of beneficial and adverse tax consequences accompanying that
characterization. Continuity was now the taxpayer's weapon.

Finally, the shareholder conduct cases introduced a cloak of
uncertainty to the reorganizations area by hinging momentous tax conse-
quences not simply on the nature of acquiror's consideration provided to
target, but on the post-acquisition conduct of a critical mass of unrelated
target shareholders. The result is uncertainty for taxpayers and
unadministrability for the Service. The courts should have immediately
recognized the unworkable nature of the test they were creating.

These shareholder conduct cases are better explained as a corollary
of the step transaction doctrine that permits interdependent events to be

118. Helvering v. Minnesota Tea Co., 296 U.S. 378 (1935).
119. See, e.g., John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935) (preferred

stock redeemable at stated intervals was sufficient to establish continuity); United States v.
Adkins-Phelps, Inc., 400 F.2d 737 (8th Cir. 1968) (where acquiror had right of first refusal to
purchase its shares at par from target shareholder, continuity satisfied); Schweitzer & Conrad,
Inc. v. Commissioner, 41 B.T.A. 533 (1940) (nonconvertible nonvoting preferred stock,
redeemable at any time and mandatorily redeemable after six months if earnings exceeded
specific threshold, was sufficient equity stake for continuity purposes). See also Rev. Rul. 68-
22, 1968-1 C.B. 142 (preferred stock, redeemable at 10% per year after one year, is sufficient
equity consideration if acquiror has no present intention to redeem).

120. See McDonald's of Zion v. Commissioner, 76 T.C. 972, 997 n.43 (1981) (the
market price of McDonald's stock on receipt was $66-3/8 per share; the stock was sold for
$71-318); Heintz v. Commissioner, 25 T.C. 132, 139 (1955) (acquiror stock was worth $50
when received but was sold for $30).

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1996] Devolution & Inevitable Ertinction of the Continuity of Interest Doctrine 221

integrated and, in certain circumstances, permits taxpayers to disavow their
form if the tax treatment of the entire transaction is consistently reported."
In any event, it is important that these cases involved a concerted plan
between the target shareholders and the acquiror.

Revenue Procedure 77-37,'2- which lists the representations neces-
sary to obtain a private letter ruling, in effect offers a continuity safe harbor
on the issue of extracurricular intent and conduct if the target's 1% (or for
publicly-traded targets 5%) shareholders represent to the acquiror their plan
and intention to retain acquiror stock representing at least 50% of the value
of the target's outstanding stock immediately before the transaction. (The
target's management must also represent that it knows of no plan or intention
on the part of the remaining target shareholders to dispose of acquiror stock
in excess of the 50% threshold.) Revenue Ruling 66-23' concludes that
a five-year holding period of unrestricted rights of ownership should
"ordinarily" suffice.

However, taxpayers that drift (intentionally or inadvertently) from
these quantitative and temporal havens risk dangerously dark and murky
waters. Commentators assert that the Service could bust an otherwise valid
reorganization for all of the parties if a sufficiently large shareholder engages
in a short-sale-against-the-box with respect to acquiror stock,'24 even though

121. See generally Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987) ("The
resolution of this issue turns on the application of the so-called step transaction doctrine."
explaining Heintz and McDonald's on that ground and finding continuity to be present despite
sale of acquiror's stock with acquiror's assistance): Estate of Christian v. Commissioner, 57
T.C. Memo (CCH) 1231, 1239, T.C. Memo (P-H) 89,413 at 89-2014 (1989) (same). See also
Ericsson Screw Machine Products Co. v. Commissioner. 14 T.C. 757 (1950). Severe restric-
tions on taxpayers' ability to invoke the step transaction doctrine are noted in Pittsburgh Realty
Inv. Trust v. Commissioner, 67 T.C. 260, 274-78 (1976). See also Estate of Durkin v.
Commissioner, 99 T.C. 561 (1992). See generally Ginsburg & Levin, supra note 1, § 608 at
536-56.

122. 1977-2 C.B. 568, as modified by Rev. Proc. 86-42, 1986-2 C.B. 722.
123. 1966-1 C.B. 67; see also Rev. Rul. 78-142, 1978-1 C.B. I11.
124. See Ginsburg & Levin, supra note 1. § 610.6.3 at 599-600. This issue has

sparked the passion of tax practitioners on both sides. See Robert Willens & Andrea J.
Phillips, Do Equity Swaps Affect Satisfaction of Continuity of Interest? 95 TNT 132-28
(LEXIS, FEDTAX library, TNT file) (answer "no" for short-sales-against-the-box and equity
swaps); Jared M. Rusman, Equity Swaps and Post-Transaction Continuity of Interest, 96 TNT
128-110 (LEXIS, FEDTAX library, TNT file) ("serious risk" that an equity swap or short-
against-the-box could break continuity); Robert Willens & Andrea J. Phillips. Continued
Interest in the Continuity of Interest Debate, 96 TNT 137-88 (LEXIS, FEDTAX library. TNT
file) ("vigorously contest[ing] several of Mr. Rusman's assertions" and "eagerly await[ing Mr.
Rusman's response, should he choose to submit one"). Mr. Rusman has of yet not answered
the challenge.



Florida Tax Review

such a shareholder could truthfully make the representation required by
Revenue Procedure 77-37.'25

D. Double Duty-Application of the Continuity of Interest Doctrine to
Integrated Asset Purchases

Continuity was expanded to a fourth category of cases involving inte-
grated transactions in which an acquiror purchased stock but took additional
steps in order to treat the transaction as an asset sale. Although the continuity
doctrine provided a convenient basis to permit the stock sale to be treated as
an asset sale, its invocation in these cases led to a great deal of confusion.

In a line of cases beginning before Pinellas, courts unanimously held
that where a taxpayer expresses an unambiguous intention to purchase the
assets of an incorporated company but for various business reasons is able to
accomplish the asset purchase only by purchasing the company's stock and
dissolving the corporation, the acquiror would be permitted (and, in fact,
required) to treat the stock purchase and subsequent dissolution as a single
integrated transaction for which the acquiror obtains a cost-rather than a
carryover-basis in the target's assets.1 6 The cases applied this "integrated
transaction doctrine" whether the target was dissolved (1) by upstream merger
with127 or liquidation into 128 the acquiror, (2) pursuant to a merger of the

125. In a short-sale-against-the-box, the shareholder retains the acquiror stock but
borrows other acquiror stock and sells it into the market. Since the shareholder does not
dispose of the acquiror stock received in the acquisition, the representation is not breached.

126. See, e.g., Security Indus. Ins. Co. v. United States, 702 F.2d 1234 (5th Cir.
1983); American Potash & Chem. Corp. v. United States, 399 F.2d 194 (Ct. Cl. 1968); United
States v. M.O.J. Corp., 274 F.2d 713 (5th Cir. 1960); Cannonburg Skiing Corp. v. Commis-
sioner, 51 T.C. Memo (CCH) 844, T.C. Memo (P-H) 86,150 (1986), aff'd sub nom. Russell
v. Commissioner, 832 F.2d 349 (6th Cir. 1987); Estate of McWhorter v. Commissioner, 69
T.C. 650 (1978), affd without written opinion, 590 F.2d 340 (8th Cir. 1978); Yoc Heating
Corp. v. Commissioner, 61 T.C. 168 (1973); Long Island Water Corp. v. Commissioner, 36
T.C. 377 (1961); Southwell Combing Co. v. Commissioner, 30 T.C. 487 (1958); American
Wire Fabrics Corp. v. Commissioner, 16 T.C. 607 (1951); Kimbell-Diamond Milling Co. v.
Commissioner, 14 T.C. 74 (1950), aff'd per curiam, 187 F.2d 718 (5th Cir.), cert. denied, 342
U.S. 827 (1951); Schumacher Wall Board Corp. v. Commissioner, 33 B.T.A. 1211 (1936);
Warner Co. v. Commissioner, 26 B.T.A. 1225 (1932).

127. Cannonburg Skiing Corp. v. Commissioner, 51 T.C. Memo (CCH) 844, T.C.
Memo (P-H) 86,150 (1986), aff d sub nom. Russell v. Commissioner, 832 F.2d 349 (6th Cir.
1987); Estate of McWhorter v. Commissioner, 69 T.C. 650 (1978), aff'd without written
opinion, 590 F.2d 340 (8th Cir. 1978). See also Kass v. Commissioner, 60 T.C. 218 (1973).

128. See, e.g., Security Indus. Ins. Co. v. United States, 702 F.2d 1234 (5th Cir.
1983); United States v. M.O.J. Corp., 274 F.2d 713 (5th Cir. 1960); Commissioner v. Ashland
Oil & Ref. Co.. 99 F.2d 588 (6th Cir. 1938); Southwell Combing Co. v. Commissioner, 30
T.C. 487 (1958); Koppers Coal Co. v. Commissioner, 6 T.C. 1209 (1946); Warner Co. v.
Commissioner, 26 B.T.A. 1225 (1932).

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 223

target into the acquiror's subsidiary, -'2 or (3) following an asset transfer by
the target to the acquiror's subsidiary." As discussed below, these deci-
sions were partially codified, first in 1954 and then in 1982 under current
section 338.

Despite the uniform holdings of these cases, their legal bases varied
depending upon the method that the taxpayer used to dissolve the target. Prior
to 1936, the courts could respect each independent step of the transaction
because the target's liquidation was a taxable event to its shareholders and
therefore gave the acquiror a stepped-up basis in the target's assets."' After
the enactment of section 112(b)(6) of the Revenue Act of 1936, which
provided for tax-free liquidations with substituted basis, the liquidation of the
target into a corporate acquiror following a stock purchase did not provide the
acquiror with a stepped-up basis under the statute. Instead, courts permitted
stepped-up bases by applying the common law principle of substance over
form to disregard the transitory ownership of target stock and treat the stock
purchase and liquidation as a single asset purchase by the acquiror under an
integrated transaction doctrine. 32

If the acquiring company purchased target stock and the acquiror then

either merged the target into (or caused it to transfer its assets to) a new or
existing subsidiary, the continuity of interest doctrine was added to and
combined with the integrated transaction doctrine as an additional pillar of
support against the Service's assertion that the merger was a tax-free
reorganization giving rise to a carryover basis.' Since continuity was
originally designed to deny corporate targets reorganization treatment on sales
of their assets for cash or short-term notes, it was serving double duty as a

129. Superior Coach of Florida. Inc. v. Commissioner, 80 T.C. 895 (1983); Long
Island Water Corp. v. Commissioner, 36 T.C. 377 (1961). In Superior Coach, the acquirors
were individual majority shareholders of an existing corporation who purchased target stock
and caused the target to merge into their existing corporation, with former target shareholders
receiving stock of their corporation. In Long Island Water, target shares were purchased by
a parent company and contributed to a newly-formed subsidiary, and the target was then
merged upstream into the subsidiary.

130. Yoc Heating Corp. v. Commissioner. 61 T.C. 168 (1973) finvoling an asset
transfer); American Wire Fabrics Corp. v. Commissioner, 16 T.C. 607 (1951): Schumacher
Wall Board Corp. v. Commissioner, 33 B.T.A. 1211 (1936).

131. See, e.g., Commissioner v. Ashland Oil & Ref. Co.. 99 F.2d 588, 591 (6th Cir.
1938); Koppers Coal Co. v. Commissioner, 6 T.C. 1209, 1221 (1946).

132. See Koppers Coal Co., 6 T.C. 1209 (1946). In Kimbell-Diamond Milling v.
Commissioner, 14 T.C. 74 (1950), aff'd per curiam, 187 F.2d 718 (5th Cir.). cert. denied, 342
U.S. 827 (1951), where the target's assets had a higher basis than the price paid for target
stock, it was the Service, not the taxpayer, that argued for integrated transaction treatment.

133. Prairie Oil & Gas Co. v. Motter. 66 F.2d 309. 311 00th Cir. 1933); Yo
Heating Corp. v. Commissioner, 61 T.C. 168. 171 (1973): Carter Publications. Inc. v.
Commissioner, 28 B.T.A. 160, 164 (1933).



Florida Tax Review

basis for permitting taxpayers to treat an integrated stock purchase and
merger as an asset purchase. This doctrinal expansion produced no distortions
when the sole issue was whether the acquiror obtained a cost basis in the
transferred assets. However, the continuity of interest doctrine was far too
blunt an instrument to provide the correct answer when it was applied to the
target in these cases.

Under the law after 1936 and before 1954, if a purchase of target
stock and the target's subsequent merger into the acquiror was treated under
the integrated transaction doctrine as a liquidation of the target and the sale
of its assets by target shareholders to the acquiror, the target was not affected
by the recharacterization. Under the statutes then in effect, a corporation
generally recognized no gain or loss on distributing its assets in liquidation,
and the Cumberland case"3 permitted this rule to apply if the shareholders
had first unsuccessfully attempted to sell their stock to the acquiror and then
liquidated target and sold its assets. 35 The Cumberland holding certainly
appears to have applied to a stock sale by target shareholders, followed by a
merger of the target into the acquiror or acquiror's subsidiary, if the
transactions were recharacterized under the integrated transaction doctrine as
a liquidation of the target followed by an asset sale by target shareholders.
However, since a failure of continuity historically resulted in the target being
treated as selling its assets to the acquiror, the logical extension of applying
the continuity of interest doctrine to these cases appears to be a corporate-
level tax on the target-a result entirely ignored by the courts that applied the
doctrine to taxable years between 1936 and 1954. 36 This suggests either
that the continuity doctrine cited as a rationale for these cases was no longer
the doctrine of Cortland and Pinellas, or else that courts were applying an
integrated transaction doctrine, and not continuity.

This distinction remains important under current law.

Example. Target is a wholly-owned subsidiary of a corporate Seller,
and the two corporations file a consolidated return. Acquiror

134. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451 (1950).
135. See generally Bittker & Eustice, supra note 5, 10.05[5] at 10-31 to 10-34 and

9110.41, at 10-84 to 10-89. Section 337 extended nonrecognition treatment to targets that sold
their assets in the 12-month period prior to liquidation.

136. See Commissioner v. Ashland Oil & R. Co., 99 F.2d 588, 593 (6th Cir. 1938)
(Hamilton, J., dissenting on grounds that target should be subject to tax on deemed asset sale).
Cf. Carter Publications Inc. v. Commissioner, 28 B.T.A. 160 (1933) (taxing the target on
deemed asset sale under continuity of interest theory, as applied to tax year before 1936).

Between 1954 and 1987, this result was codified in § 334(b)(2), which gave the
acquiror a stepped-up basis in target's assets without subjecting the target to tax on any
appreciation in the value of its assets. See infra note 156 and accompanying text.

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 225

purchases 79% of Target's stock 137 from Seller for cash and, as part
of an integrated transaction, merges Target upstream into Acquiror,
with Seller receiving Acquiror stock for the remaining 21% of
Target's stocks.

If the integrated transaction doctrine is applied, Target is treated as
first having liquidated tax-free into Seller, 3 and Seller is treated as selling
Target's assets to Acquiror. Seller recognizes gain or loss equal to the
difference between the value of the consideration received and Target's basis
in its assets, and Acquiror holds Target's assets with a cost basis. Continuity
has no place in this analysis because the merger is disregarded and the
liquidation is deemed to occur prior to the asset transfer.

On the other hand, if the continuity of interest doctrine is applied,
Target recognizes gain on either of two theories. First, the stock purchase by
Acquiror could be respected, but if so, the upstream merger of Target into
Acquiror fails continuity because Acquiror is not Target's historic sharehold-
er.139 Under this analysis, Seller has gain or loss equal to the difference
between the value of the consideration received and its basis in the Target
stock, and, after being deconsolidated from Seller, Target is treated as making
a taxable sale of its assets to Acquiror in the upstream merger.1' ° Alterna-
tively, the stock purchase by Acquiror could be ignored, and Target could be
viewed as merging directly into Acquiror, with Seller receiving Acquiror
stock and cash.' The 21% equity consideration received by Seller is
insufficient to satisfy traditional tests of continuity. Acquiror obtains a
stepped-up basis under either theory, but, under the second, Target's gain or
loss occurs while it is still a member of Seller's consolidated group.4 2

137. This percentage is important because it bypasses the statutory result imposed
by § 338 that is discussed infra Part IV.B.

138. IRC § 332. Seller acquires Target's assets with a carryover basis. See IRC
§ 334.

139. This was the apparent rationale of Kass and Superior Coach. See Superior
Coach of Florida v. Commissioner, 80 T.C. 895, 906-07 (1983); Kass v. Commissioner, 60
T.C. 218, 222-23 (1973).

140. Whether Target's gain or loss is properly includible in Seller's or Acquiror's
consolidated return is another matter. See Regs. § 1.1502-76(b)(l)(ii)(B)(4) (providing an
exception to next-day rule for prearranged transactions) and (b)(2)(ii)(C) (providing an
exception to ratable allocation rule for items that result in substantial distortion).

141. King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (applying
this analysis to treat as an A reorganization the upstream merger of target into acquiror
following acquiror's purchase of target stock for consideration consisting 51% of acquiror
stock).

142. Other uncertainties exist. If the first continuity analysis described in the text
were applied literally, it would deny reorganization treatment on the second step merger even
if the stock purchase was entirely for acquiror stock.



Florida Tax Review

Under either theory, the transaction is taxable to a minority share-
holder of Target. Regardless of whether the transaction is viewed as a
liquidation followed by an asset sale, or as a stock sale followed by a busted
reorganization (a taxable asset sale) and then a liquidation of Target, the
minority shareholder is subject to tax. It was more or less the second theory
that the Tax Court used in Kass v. Commissioner143 as its basis for taxing
one of Target's minority shareholders on her receipt of acquiror stock.'"

Thus, although courts in these integrated transaction cases often
appended the continuity doctrine as an alternate basis to find that an other-
wise valid reorganization could be combined with an antecedent stock
purchase and treated as a single asset purchase, the expansion of the
continuity doctrine to reach this result only muddled the law. Moreover, these
aspects of the integrated transaction doctrine (and its interaction with
continuity) have been further complicated by the enactment of section 338,
the repeal of General Utilities, and certain recently promulgated regulations
which would significantly limit-but not eliminate-the application of
continuity to many integrated transactions. These developments are discussed
below in Part IV.B.

E. The Specter of Historic Shareholder Continuity

Lurking behind the integrated transaction cases is the possibility,
suggested by the Service and commentators, that those cases may not be
limited to an acquiror's concerted effort to purchase a target's assets. Instead,
the cases might establish the continuity of interest doctrine as requiring a
continuous thread of ownership linking the target's shareholders before the

From time to time, courts have suggested that the first analysis is proper. See Russell
v. Commissioner, 832 F.2d 349 (6th Cir. 1987); Kass v. Commissioner, 60 T.C. 218 (1973),
aff'd without published opinion, 491 F.2d 749 (3d Cir. 1974). However, when push has come
to shove, and the issue is squarely presented, the second analysis has been adopted (albeit not
expressly). See King Enterprises v. United States, 418 F.2d 511 (Ct. Cl. 1969).

143. 60 T.C. 218 (1973), aff'd without opinion, 491 F.2d 749 (3d Cir. 1974). See
also Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987).

144. In Kass, the acquiror first purchased more than 80% of the target's stock for
cash and then merged the target upstream into the acquiror, with minority shareholders who
had retained their target stock (including the taxpayer) receiving acquiror stock in exchange
for their former target stock. The court held that because the acquiror had purchased the
target's stock as part of a plan to absorb the target by merger, the acquiror could not be treated
as one of the target's historic shareholders for continuity purposes. Accordingly, the merger
failed to qualify as a reorganization, and the target's minority shareholders recognized gain or
loss on their exchange of target stock for acquiror stock. The Kass transaction arose after the
enactment of § 334(b)(2) of the 1954 Code, but it appears that the court's conclusions are
applicable to transactions before 1954. The status of Kass after the enactment of § 338 is
discussed below in Part IV.B.

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1996] Devolution & Inevitable Ertinction of the Continuity of Interest Doctrine 227

acquisition to the combined corporation's shareholders afterwards. Under this
view, if a sufficient number of target shareholders sell their stock in the dawn
before an acquisition, the continuity fiber could snap. The nightmarish conse-
quences of such a rule, if applied rigorously to a publicly held target, would
be that even unsuspecting target shareholders could blow a reorganization (for
all parties) by selling too many of their shares during the prelude to a
proposed acquisition, regardless of whether the other parties to the transaction
assisted or were even aware of the sales.

These fears are fanned by Revenue Procedure 77-37,4 which states
the conditions for private letter rulings confirming the tax-free status of
acquisitions. It requires a representation that the target's 1% shareholders (5%
shareholders for public targets) intend to retain acquiror stock representing at
least 50% of the value of the target's outstanding stock immediately before
the transaction and a representation that the target's management has no
contrary knowledge with respect to the rest of the shares. Target stock sold,
redeemed, or otherwise disposed of "prior to" the transaction is taken into
account in applying the 50% test. Thus, Revenue Procedure 77-37 suggests
that the Service might view continuity as threatened even in the absence of
directed efforts by the acquiror to purchase target's stock for cash.

Anxiety is heightened by an example in regulations under section 355
that finds continuity to be lacking where, pursuant to a plan, a 50%
shareholder of a distributing company sells its stock and the company then
splits-off its subsidiary to the other 50% "historic" shareholder."' The
example concludes that continuity is lacking because the distributing
corporation's historic shareholders retain none of its stock (one selling out
before the split-off and the other exchanging distributing corporation stock for
stock of the controlled subsidiary). The example appears to confirm that
preacquisition conduct of the target's shareholders is relevant to continuity
analysis.

Indeed, it does not take a particularly vivid imagination to portend
from these authorities a grand scheme of continuity reflecting a triple
expansion of the post-acquisition shareholder conduct cases. First, Heintz and
McDonald's would apply regardless of whether other parties to the trans-
action actively assist the target shareholders' sales; second, Heintz and
McDonald's would apply to the sale of target stock prior to the acquisition;
and third, these cases could be asserted by the Service, not just by taxpayers.
Under this alternative reality, the essence of continuity would be the
relationship of historic shareholders to each other, and a substantial shift in
that relationship would affect all parties.

145. 1977-2 C.B. 568.
146. Regs. § 1.355-2(c)(2) ex. 3.



Florida Tax Review

Some of these doomsday apprehensions were at least temporarily
consoled by the Tax Court's recent opinion in J.E. Seagram Corp. v.
Commissioner.147 In Seagram, Conoco, a public company, was the subject
of two competing tender offers by Seagram and a DuPont subsidiary.
Seagram, which succeeded in acquiring only 32% of the target in its tender
offer, conceded defeat to the DuPont subsidiary, which had acquired 46% of
Conoco's stock. Seagram, along with other target shareholders owning in the
aggregate some 16% of the target, tendered its shares for DuPont stock that
was worth substantially less than the price paid by Seagram in its tender
offer. Subsequently, Conoco was merged into the victorious DuPont
subsidiary, with shareholders holding the remaining 6% of Conoco's stock
being squeezed out for DuPont stock.

It was not the Service that sought to realize practitioners' worst fears
by taxing the target and its former shareholders. Instead, it was Seagram, the
defeated bidder, that shot a newly whittled continuity arrow with hopes of
killing the reorganization. Seagram had paid dearly for the target stock
acquired for cash in its own tender offer and sought to recognize loss on its
exchange for DuPont stock. It argued that its recent cash purchase, although
unassisted by the target (and vehemently opposed by the ultimate acquiror),
nevertheless disqualified it as a historic shareholder. And, since the DuPont
subsidiary purchased 46% of Conoco's stock for cash, that left a mere 22%
(100% less DuPont's 46% acquired for cash and Seagram's 32%) of
Conoco's historic shareholders who could be said to have received DuPont
stock. This amount, Seagram claimed, was insufficient to establish continuity.

The court dismissed this argument and validated the reorganization
in an opinion that faced practitioners' fears directly. It acknowledged that
Seagram's position could cast a long shadow on acquisitions of public
companies by conditioning reorganization status on the independent actions
of numerous target shareholders. More importantly, the court returned the
continuity of interest doctrine a step closer to its historical roots. Continuity
depends, the court held, solely on the nature and amount of the acquiror's
consideration. Since DuPont's subsidiary obtained a majority of Conoco's
stock for stock of DuPont, continuity was maintained.

This holding at once captures the essence of Cortland and Pinellas,
which distinguished taxable sales of target assets from tax-free reorganiza-
tions based on the nature and amount of the acquirors' consideration, and
rebukes the suggestion that the shareholder conduct cases of Heintz and
McDonald's and the integrated transaction decisions are relevant as continuity

147. 104 T.C. 75 (1995). The case is discussed in Ginsburg & Levin, supra note 1,
§ 610.10 at 627-30; Jasper L. Cummins, Jr., Seagram Files Brief With Second Circuit, 69 Tax
Notes 223 (Oct. 9, 1995).

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1996] Devolution & Inevitable Extinction of the Continuit. of Interest Doctrine 229

of interest precedents. Instead, these decisions should be viewed as extensions
of the step-transaction doctrine, which permits several steps of a single
transaction to be treated as one if all of the parties cooperated to achieve a
particular result. Equally important, the Seagram decision offers taxpayers
and the Service alike stability and administrability. Under the decision, the
characterization of a transaction as a reorganization or a taxable sale may be
determined definitively at the moment of the acquisition, based on the
objective nature of acquiror's consideration.

The Seagram opinion has been criticized, largely on two grounds.'
First, commentators have dismissed as "misplaced" the court's concern about
the ability of public targets to engage in tax-free reorganizations without
tracking large volumes of pre-acquisition trading in target stock. Under their
view, Revenue Procedure 77-37 which, for purposes of the representations
necessary to obtain a favorable ruling, treats less-than-5% shareholders as
historic, should have allayed the Court's fears.

This view raises two preliminary questions. First, should the
representations required to obtain a private letter ruling preclude the Service
from proceeding against taxpayers that fail to obtain a ruling? Second, is the
50% threshold of Revenue Procedure 77-37-which quite clearly is higher
than the case law establishes' 49-a hindrance to tax-free acquisitions of
public targets? Even conceding affirmative answers to these questions, the
view of these critics simply illuminate another reason why the Seagram
court's decision represents sound tax policy.

If Seagram's arguments were accepted, a target shareholder realizing
a loss on its exchange could argue that, notwithstanding the safe harbor,
continuity was failed under traditional standards. For example, these
arguments, if accepted, would open the door to an argument that continuity
is broken if (1) 50% of the target's stock is held by less-than-5% sharehold-
ers, (2) the balance is held by a taxpayer who purchased for cash immediately
before the acquisition, and (3) the taxpayer is able to demonstrate that 60%
of the target stock held by less-than-5% shareholders was sold for cash in
contemplation of the transaction. Moreover, the Seagram position would
encourage inconsistent tax positions and whipsaw of the government.

Alternatively, these commentators would accept the Seagram result,
but only if Seagram had the intent of acquiring the target but no intent of

exchanging its stock for DuPont stock. This test, however, would rest the
status of reorganizations on the subjective intent of significant target
shareholders-hardly a basis for stable, predictable, and consistent results.

148. See Ginsburg & Levin, supra note 1, § 610.10 at 628-29.
149. See infra notes 194-196 and accompanying text.



Florida Tax Review

IV. THE DECLINE OF THE CONTINUITY OF INTEREST DOCTRINE

Despite the historic and continued vigor of the continuity of interest
doctrine, its tangled branches have undergone significant pruning by
Congress, the Service, and the courts. This Part examines a variety of
limitations that have restrained continuity from breaking otherwise valid
reorganizations.

The discussion is divided into three subheadings. First, this Part
describes the legislative limitations on the remote continuity doctrine. Second,
this Part considers the partial codification of the integrated transaction
doctrine in section 338 and the anti-Yoc Heating regulations, which all but
eliminate continuity as a requirement for a reorganization following a
qualified stock purchase. Finally, this Part traces the abolition of continuity
as a doctrine of disqualification for mutual savings bank and mutual savings
and loan association reorganizations.

A. Limitations on Remote Continuity

As discussed above in Part III.B, one of the earlier expansions of the
continuity of interest doctrine was the development of a remote continuity
aspect that could defeat otherwise valid reorganizations depending on the
spacial relationship between the target's assets and the acquiror's consider-
ation.

Starting in 1954, Congress began the piecemeal repeal of the remote
continuity doctrine by adding to section 368(a)(1)(C) an anti-Groman
parenthetical clause-"(or in exchange solely for all or part of the voting
stock of a corporation which is in control of the acquiring corporation)"--and
by enacting an anti-Bashford provision, section 368(a)(2)(C). The parentheti-
cal in section 368(a)(1)(C) permits the use of parent stock in C reorganiza-
tions, while section 368(a)(2)(C) permits the target's assets to be dropped
down to a subsidiary following an A or C reorganization. In 1964, an anti-
Groman parenthetical was added to section 368(a)(1)(B), permitting parent
stock to be used as consideration in a B reorganization. Finally, Congress
added section 368(a)(2)(D) in 1968 and section 368(a)(2)(E) in 1971, thereby
permitting triangular forward and reverse mergers to qualify as A reorganiza-
tions. Accompanying each amendment was an expansion of the definition of
a party to a reorganization. 5

0

150. See IRC § 368(b). For a discussion of issues that remained after these statutory
changes, see M. Carr Ferguson & Martin D. Ginsburg, Triangular Reorganizations, 28 Tax.
L. Rev. 159 (1973).

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrinze 231

Several years after these statutory changes were completed, the
Service largely abandoned its view that consideration remoteness (which it
had asserted even within a wholly-owned group) could break continuity.15'

Today, although there are lingering remoteness issues, 152 remote continuity
remains a significant impediment only with respect to partnership drop-
downs, the use of grandparent (rather than parent) voting stock,' and the
use of consideration from two different parties.'-' And, based on the public
statements of Service officials, remote continuity may soon undergo further
limitations.

55

B. The Virtual Elimination of Continuity Front Section 338 Integrated
Transactions

As discussed above in Part III.D, the continuity of interest doctrine
became a convenient reason for treating the integrated stock purchase and
merger of the target into the acquiror's subsidiary as an asset purchase,
permitting the subsidiary a cost basis in target's assets. In 1954, Congress

151. See Rev. Rul. 84-30, 1984-1 C.B. 114; G.C.M. 39100 (May 13. 1983). In
1981, the Service ruled that consideration remoteness resulted when the target's parent
distributed acquiror stock to its own shareholders after the transaction, thereby separating the
consideration (held above by the parent's shareholders) from the target's assets (held below
in acquiror). G.C.M. 38660 (Mar. 19, 1981).

In Rev. Rul. 95-69, 1995-42 I.R.B. 4 (Oct. 16), the Service held that a partner-
ship/shareholder's distribution of acquiror stock to its partners on a pro rata basis does not
defeat continuity.

152. For example, is the conclusion in Rev. Rul. 84-30, supra note 151. limited to
transactions among a wholly-owned group? For a discussion of this issue, see Ginsburg &
Levin, supra note 1, § 610.11.1 at 631-32.

153. See James A. Nitsche, "Asset Remoteness" Problems Persist in Affiliated
Group Acquisitive Reorganizations, 83 J. Tax'n 94, 97 (1995).

154. The anti-Groman parentheticals permit solely voting stock consideration from
either the acquiror "or" its parent, and not acquiror "and/or" its parent. See IRC § 368(a)( I)(B)
(parenthetical), (C) (parenthetical). However, the regulations state:

As used in section 368, as well as in other provisions of the Internal
Revenue Code, if the context so requires, the conjunction 'or' denotes both
the conjunctive and the disjunctive, and the singular includes the plural.
For example, the provisions of the statute are complied with if 'stock and
securities' are received in exchange as well as if 'stock or securities' are
received.

Regs. § 1.368-2(h).
Section 368(a)(2)(D) is clear that only parent-and not subsidiary-stock may be

used. See IRC § 368(a)(2)(D)(i). Section 368(a)(2)(E) is ambiguous on this point.
155. See Juliann Avakian Martin, IRS Considers Guidance of Postreorganization

Sales and Continuity of Interest, 96 TNT 55-9 (Mar. 19, 1996) (quoting Nelson F. Crouch.
Chief of Branch 1, remarking on General Counsel Memoranda 39150 and 35117, which
conclude that continuity may be broken on a post-reorganization drop-down to a partnership:
"The GCMs are out there ... and we don't like them anymore").



Florida Tax Review

confirmed acquirors' ability to achieve a cost basis in certain integrated stock
purchases by enacting section 334(b)(2), and it reaffirmed this treatment in
1982, when it substituted the present section 338 for section 334(b)(2).
However, by eliminating the need to rely on a judicial doctrine to achieve the
desired result, Congress further complicated continuity analysis. This
confusion continues, but, under recently issued regulations, the continuity of
interest doctrine is significantly limited for integrated qualified stock purchase
and merger transactions.

Section 334(b)(2) was enacted as part of the 1954 Code to replace the
subjective integrated transaction doctrine with an objective test, which
permitted the acquiror a cost basis in the target's assets if it made a "qualified
stock purchase" of at least 80% by value of the target's stock (excluding
certain preferred stock) and liquidated the target in a transaction meeting
various requirements. 56 The treatment of nonqualifying stock purchases
followed by liquidations and of qualified stock purchases followed by
statutory mergers and other asset transfers that failed to qualify as liquidations
was left to common law.

In 1982, Congress replaced section 334(b)(2) with section 338, which
permits acquirors to elect to treat a qualified stock purchase as an asset
purchase, but treats the target as selling its assets for fair market value to a
new target that does not succeed to the original target's corporate tax
attributes. Under pre-1987 law, this deemed asset sale was tax-free to the
target (except to the extent of certain recapture income).'57 In an oft-quoted
passage, the Conference Report accompanying section 338 states that the
provision was "intended to replace any nonstatutory treatment of a stock
purchase as an asset purchase under the Kimbell-Diamond doctrine."'' 58

In Revenue Ruling 90-95, 159 the Service relied on this language in
interpreting section 338 as preempting and reversing the Kimbell-Diamond
doctrine with respect to a qualified stock purchase followed by the target's
liquidation where a section 338 election is not made."6 In other words, a

156. Sections 334(b)(2) and 337 left a doctrinal anomaly that rendered the statutory
result inconsistent with the continuity of interest theory underlying prior case law: The
acquiror was permitted a cost basis in the target's assets, which is consistent with an asset
purchase, but the target was not taxed, and the stock seller's gain or loss on the sale was
measured by reference to stock basis (which together are more consistent with a stock sale
than a deemed liquidation followed by an asset sale).

157. See IRC § 337 (1954).
158. H.R. Conf. Rep. No. 760, 97th Cong., 2d Sess. 536 (1982), reprinted in 1982-2

C.B. 600, 632.
159. 1990-2 C.B. 67.
160. As discussed supra Part III.D, the Kimbell-Diamond doctrine would treat an

integrated stock purchase and liquidation as a deemed asset purchase in which purchaser
acquires the assets with a cost basis.

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19961 Devolution & Inevitable Extinction of the Continuit. of Interest Doctrine 233

nonelecting acquiror purchasing 80% or more of target's stock for cash and
liquidating target as part of an integrated transaction (the facts of Kimbell
Diamond) is not treated as purchaser of the target's assets; instead, each step
is "awarded independent significance," and the acquiror absorbs the target
with a carryover basis in its assets. 6 '

In October 1995, following the recommendations of the New York
State Bar Association, 6 2 the Service promulgated regulations that signifi-
cantly limit the application of the continuity doctrine, extending the result of
Revenue Ruling 90-95 beyond the second-step liquidation transaction that was
the subject of Kimbell Diamond to include a qualified stock purchase for
which a section 338 election is not made, followed by a reorganization.'"
The regulations interpret section 338 to require, in effect, that a non-electing
acquiror be treated as a historic shareholder of the target, but only with
respect to the acquiror, its subsidiary, and the target. Thus, under the
regulations, the qualified stock purchase of target stock by the acquiror,
followed by a merger of the target into the acquiror's wholly-owned
subsidiary, is a tax-free reorganization for target and subsidiary, and the
subsidiary takes the target's assets with a carryover basis.

The regulations effectively reverse Yoc Heating Corp. v. Commission-
er,"6 where an acquiror purchased 85% of a target's stock for cash and
notes and, as part of an integrated transaction, caused the target to transfer its
assets to acquiror's newly formed subsidiary. In the latter step, the target's
minority shareholders received cash in exchange for their target stock, the
acquiror received additional shares of its subsidiary, and the target liquidated.
The Service argued that the second-step was a D or F reorganization and that
the acquiror's subsidiary therefore received the target's assets with a
carryover basis (which was less than the sum of the acquiror's purchase price
and the cash paid by subsidiary for the minority shareholders' target shares).
The taxpayer disputed this assertion and claimed the benefit of section
334(b)(2), the Kimnbell-Diamnond doctrine, or the integrated transaction
doctrine to obtain a stepped-up cost basis in the acquired target assets.

The Tax Court, in allowing a cost basis, held that while section
334(b)(2) and the broader Kimnbell-Diamond doctrine applied only to
liquidations, the asset transfer by the target to acquiror's subsidiary also was

161. IRC § 334(b).
162. New York State Bar Ass'n Tax Section. Report on Reorganizations of Target

Corporations Following a Qualified Stock Purchase Under Section 338. 94 TNT 205-11 (Oct.
19, 1994) (LEXIS, FEDTAX library, TNT file).

163. Regs. § 1.338-2(c)(3). 60 Fed. Reg. 54942 (Oct. 27, 19951. The regulations
were proposed in February, 1995. See 60 Fed. Reg. 9309 (Feb. 17. 1995).

164. 61 T.C. 168 (1973). Accordingly, the regulations are commonly known as the
anti-Yoc Heating regulations, and are referred to as such from time to time in this article.



Florida Tax Review

not a reorganization because it failed the continuity of interest test. The court
held further that the integrated transaction doctrine provided authority for a
stepped-up basis equal to the cash paid by the acquiror for target stock plus
the cash paid by subsidiary to the target's minority shareholders. 6 5

However, while the regulations reverse Yoc Heating and deem
continuity to be satisfied with respect to acquiror and target, they retain the
continuity of interest doctrine-and deem it to be failed-with respect to the
target's minority shareholders, even if they receive acquiror or subsidiary
stock in the transaction, unless the combined transactions otherwise satisfy the
continuity requirement. Accordingly, minority shareholders of target in a
section 338 integrated stock purchase and merger generally recognize gain or
loss. This result preserves the result of Kass v. Commissioner.'66

The Preamble to the Regulations explains the Service's view that
Congress intended a section 338 election to be the exclusive means for
acquiring a cost basis in a target's assets following a qualified stock purchase
and that a merger of the target into a wholly-owned subsidiary therefore
should not result in a cost basis unless the election is made. Deeming
continuity to be met for target, acquiror, and subsidiary is "the simplest and
most effective means" of achieving that result. 167 The Preamble asserts that
retaining a continuity requirement for minority shareholders is appropriate
because "the legislative history does not indicate any intention to provide
reorganization treatment for all purposes to exchanges of stock incident to
asset transfers after [qualified stock purchases]." The legislative history of
section 338 does not "indicate any intent to eliminate the continuity of
interest requirement generally ....16

Neither the policy behind section 338 nor its legislative history
compels the approach of the anti-Yoc Heating regulations. After the repeal of
General Utilities, an acquiror cannot make a qualified stock purchase, decline
to make a section 338 election, merge the target into the acquiror's wholly-
owned subsidiary and simply claim a cost basis in target's stock, as could the
taxpayer in Yoc Heating. Instead, if the second-step merger is integrated with
the stock purchase or fails to satisfy continuity, the target recognizes gain or
loss on the transfer of its assets in the merger,69 which is exactly what

165. As discussed above in note 99, the Yoc Heating court applied the continuity
test for F reorganizations, which arguably is different in purpose, history, and application from
the more generally applicable continuity of interest doctrine that originated in Cortland and
Pinellas.

166. Kass is described in supra note 144.
167. 60 Fed. Reg. 54942, 54943 (Oct. 27, 1995).
168. 60 Fed. Reg. 9309, 9310 (Feb. 17, 1995).
169. This result occurs whether the target is viewed as liquidating and its share-

holders as making the sale, or the merger is viewed as a taxable asset sale.

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1996] Devolution & hievitable Extinction of the Continity of Interest Doctrine 235

happens with a section 338 election. The legislative history to section 338
that was relied upon in the Preamble as the basis for overruling Yoc Heating
states only that Congress intended to replace common law "under the
Kimbell-Diamnond doctrine." As described above, the Tax Court in Yoc
Heating (which was decided nine years before section 338 was enacted) took
pains to hold that the Kinbell-Diamnond doctrine applied only to a second-step
liquidation, and not to a second-step reorganization. Thus, if Congress
intended to overrule Yoc Heating, it would not have done so by mentioning
only Kimbell-Diamnond. Moreover, if by citing only Kimnbell-Dianmond and not
Yoc Heating, Congress intended to replace common law treatment for
liquidations only, it would have no occasion for addressing the continuity of
interest requirement. Thus, Congress' silence is not necessarily a basis for
selectively taxing the target's minority shareholders on a merger following a

qualified stock purchase.
Although the Preamble to the regulations offers no further insights to

the statutory basis or other reasons for the new rules, the New York State Bar
Association report (the Bar Report) that precipitated them offers several
reasons for the treatment of both the corporate parties and the target's
minority shareholders.

First, the Bar Report notes that, in the most straightforward case, in
which the acquiror after a 100% qualified stock purchase merges the target
into acquiror's wholly-owned subsidiary, tax-free treatment and a carryover
basis could have been achieved by having acquiror's subsidiary make the
stock purchase with funds contributed by the acquiror and then causing the
target to liquidate into the subsidiary. Alternatively, where the target's
minority shareholders receive subsidiary stock in a merger following the
qualified stock purchase, the same result could be achieved by the acquiror
and the target's minority shareholders contributing target stock to the
subsidiary for subsidiary stock in a tax-free section 351 exchange and causing
target to liquidate.17' Since the result of a qualified stock purchase and
merger can be accomplished tax-free by alternative means, the Bar Report
argues that the direct transaction should also be tax-free. Stated another way,
no valid policy is served by imposing a corporate-level tax on a target
corporation that is merged into a nonelecting acquiror's subsidiary following

170. See supra text accompanying note 165.
It was necessary for Congress to make clear that a § 338 election was the exclusive

means to obtain a cost basis in an integrated qualified stock purchase and liquidation
transaction. In American Potash & Chem. Corp. v. United States. 399 F.2d 194 (Cl. Ct. 1968),
the court held that § 334(b)(2) did not preempt the Kimbell-Diantond doctrine and that a
taxpayer failing to satisfy § 334(b)(2) could still obtain a cost basis under Kimbell-Diamond.

171. Other paths to this happy result are traversed in Ginsburg & Levin. supra note
1, § 610.9 at 616-22.



Florida Tax Review

a qualified stock purchase. Since the only bar to this treatment is the
continuity of interest requirement, the most direct path to achieve this result
(short of reexamining the entire continuity doctrine) is to deem continuity to
be satisfied selectively.

However, this leaves the nagging question of why the continuity of
interest requirement was not entirely eliminated for section 338 integrated
transactions and why the regulations continue to apply it to cause the target's
minority shareholders to recognize gain or loss on the exchange of target for
subsidiary stock. The Bar Report offers several reasons for this result.

First, if the economically similar result were accomplished without
a qualified stock purchase but simply by merging target into subsidiary with
the consideration consisting of more than 80% cash, the continuity of interest
doctrine would deny tax-free treatment to minority shareholders receiving
subsidiary stock. Accordingly, the target's minority shareholders should not
be entitled to tax-free treatment solely as a result of the acquiror's qualified
stock purchase.

The argument that like transactions should be taxed similarly has
great appeal. Absent a wholesale rejection of the continuity of interest
doctrine (which would allow tax-free treatment to minority shareholders in
either situation), if under any similar transaction, minority shareholders would
be subject to tax, the regulations might be justified in maintaining the status
quo. However, if the acquiror purchases target stock in a qualified stock
purchase and together with target minority shareholders contributes target
stock to the acquiror's subsidiary for subsidiary stock in a section 351
transaction, both acquiror and target minority shareholders would receive the
subsidiary stock tax-free. The subsidiary could then liquidate the target tax-
free into subsidiary and receive the target's assets with a carryover basis.
Thus, the rationale for not taxing the corporate parties in a Yoc Heating
transaction-that a nontaxable result can be achieved in an alternative
structure-might also justify the conclusion that the continuity of interest
doctrine should not be a bar to tax-free treatment for the minority sharehold-
ers. 1

7 2

172. Section 351 treatment is not available if target minority shareholders receive
acquiror stock. There is no evident reason for taxing target minority shareholders if they
receive acquiror stock, while not taxing them if they receive subsidiary stock, especially after
the statutory repeal of Groman and Bashford. See supra Part IV.A and infra Part V.A.6.

However, parent stock consideration may be possible in a tax-free transaction. If the
target is recapitalized before the merger by making its common stock mandatorily exchange-
able for parent stock, this E-type recapitalization would apparently be respected, even though
it is a component of a larger transaction. See Rev. Rul. 76-223, 1976-1 C.B. 103 (two step
transaction in which preferred stock of target was converted into 19% of voting common stock
and acquiror acquired remaining 81% of voting common stock for voting stock of acquiror
qualified as a recapitalization followed by a B reorganization); Priv. Let. Rul. 9207028 (Nov.

[Vol. 3:5



1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 237

Second, the Bar Report argues that it is appropriate to tax minority
shareholders because existing law (e.g., Kass) denies tax-free treatment to the
target's minority shareholders and, absent a compelling reason, regulations
under section 338 should not change this result. 17" Although Kass held that
minority shareholders in a section 334(b)(2) liquidation/merger were subject
to tax, Kass (and for that matter Yoc Hearing) was decided prior to the
enactment of section 338. The legislative history of section 338 indicates that
Congress intended to "replace any nonstatutory treatment of a stock purchase
as an asset purchase." The only reason the Yoc Heating court treated the
stock purchase as an asset purchase was the continuity of interest doctrine.
If Congress really had the reversal of Yoc Healing in mind when it enacted
section 338, it is far more likely that its stated intent to "replace any
nonstatutory treatment" meant that the entire continuity doctrine should be
abandoned in the context of a qualified stock purchase followed by a merger,
rather than that it be retained only with respect to minority shareholders. This
result is also more consistent with the statutory framework. Section 368(a)(1)
defines a reorganization for all parties to a transaction, and if a reorganization
is found, the balance of Part IIH of Subchapter C determines the consequences
of the transaction for each party. The regulations reject that framework and
impose another, in which "reorganization" is defined party by party. Perhaps
the Service has the regulatory authority to promulgate such a rule, but even
if Congress intended section 338 to reverse Yoc Healing, it likely did not
intend to adopt the regulations' mechanism, rather than simply deeming the
nonstatutory continuity requirement to be satisfied for all parties.

Finally, the Bar Report argues that minority shareholders should be
taxed because the nature of their investment has changed. This argument
simply begs the ultimate question of whether the continuity of interest
doctrine is an appropriate basis to deny minority shareholders tax-free

19, 1991) (recapitalization as part of an integrated merger respected as separate transaction),
discussed infra text accompanying note 185. Of course, exchangeable stock presents issues that
are beyond the scope of this article. See generally Kenneth H. Heitner & Jonathan M. Kushner,
To Bifurcate or Not to Bifurcate: The Answer Becomes Less Clear. 46 Tax Law. 43 (1992).

In addition to its Yoc Heating recommendations, the Bar Report proposed that the
continuity of interest requirement be jettisoned (even for minority shareholders) for the merger
of a target into a newly-formed subsidiary in a transaction that would otherwise qualify as an
F reorganization. See supra note 97. This proposal has not of yet been accepted or rejected by
the Service. It is not clear as a policy matter why a merger into an existing subsidiary should
be taxable to minority shareholders for failure of continuity, but the identical merger into a
newly-organized subsidiary should be tax-free.

173. The Preamble also suggests that the Service saw sonic merit to this argument.
See 60 Fed. Reg. 54942, 54943 (Oct. 27, 1995) ("extension of reorganization treatment to the
minority shareholders in this case would inappropriately alter general reorganization principles.
and would not be grounded in the policies of section 338").



Florida Tax Review

treatment since all reorganizations change the nature of all target share-
holders' investments.

The continuity of interest doctrine was originally developed to
distinguish merger-like reorganizations from asset sales on the basis of the
consideration received by the target. As described above in Part III.D,
applying the continuity doctrine to integrated transactions is wholly
inconsistent with its original purpose because its invocation has no effect on
the target. Nevertheless, the doctrine did serve as a convenient basis to permit
a purchaser of target stock to obtain a stepped-up basis for the assets after the
target is merged into the acquiror's subsidiary. And, application of the
continuity doctrine to integrated stock purchase and merger transactions did
allow for consistent treatment of the acquiror's subsidiary (which, under
Madison Square Garden,74 received target's assets with a full step-up to
fair market value) and target's minority shareholders (who, under Kass,
recognized gain or loss on the transaction). With the enactment of section
338, failing continuity is no longer necessary to permit the subsidiary to
achieve a cost basis; instead, that treatment is elected under section 338.175
Thus, section 338 and its legislative history can be seen as a legislative
rejection of the application of continuity to integrated qualified stock purchase
and merger transactions.

Ironically, the Bar Report's suggestion to the Service that it tax only
the minority shareholders in a merger following a qualified stock purchase
may imperil the original purpose of the Report-to facilitate these transac-
tions. Under the laws of many states, parents of subsidiaries with minority
shareholders have a fiduciary duty to treat the minority shareholders fairly
with respect to transactions with the parent (and, presumably, with the
parent's other subsidiaries).'76 According to one court, this duty is breached
when the parent receives something "to the exclusion of, and detriment to, the
minority stockholders of the subsidiary."' 177 It is an open question as to
whether, without some additional compensation, this standard is satisfied by
a merger that allows a parent to combine the business of two subsidiaries but
subjects to tax only the minority shareholders that receive stock of the
surviving corporation.

174. Madison Square Garden Corp. v. Commissioner, 500 F.2d 611 (2d Cir. 1974).
175. One must consider whether continuity is necessary where a § 338 or

§ 338(h)(10) election is made.
176. See generally David A. Drexler, et al., Delaware Corporation Law and Practice

§§ 15.11, 15.59 (1996).
177. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) ("Self dealing

occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to
act in such a way that the parent receives something from the subsidiary to the exclusion of,
and detriment to, the minority stockholders of the subsidiary").

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1996] Devolution & Inevitable Eiinction of the Continuity of Interest Doctrine 239

C. Continuity Without Stock

Despite the Service's success in Le Tulle, where the Court severed the
stock or securities requirement from the definition of reorganization, holding
that some acquiror stock was required to be received by the target in order
for an acquisition to be a reorganization, the Service has not hesitated to
distance itself from that requirement where contrary policies predominate.

In Paulsen v. Conmzissioner,"'7 the Supreme Court, at the Service's
urging, held that the statutory merger of a state stock savings and loan into
a federal mutual was not a reorganization for lack of continuity. In the
merger, the target's shareholders exchanged their stock for passbook savings
accounts in the mutual. The Service argued that the transaction failed the
continuity requirement because the passbook accounts were not equity in the
mutual. The Court ruled for the Service, but based its opinion on the
narrower ground that the passbook accounts were "cash equivalents,"'79

which were not an adequate interest in the acquiror to satisfy the continuity
test. Paulsen is consistent with the teachings of Cortland and Pinellas that an
asset transfer entirely for cash or cash equivalents is more like a sale than a
tax-free transaction. Although the Paulsen Court was without statutory basis
in applying the continuity doctrine to a statutory merger," there is at least
some historical support and strong policy reasons for requiring at least some
acquiror equity consideration in even a statutory merger.

As discussed above, in 1934, when Congress introduced the statutory
continuity requirement of solely voting stock consideration for B and C
reorganizations, implicitly reaffirming that no continuity is required for a
statutory merger, most states' laws required that the consideration in a
statutory merger include stock or securities of the acquiror. Although A
reorganizations continue to be defined by reference to state laws (presumably
current laws), which reflect relaxed merger requirements since 1934, it was
not unreasonable for the Paulsen court to, in effect, interpret the phrase
"statutory merger or consolidation" by reference to the law in 1934, when
Congress last considered the issue.

Moreover, a contrary holding, allowing a merger or consolidation
with only cash consideration, would entirely eliminate the distinction between
tax-free transactions and taxable sales. The Paulsen Court, in holding that the
acquiror's consideration in a reorganization may not consist entirely of "cash
equivalents," therefore adopted a pragmatic approach that was consistent with
Cortland and Pinellas and as loyal to the statutory language as countervailing

178. 469 U.S. 131 (1985).
179. Id. at 140. The position upheld in Paulsen was first asserted by the Service in

1969. See Rev. Rul. 69-6, 1969-1 C.B. 104.
180. See supra Part II.C.



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policy views would permit. It is notable that the Court in Paulsen did not
prohibit a statutory merger solely for securities of the acquiror.

The Service soon found that the requirement it succeeded in imposing
in Paulsen-that the target or its shareholders must receive equity in the
acquiror-would imperil tax-free treatment for other transactions involving
mutual savings banks and mutual savings and loans. First, in a conversion of
one of these institutions into a stock corporation, depositors in the mutual
typically receive a "liquidation account" that preserves only their rights to the
assets of the mutual on its liquidation (and only then to a limited extent).
Depositors are also usually issued subscription rights for stock, but these
rights normally require a cash payment by the holder on exercise. Under
traditional debt/equity analysis, an instrument, such as the liquidation account,
that provides a fixed return and does not provide for any meaningful upside
potential or downside risk in the issuer, or voting rights, is not ordinarily
treated as stock.' 8' Thus, since neither the target nor its shareholders receive
acquiror stock for target assets, the transaction apparently fails the Service's
exposition of the continuity doctrine. Nevertheless, in two published rulings,
the Service held that in the merger of one mutual into another, the liquidation
accounts are a sufficient equity interest for continuity of interest purpos-
es. 82 In Revenue Ruling 80-105,' the Service further held, on the basis
of the earlier rulings, that the conversion of a mutual into a stock institution
is an F reorganization.

Next, the Service was faced with whether such a converted entity
could be acquired in a triangular reorganization. In a triangular merger of a
former mutual into a subsidiary of a stock corporation, only actual sharehold-
ers in the target receive parent stock; the former passbook holders retain their
liquidation accounts in the acquiring subsidiary. Thus, the lingering Groman-
Bashford problem was presented in spades: If passbook holders and stock-
holders in the former mutual hold equity and the passbook holders receive an
interest in subsidiary, while the stockholders receive an interest in the parent,
is the parent or the subsidiary the "party to the reorganization?" Or, to take
the Service's view of Groman and Bashford, the transaction flunks remote

181. See generally William T. Plumb, Jr., The Federal Income Tax Significance of
Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971).

182. See Rev. Rul. 69-646, 1969-2 C.B. 54; Rev. Rul. 69-3, 1969-1 C.B. 103.
In dictum, the Paulsen court rationalized these rulings by comparing what target

shareholders received with what they gave up; since passbook holders held only a nominal
equity interest, they need receive nothing more. This reasoning is tangled in the branches of
continuity dogma. The continuity question is whether, at the corporate level, the consideration
tendered by the acquiror renders the transaction more sale-like or more merger-like. Only if
the consideration received by the target is sufficiently merger-like is the consideration received
by target's equity holders tested for "stock or security" status under § 354.

183. 1980-1 C.B. 78.

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1996] Devolution & Inevitable Extinction of the Contiuuity of Interest Doctrine 241

continuity. However, in a triumph of policy over doctrine, the Service, in a
series of private rulings, adopted the inconsistent position that, although the
liquidation accounts sufficed as a continuing interest in mutual-mutual
mergers and mutual to stock conversions, they are not considered stock of the
acquiror that could blow a triangular reorganization.'

The final hoop involved the consequences of an integrated transaction
in which a mutual savings bank converts into a stock savings bank (with
passbook holders in the mutual receiving liquidation accounts in the stock
institution) and the new stock bank merges into a newly-formed subsidiary
of an acquiror with former passbook holders receiving cash for their
liquidation accounts.s' If liquidation accounts are treated as equity in the
former mutual for purposes of qualifying the first step of the transaction as
an F reorganization, the immediate cash-out of that equity interest in the
second step of the transaction defeats the first-step F reorganization. This
time, to reconcile the irreconcilable, the Service held that the first-step
conversion is not an F reorganization, as Revenue Ruling 80-105 held, but is
instead an E-type recapitalization, which has no continuity requirement."

V. THE END OF CONTINUITY AS WE KNOW IT

Parts I through IV of this article show how the continuity doctrine
escaped its rationale and was applied indiscriminately without regard to its
historical purpose, and how only significant contrary policies have forced
Congress, the Service, and the courts to reexamine its outer boundaries. This
Part begins by examining some of the consequences of the current continuity
of interest doctrine from a tax policy perspective. It concludes that the
consequences of the doctrine reflect such poor tax policy that revision is
inevitable, and considers some alternative conceptions of continuity that could
form the basis of a new doctrine of more limited scope.

A. The Consequences of Continuitn

1. Abuse Potential.-Continuity has always been a doctrine of
universal application. Historically, it has been invoked by taxpayers seeking

184. See, e.g., Priv. Let. Rul. 8942058 (July 25. 1989). Priv. Let. Rut. 8739053
(June 30, 1987).

185. See Priv. Let. Rul. 9207028 (Nov. 19. 1991). For a more detailed history and
analysis of mutual conversions and acquisitions, see Robert J. Jones, et al., IRS Clarifies
Conversions of Financial Institutions from Mutual to Stock Form, 6 J. Bank Tax'n 9 (1992);
Gregory J. Soukup, The Continuity-of-Proprietary-Interest Doctrine and Thrift Institution
Mergers, 12 J. Corp. Tax'n 141 (1985).

186. This ruling suggests that a recapitalization that is the first step of an integrated
transaction is respected as such, and not collapsed into the other steps.



Florida Tax Review

to recognize losses or avoid other undesirable consequences of reorganization
status, with the same frequency and zeal as it has been invoked by the
Service.187 When the Service applies the doctrine expansively to force
recognition of gain, it invites taxpayers to assert the doctrine to recognize
loss. For example, the Service apparently maintains that remote continuity
may be lost by an acquiror's transfer of a target's assets to a partnership
largely owned by the acquiror (or even wholly-owned by an acquiror
group).' 88 When asserted by taxpayers, this position effectively permits tax-
payers to elect out of reorganization treatment by engaging in an economical-
ly insignificant transaction. Additionally, in a private acquisition that hugs the
boundaries of continuity thresholds, different parties may take inconsistent
positions as to the existence of continuity, with, for example, target
shareholders realizing gain on their receipt of acquiror stock reporting a tax-
free reorganization and those with losses claiming that continuity was lacking.

In this respect, the Seagram case is interesting not only as a
substantive decision, but as a roadmap of tax-planning potential for target
shareholders wishing to deduct losses with respect to their exchanged target
shares. In Seagram, escape from the reorganization provisions appears to have
been an afterthought for a large target shareholder but, had the decision gone
the other way, Seagram's progeny would almost certainly have involved
clever prearranged transactions in public deals.

A private letter ruling issued on the basis of the representations
required by Revenue Procedure 77-37 may also open the door to inconsistent
treatment. So long as less-than-5% noninsider shareholders of a public target
own at least 50% of the target's stock, and at least 50% of the consideration
in the acquisition consists of acquiror stock, continuity is deemed met,
regardless of whether all of the target's shares immediately before-or the
acquiror's equity consideration immediately after--changes hands. Current
continuity law suggests that, notwithstanding a private ruling recognizing
reorganization status, the target or target shareholders with information about
pre- or post-acquisition sales could report the transaction as taxable, without
affecting the other parties' treatment.8 9 This abuse potential of continuity

187. Reorganization status may give rise to adverse tax consequences that could be
avoided by qualifying the transaction under some other nonrecognition provision and
simultaneously breaking continuity. For example, preferred stock issued in a B reorganization
may be § 306 stock, but preferred stock issued in a § 351 transaction is not § 306 stock. All
other things being equal, taxpayers might choose to flunk continuity to avoid § 306. See Rev.
Rul. 79-274, 1979-2 C.B. 131 (for purposes of § 306, § 368(a)(1)(B) and not § 351, governs
if a transaction qualifies under both).

188. See supra note 101 and accompanying text.
189. Likewise, for reorganizations clearly busted under the continuity doctrine, but

which might arguably qualify for tax-free treatment under § 351, the continuity doctrine
suggests additional potential for inconsistent treatment.

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19961 Devolution & hIevitable Ertinction of the Continuity of Interest Doctrine 243

is compounded if the representation protocol of Revenue Procedure 77-37 is
a safe harbor for taxpayers, even in the absence of a private letter ruling, as
some suggest. 90

The anti-Yoc Heating regulations, by requiring inconsistent treatment
of the corporate parties, on the one hand, and the target's shareholders, on the
other, sanction what might be regarded as a similar abuse. For example,
assume that a target's basis in its assets and the target shareholders' aggregate
basis in their stock each exceed the value of target. If the shareholders sell
80% of the stock for cash to an unrelated parent company, and the parent
company merges the target into its wholly-owned subsidiary without making
a section 338 election, the target shareholders recognize loss on all of their
target stock, including the 20% exchanged for stock of the parent, while the
parent retains the benefit of the target's high asset basis.

While complexity, uncertainty, and inconsistency might be regarded
as inevitable taxpayer tools in any sophisticated tax system, a test that
depends upon subjective elements and ill-defined rules, as does the current
continuity doctrine, is an invitation to abuse.

2. Admzinistrability.-The Seagran case, viewed from the govern-
ment's perspective, also reveals the unadministerability of a doctrine that
depends on the intent and conduct of the acquiror and unrelated target
shareholders, that does not require disclosure or consistent treatment, and that
is vaguely-defined by uncertain criteria. If Seagram had ultimately succeeded
in its litigation (Seagram lost in the Tax Court and the case was settled before
a decision on appeals), the Service would have faced tremendous whipsaw
potential from Conoco's public shareholders who are not likely to amend
their returns to report gain. And, Seagram's failure in the Tax Court certainly
does not prevent the Conoco shareholders that realized losses on receipt of
DuPont stock from making similar claims on their open tax returns (especial-
ly now that the case will not win appellate level imprimatur). The Code could
be amended to provide for disclosure and universal characterization of
reorganization transactions, as it does in other contexts,' 9' or to provide for
unified audit procedures,192 but the system is unequipped for the continuity
doctrine in all of its present glory.

3. Economic Efficiency.-The current continuity rule creates basic
economic inefficiencies. First, because under Revenue Procedure 77-37 only
5% or greater shareholders of a public target can adversely affect continuity,

190. Ginsburg & Levin, supra note 1, § 610.10 at 629.
191. See, e.g., IRC § 385(c) (issuer's characterization of instrument as equity or

debt is binding on holders unless contrary position is disclosed).
192. See, e.g., IRC §§ 6221-6233 (unified audit procedures for partnerships).



Florida Tax Review

the doctrine places a premium on their actions. This premium may be
magnified if some 5% shareholders are unable (or unwilling) to indicate their
intent with respect to the acquiror stock they will receive. (For example,
mutual funds routinely decline to represent that they have no plan or intention
to sell acquiror stock.) 193 This artificial premium generated by the tax law
is inefficient because one historic 5% shareholder, by declining to give the
necessary representation or threatening to dispose of acquiror shares
immediately after receipt, can potentially stall an acquisition that would
increase value for all target shareholders.

Second, the continuity representation of Revenue Procedure 77-37,
by deeming all less-than-5% shareholders of a public target to be historic
holders of target stock and long-term holders of acquiror stock, regardless of
actual conduct, permits these shareholders to cash out. By also requiring that
no more than 50% of acquiror's aggregate consideration consist of nonequity,
Revenue Procedure 77-37 requires that target shareholders who cash out must
use their own brokers to sell acquiror stock. The practical effect of this
requirement is simply an added cost for these target shareholders: their
broker's commission.

Finally, by virtue of the favorable representation for public tar-
gets-all less-than-5% (as opposed to 1%) noninsider target shareholders are
counted as good for continuity purposes-the tax law encourages acquisitions
of public as opposed to private targets because it is generally easier to be
assured of tax-free treatment.

None of these inefficiencies is justified by any countervailing policy
reason, and each of them could be reduced or eliminated by a lower
continuity threshold.

4. Fairness.-Fairness concerns are always raised when an acquiror's
post-reorganization use of target assets or the actions of a majority of the
target shareholders has the potential to affect minority target shareholders.
These concerns are also raised under the anti-Yoc Heating regulations, which
tax only minority shareholders on a qualified stock purchase-merger
transaction. As mentioned earlier, these fairness issues present interesting
questions under state law.

5. Uncertainty.-It is unclear what percentage of the acquiror's
consideration must consist of stock in order to satisfy the continuity of
interest test. Revenue Procedure 77-37 provides that a favorable private letter
ruling will be issued only if the historic target shareholders, as a group,
exchange at least 50% by value of the total outstanding target stock for

193. See Ginsburg & Levin, supra note 1, § 610.10 at 630.

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1996) Devolution & Inevitable Ertinction of the Continuity of Interest Doctrine 245

acquiror stock. In John A. Nelson Co. v. Helvering,'" the Supreme Court
found that continuity was satisfied when 38% of the target shareholders'
consideration consisted of stock. The Sixth Circuit has found continuity to be
satisfied when only 25% of target shareholders' consideration consisted of
acquiror stock.195 On the other hand, the Tax Court found 16% to be
inadequate in Kass v. Commissioner.'" These ranges of acceptability create
uncertainty, which tends to interfere with transactions at the fringes and
otherwise to contribute to the heartburn of tax lawyers.

6. Inconsistent and Anomalous Treatment.-The existence of a
continuity requirement for some nonrecognition transactions but not others
results in anomalous treatment when economically similar transactions are
characterized differently. For example, the Service apparently maintains that
the use of grandparent stock as consideration for a merger violates the remote
continuity doctrine, but a direct acquisition followed by a double drop-down
of the target's assets to a second-tier subsidiary is tax-free.',9 Second,
because the continuity test is concerned only with consideration received by
the target's shareholders, a "cash out merger" of target into acquiror fails
continuity, but the transaction can be made tax-free by reversing the
parties."' Third, it is sometimes possible to use other nonrecognition
provisions without a continuity requirement-such as section 35 1-to reach
the same results as a reorganization.' 9 Finally, nonconvertible, nonvoting
preferred stock that is redeemable at any time and mandatorily redeemable
if earnings exceed a specific threshold is considered a sufficient equity stake
for continuity purposes, -° but a reorganization is flunked on continuity
grounds if the acquiror agrees to assist the target shareholders in selling
acquiror stock, even if the shareholders bear real equity risk for six
months.20' These opportunities all perpetuate anomaly and elevate form
over substance.

194. 296 U.S. 374 (1935).
195. Miller v. Commissioner, 84 F.2d 415 (6th Cir. 1936).
196. 60 T.C. 218 (1973), aff'd without opinion, 491 F.2d 749 (3d Cir. 1974j.
197. See supra note 110.
198. See Bittker & Eustice, supra note 5, 1 12.21191 at 12-39; Ginsburg & Levin.

supra note 1, §§ 610.12-610.13 at 637-40.
199. See, e.g., Rev. Rul. 84-71, 1984-1 C.B. 106 (failed reverse triangular merger

treated as a § 351 transaction). See generally Ginsburg & Levin, supra note 1, § 610.14 at 640.
See also Ginsburg & Levin, supra, § 610.15 at 640-41 (use of recapitalization to bypass
continuity).

200. See Schweitzer & Conrad, Inc. v. Commissioner, 41 B.T.A. 533 (1940).
201. See McDonald's Restaurants of Illinois v. Commissioner. 688 F.2d 520 (7th

Cir. 1982) (merger occurred on April 1, 1973; stock was sold on October 3. 1973).



Florida Tax Review

7. Tax Policy ofNonrecognition.-A full discussion of the continuity
doctrine requires at least some mention of the basic policies behind tax-free
acquisitions and a consideration of whether the modem expression of the
continuity doctrine is consistent with those policies. Two categories of
policies are frequently cited as supporting tax-free treatment for reorganiza-
tions."oz

From the target shareholders' perspective, a "paper transaction," in
which the shareholders' investment acquires new legal form but is economi-
cally unchanged, is viewed as not being an appropriate event to trigger
recognition of gain or loss.20 3 Also, even if the target shareholders' invest-
ment changes dramatically (as often occurs when an operating target merges
into an operating acquiror), the illiquidity or possibly difficult valuation of the
newly-received shares (especially in a private deal), and the notion that a
passive exchange should not be a taxable event, possibly requiring a sale of
the investment to pay taxes, all argue against current taxation."w

At the corporate level, the policies are somewhat different. In addition
to policies against the conversion of dividends into liquidation proceeds (e.g.,
in a liquidation-reincorporation transaction) or the artificial generation of
losses (for example, by having an operating company with high basis assets
sell those assets to a shell owned entirely by its former shareholders), the
reorganization provisions act as a subsidy for-or, at least, do not discour-
age-certain corporate transactions meeting specific statutory descrip-
tions.20 5 These policies are tempered by a generalized tax policy against
expanding nonrecognition to situations that are not intended to benefit from
such favorable treatment. This countervailing policy is difficult to apply at the
corporate level where the statutory policies supporting tax-free treatment are
based largely on form and are at times indeterminate. However, it has been
clear for over 60 years that cash asset sales are not deserving of nonrecogni-
tion treatment. The continuity of interest doctrine has served as one

202. See generally Staff of Joint Comm. on Taxation, 99th Cong., 1st Sess., Federal
Income Tax Aspects of Mergers and Acquisitions, reprinted in DTR (BNA) No. 62 (April 1,
1985); Bittker & Eustice, supra note 5, 12.01[1] at 12-7 to 12-9; Sheldon S. Cohen,
Conglomerate Mergers and Taxation, 55 A.B.A. J. 40 (1969); John Dane, Jr., The Case for
Nonrecognition of Gain in Reorganization Exchanges, 36 Taxes 244 (1958); Jerome R.
Hellerstein, Mergers, Taxes, and Realism, 71 Harv. L. Rev. 254 (1957); Milton Sandberg, The
Income Tax Subsidy in Reorganization, 38 Colum. L. Rev. 98 (1938); Stanley S. Surrey,
Income Tax Problems of Corporations and Shareholders: American Law Institute Tax
Project-American Bar Association Committee Study on Legislative Revision, 14 Tax L. Rev.
1 (1958); William J. Turnier, Continuity of Interest-Its Application to Shareholders of the
Acquiring Corporation, 64 Cal. L. Rev. 902, 910-16 (1976).

203. S. Rep. No. 617, 65th Cong., 3d Sess. 5 (1918).
204. See Hellerstein, supra note 202, at 262, 266.
205. See id. at 276-77; Sandberg, supra note 202, at 98.

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1996] Devolution & Inevitable Extinction of the Continuity of Interest Doctrine 247

mechanism to distinguish corporate transactions that advance corporate
nonrecognition policies from those, such as asset sales for cash, that do not.

However, the use of continuity to disqualify a reorganization on the
basis that it does not advance corporate-level policies sometimes clashes with
the policies that support nonrecognition treatment at the shareholder level.
Application of continuity in these cases to disqualify a reorganization elevates
the corporate policies over the shareholder policies.

For example, if only 10% of the acquiror's consideration for target
assets consists of acquiror equity-an insufficient amount to satisfy the
modem continuity test-the corporate-level policies are advanced by denying
the transaction tax-free treatment because it more resembles a sale than a
merger and therefore is beyond the intended scope of the corporate-level
subsidy. However, because continuity has not historically developed as a
doctrine that taxes only the party for which tax-free treatment is inappropri-
ate, applying the doctrine to the entire transaction, and taxing target
shareholders who receive illiquid acquiror stock, conflicts with one of the
important shareholder-level policies.

Moreover, while the continuity of interest doctrine is helpful in
identifying transactions that at the corporate level are not deserving of
nonrecognition treatment, it is not needed to distinguish those transactions in
which tax-free treatment is inappropriate at the shareholder level. Sections
354 and 356 ensure that target shareholders receiving cash and other
nonsecurity boot are subject to tax on any gain realized on the transaction,
notwithstanding reorganization status.

This conflict between corporate-level policies against tax-free
treatment and those favoring nonrecognition treatment at the shareholder level
is inevitable without a statutory mechanism at the corporate level that taxes
the target's realized gain in respect of assets transferred for nonqualifying
consideration. The continuity doctrine could be understood to reflect the view
that it is worse to allow a corporate target to escape taxation on an asset sale
than it is to tax a target shareholder deserving of tax-free treatment. But there
is no evidence that Congress ever made that choice. And the conflicting
policies suggest that continuity should bust an otherwise qualifying reorgani-
zation only where the reasons for taxing the target are clear.

On the other hand, it is clearly inappropriate to use continuity to bust
a putative reorganization that does not look like an asset sale at the corporate
level if doing so would result in taxing target shareholders deserving of
nonrecognition treatment. The Seagram case and the anti-Yoc Heating
regulations demonstrate this point best.

At the corporate level in Seagram, the transaction had all of the
hallmarks of a reorganization. The DuPont group's consideration for
Conoco's assets consisted over 50% of stock, which traditional notions of
continuity regard as sufficient to distinguish the acquisition from a taxable



Florida Tax Review

sale, and no other corporate-level considerations were identified that are
inconsistent with tax-free treatment. At the shareholder level, the DuPont
stock, while neither illiquid nor difficult to value, was received under
circumstances that are entirely consistent with the tax-free treatment of
shareholders under the reorganization provisions. Application of the
continuity doctrine to disqualify the reorganization therefore would not
advance either corporate- or shareholder-level policies. To the contrary, the
doctrine, if applicable, would permit Seagram to recognize a loss in a
transaction that, from its perspective, is indistinguishable from any other tax-
free transaction and-owing to the blunt nature of the continuity doc-
trine-could result in the taxation of Conoco and other Conoco shareholders
that received DuPont stock.

Application of the continuity of interest doctrine to tax minority
shareholders under the anti-Yoc Heating regulations is even more contrary to
congressional policies. The regulations express a policy decision, supported
by the legislative history to section 338, that the relevant corporate-level
policies support nonrecognition treatment. Yet, regardless of the shareholder
level policies that could be advanced by nonrecognition treatment (especially
if acquiror's stock is illiquid and difficult to value), the regulations apply the
dull edge of continuity to tax the minority shareholders on purely doctrinal
grounds.

B. Constructing a Valid Policy for a Strong Form of Continuity

It is certainly possible to conceive of a policy rationale for a strong
form of the continuity doctrine that would deny reorganization status to a
corporation undergoing significant equity shifts. Historically, our classical tax
system has tended to impose a corporate level of tax on those entities whose
interests are freely transferable. 2°6 Today, by virtue of the ease of qualifying
an entity as a partnership (including the recently proposed check-the-box
regulations), 2 7 the corporate-level toll charge effectively applies only to
operating entities whose interests are treated as liquid (publicly traded) under
section 7704. To the extent that the reorganization provisions (by deferring
corporate tax that would otherwise be imposed) represent an exception to the
corporate-level toll charge for liquidity, it may be appropriate to condition
this exception upon the equity holders foregoing their liquidity for some
period. The continuity doctrine is such a condition.

206. See Regs. § 301.7701-2(e) (distinguishing partnerships from corporations based
on, among other things, whether their interests are freely transferred).

207. See Prop. Regs. §§ 301.7701-1 to -3.

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1996] Devolution & Inevitable Ertinction of the Continuitn of Interest Doctrine 249

A related policy, expressed for partnerships in section 708, measures
liquidity by actual transfers and subjects to tax even equity holders that
remain invested if the ownership of the entity shifts significantly over a short
period of time. Continuity could be considered a similar rule, subjecting
shareholders to tax if their brethren abuse the transferability privileges
enjoyed by the group as a whole.20

However, if the continuity doctrine is a system for exacting a lock-up
of corporate ownership interests in exchange for deferral of corporate-level
tax, one would expect that a target corporation and its shareholders should
not be able, by failing continuity, to recognize loss.109 Moreover, if the
continuity doctrine is a mechanism for moderating the toll charge when
equity holders restrict transfers of their interests, its application is hopelessly
imprecise. The doctrine is an absolute test: Full nonrecognition is permitted
for targets experiencing significant shifts in ownership, so long as the shifts
are not greater than the continuity threshold. On the other hand, the target and
its shareholders are fully taxed on their gains if the threshold is exceeded by
even one selling shareholder.

Moreover, analogies to section 708 are, on close scrutiny, inapposite.
The continuity doctrine does not depend on the relative percentage interests
of the former target group in the new combined enterprise; in contrast to
section 708, a corporate minnow is permitted to swallow a whale tax-free
without severing continuity. ' 0 The section 708 comparison breaks down
entirely in the context of a publicly traded corporation, where the relationship
among shareholders regularly shifts without consequence. Placing significance
on this relationship for nontrading shareholders only proximate to an
acquisition is inappropriate. Finally, this rationale for continuity does not
embrace the remote continuity doctrine, which can break continuity even if

208. See Stanley S. Surrey & William C. Warren. Federal Income Taxation 1120
(1953) ("The congressional policy is that while such readjustments may produce changes in
the conduct of a business enterprise, these changes do not involve a change in the nature or
character of the relation of the owners of the enterprise to that enterprise sufficient to warrant
taxation of gain [or] allowance of loss").

209. Partners in an operating partnership (i.e., with assets other than cash or
marketable securities) that experiences a § 708 event are not permitted to claim a loss. See
IRC § 731(a)(2).

210. When partnerships merge, the partnership whose members on more than 50%
of the capital and profits interests in the surviving entity is deemed to continue; the other
partnership terminates (possibly subjecting its members to tax). IRC § 708(b)t2)lA). Thus, the
merger of a tiny partnership into a huge partnership is taxable for members of the tiny
partnership; in contrast, a merger of a tiny target corporation into a huge acquiror can be
entirely tax-free. Moreover, recently proposed regulations under § 708(b)(I)(B) would
altogether eliminate tax for partners whose partnership experiences a § 708 event. See Prop.
Regs. § 1.708-1(b)(1)(iv).



Florida Tax Review

the target's shareholders retain their acquiror stock and is without parallel in
subchapter K.

C. Alternative Conceptions of Continuity

The preceding discussion suggests that while the continuity doctrine
is useful in some limited form to distinguish a taxable sale from a tax-free
reorganization, the current doctrine has little statutory, historic, or tax policy
basis. Although conceivable policy rationales for the strong form do exist,
they have never been articulated by Congress or the Service, and at best are
a crude mechanism to advance those policies. The balance of this Part
suggests alternative and limited conceptions of continuity that could be the
basis for a coherent doctrine.

1. The Corporate Lawyers' Approach of Ginsburg &
Levin.-Professor Martin D. Ginsburg and Jack S. Levin, in their seminal
treatise on the taxation of corporate transactions, advocate a restricted but still
strong form of the continuity doctrine. They argue that the requirement that
the target shareholders as a group maintain a substantial equity participation
in the acquiror's enterprise following an acquisition is good tax policy.2'1

In general, they would abandon the remote continuity doctrine and measure
continuity based on beneficial interests in the target, whether directly or
indirectly held.2 12 They would codify Revenue Procedure 77-37 as a bright
line test binding the Service and taxpayers alike. However, they support the
anti-Yoc Heating regulations' treatment of the minority shareholders in an
integrated qualified stock purchase and merger.2 3 They would permit tax-
payers to assert the failure of continuity on equal terms with the Service, and
they argue that the taxpayer should have prevailed in the Seagram case.2 1

4

In many respects, the Ginsburg and Levin position represents
practitioners' tempered continuity wish list. By rejecting remote continuity,
they disclaim one aspect of the doctrine that most often interferes with
legitimate business structures. By arguing for codification of Revenue
Procedure 77-37, they express the tax lawyer's preference for clear rules that
do not impede most transactions, as well as the savvy realization that wars
are won battle by battle. Their failure to criticize the taxation of minority
shareholders under the anti-Yoc Heating regulations may reflect the nature of
their client base: typically, acquirors and targets who benefit from the rule,
rather than minority shareholders who are harmed. And, their unequivocal

211. Ginsburg & Levin, supra note 1, § 610 at 566.
212. Id. §§ 610.11.1-610.11.3 at 630-37.
213. Id. § 610.19 at 612.
214. Id. § 610 at 626-30.

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1996] Devolution & Inevitable Ertinction of the Contihuityl. of Interest Doctrine 251

support for a doctrine that permits taxpayers to elect in and out of reorganiza-
tion treatment by invoking continuity (even if that treatment is inconsistent
with the treatment accorded to other parties to the transaction) reflects their
desire to retain maximum flexibility for their corporate clients who might
alternatively wish to defer gain or recognize loss.

Although Ginsburg & Levin's suggestions would introduce modest

improvements in current law, they do not appear to be supported by any
comprehensive policy or basis. Also, they would perpetuate many of the
detrimental consequences of the continuity doctrine described above in Part
V.A.

2. Continuity as an Anti-Abuse Ruie.-Recent administrative practice
suggests that if the continuity doctrine were first introduced today, it would
be phrased as an anti-abuse rule whose failure would permit the Service to
bust an otherwise qualifying reorganization, but would not be available to the
target or its shareholders as a basis for deducting a loss on a transaction that
otherwise meets the statutory reorganization definition. '1

Transforming the continuity doctrine into an anti-abuse rule would be
consistent with Cortland and Pinellas, which fashioned the doctrine to
prevent taxpayers from obtaining reorganization treatment for transactions that

are, in substance, taxable sales. It would, however, run contrary to Heintz and
McDonald's, which suggest that continuity is equally available to taxpayers.
It would also be inconsistent with the integrated transaction cases, to the
extent that they rely on the continuity doctrine. (However, these cases may
be discounted as of limited precedential value to the extent they have been
overturned by section 338 and the anti-Yoc Heating regulations.)

Making continuity an anti-abuse rule would obviously eliminate the
whipsaw potential for the Service under the present doctrine, and it would
also improve administrability and curb anomalous treatments of economically
similar transactions. Whether a regulatory anti-abuse rule would eliminate
uncertainty, increase economic efficiency and fairness, and advance the tax
policies of the reorganization provisions would depend upon the details of the
regulations issued to effectuate the change (including any safe harbors they
might provide). For instance, if failure of continuity continues to affect target
shareholders receiving acquiror stock, the transformation would not advance
the policies behind nonrecognition treatment at the shareholder level.

It appears that continuity as an anti-abuse rule has some appeal to the
Clinton Administration. In March 1996, it introduced a proposal to tax the
distributing company in a section 355 transaction if a requisite amount of
continuity (as defined in the proposal) does not exist for two years before and

215. See, e.g., Regs. § 1.701-2; Temp. Regs. § 1.1275-2(g).



Florida Tax Review

two years after the transaction. No loss would be allowed for a distribution
that failed this test.216

Although reasonable minds could differ on the issue, the Treasury
probably has power to remove the continuity weapon from taxpayers' hands.
While continuity originated as a judicial interpretation of the definition of
reorganization, it appears today to be entirely an administrative creature. In
the most recent Supreme Court case to consider the doctrine, Paulsen v.
Commissioner,2 17 the Court appeared most moved by the doctrine's specific
mention in the reorganization regulations and the Service's consistent
administrative practice in asserting it.218 In litigation, the Service has argued
unsuccessfully that the continuity doctrine should be treated as an anti-abuse
rule (especially in the F reorganization context discussed above in Part
III.A.3), but the Treasury has never promulgated this view in regulations.
Although anti-abuse continuity regulations would be controversial, the power
to issue them should exist.

3. Bifurcation.-A third conception of continuity, which is without
any grounding in current practice, would be to limit the effects of a
continuity failure to the corporate level. Under this approach, an otherwise
valid reorganization that lacked continuity (e.g., a statutory merger in which
only 20% of the consideration was acquiror stock) would be a taxable event
for the target, but would be tax-free for target shareholders receiving acquiror
stock or securities. The transaction could be treated as a wholly taxable event
for the target, or the target's gain or loss could be more precisely measured
by reference to the nonqualifying consideration.

This approach would go far towards advancing the tax policies behind
nonrecognition treatment for target shareholders that do not cash out their
investments and, at the same time, advance the policies that deny deferral for
targets that engage in what amounts to a taxable sale. However, while it
would generally ameliorate the condition of target shareholders subject to tax
on the receipt of illiquid acquiror stock, it would not spare them from the
indirect effects of the corporate tax paid by the target on its recognized gains.
Moreover, a bifurcation approach would not necessarily eliminate uncertainty,
inefficiencies, unfairness, or the inconsistent treatment of economically
similar transactions.

4. Restricted Scope.-As discussed above, because reorganizations
under sections 368(a)(1)(B), (C), and (E) must meet statutory continuity

216. The proposal is described in somewhat more detail in note 87.
217. 469 U.S. 131 (1985).
218. See Paulsen, 469 U.S. at 136 ("known as the 'continuity-of-interest' doctrine,

this requirement has been codified in Regs. §§ 1.368-1(b), 1.368-2(a)"), 142 (discussing
Revenue Rulings).

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1996] Devolution & Inevitable Ertincion of the Continuin. of Interest Doctrine 253

requirements (e.g., a solely for voting stock requirement), the extra-statutory
judicial continuity doctrine could be eliminated as a requirement for these
types of transactions. Continuity could remain for acquisitive A and D
reorganizations, to distinguish them from taxable sales, but the threshold
requirement for continuity could be restated as a fixed percentage of the
acquiror's consideration.

Removing B and C reorganizations from continuity's application is
consistent with the 1934 Act, which replaced the judicial continuity doctrine
for these transactions with the solely for voting stock test that applies only
at the corporate level. Thus, a stock or assets acquisition satisfying the solely
for voting stock requirement would qualify as a B or C reorganization,
regardless of what the target's shareholders did with their stock (or stock of
the acquiror) before or after the acquisition.

Subsidiary mergers under section 368(a)(2)(E), which requires that the
former shareholders of the surviving corporation receive sufficient stock in
the surviving corporation to constitute control, could also be exempted from
the continuity doctrine. As with A and C reorganizations, the statutory
requirement could be read to supplant the extra-statutory continuity test.

Section 368(a)(2)(D) subsidiary mergers present a more difficult
question. Section 368(a)(2)(D) codifies Le Tulle by requiring that stock of the
parent be included in the consideration. A reasonable inference from the
statutory language, which does not specify a threshold, is that any meaningful
amount should suffice. However, the original version of section 368(a)(2)(D)
would have required that the consideration for a forward subsidiary merger
consist "solely" of parent stock. An equally reasonable interpretation (and one
endorsed by the commentators) is that Congress relied on the continuity of
interest doctrine to ensure that a Pinellas-Cortland transaction could not be
consummated through a subsidiary merger.

As this article suggests, there is historical support for not applying
any continuity test to statutory mergers and consolidations. However,
although significant differences remain between statutory mergers and asset
transfers that do not qualify as mergers under state law,2"9 state merger
requirements have been liberalized significantly in the 62 years since the
1934 Act. Thus, the purpose of the original continuity doctrine-to distin-
guish in a meaningful way between asset sales and mergers (in the 1934
sense of the word)-would not necessarily be served by relying on state law
definitions. By the same token, although the judicial continuity doctrine has
not been generally applied to D reorganizations, to the extent that a target
could engage in an effective asset sale for cash, but literally qualify the

219. For example, the acquiror assumes liability for the target's obligations in a
statutory merger, but not in an asset transfer.



Florida Tax Review

transaction as a D reorganization, tax-policy supports at least some continuity
doctrine for D reorganizations.22 °

However, as to A and D reorganizations (and possibly section
368(a)(2)(D) subsidiary mergers), the promulgation of regulations setting a
fixed continuity threshold would be a significant improvement, importantly
advancing administrability and reducing uncertainty. The Treasury should
have the authority to promulgate such a rule, and should not be constrained
by judicial thresholds fashioned in the absence of regulatory guidance.
Moreover, if this absolute threshold was lower than the 50% representation
required by Revenue Procedure 77-37, but high enough to ensure that some
real portion of the acquiror's consideration consists of stock, continuity could
be returned to a test for distinguishing a taxable sale from a merger-like
reorganization, but not one that acts as an obstacle to nonabusive tax-free
combinations. This change would not be a panacea. If the test was still
applied at the shareholder level so that solely stock consideration would not
assure tax-free status, it would not fully eliminate uncertainty or
inadministrability. Also, if lack of continuity continues to affect shareholder
taxation, as well as the taxation of the corporations, this change would not
eliminate the unfairness of minority shareholders being taxed on the receipt
of acquiror stock in a busted reorganization or the potential for future
Seagram-type litigation.

5. Objective Continuity Test Determined Exclusively at the Corporate
Level.-Finally, the Tax Court's view in Seagram could be codified, return-
ing continuity to an objective test depending only on the nature and amount
of the acquiror's consideration, without regard for the pre- or post-acquisition
conduct of target shareholders or the use of the target's assets. Under this
view, cases like Superior Coach and Kass would be understood as resting
entirely upon the integrated transaction doctrine (and not continuity), and the
shareholder conduct cases would be understood as resting solely upon the
taxpayer's limited ability to invoke the step transaction doctrine where all
relevant parties agree to take consistent tax positions. It is this evolved but
limited form of continuity that, while far from perfect, shows the most
promise for the doctrine's long-term survival.

This alternative, if adopted, would create a historical anomaly:
Continuity could deny reorganization treatment to statutory mergers and
consolidations (the model for nonrecognition treatment), but would generally
not apply to other types of reorganizations. However, the application of
continuity to statutory mergers and consolidations is supported by the relevant
policies. Although the Code is devoid of additional qualification requirements

220. See Bittker & Eustice, supra note 5, 12.26[21 at 12-92 to 12-93.

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1996] Devolution & Inevitable Ertinction of the Continuit. of Interest Doctrine 255

for a statutory merger or consolidation, it would exalt form over substance to
permit local law definitions to dictate federal income tax consequences,
especially in the flexible world of state corporate statutes. As the recent
experience with limited liability company legislation so aptly demonstrates,
states are not beyond passing legislation solely to facilitate desired federal
income tax results. At this late date, Congress' lack of foresight in drafting
section 368(a)(1)(A) to hinge on state law definitions can be excused.
Presumably, if Roebling had gone the other way, and a statutory merger with
solely cash consideration had been held to be a reorganization, Congress
would have intervened with a stock consideration requirement for statutory
mergers. Accordingly, continuity should continue to apply to statutory
mergers and consolidations.

So evolved-or devolved to its embryonic form-continuity would
serve the purpose for which it was designed: exposing the naked corporate
asset sale that is draped in the robes of a reorganization. It would not,
however, endanger those tax-free acquisitions, such as the Seagram trans-
action, that bear all the characteristics of a reorganization at the corporate
level.

Continuity's breath should extend no further. There is no need to
deny reorganization treatment at the corporate level solely as a result of a
shift in the target shareholders remaining invested in the wake of the
acquisition. From the corporate perspective, the transaction is unaffected by
the identity of the combined entity's shareholders. To ensure that sections 354
and 356 are sufficient to prevent the betrayal of shareholder-level policies, it
may be appropriate to tighten the definition of "stock or securities," whose
receipt gauges the extent of the target shareholders' tax-free treatment. For
example, it is consistent with these shareholder-level policies to require that
a target shareholder actually bear equity risk with respect to acquiror stock
for some period of time in order to receive the stock tax-free.2- ' According-
ly, rules could be promulgated to deny the deferral of gain on a shareholder-
by-shareholder basis if market risk in the acquiror is hedged with an equity
swap, short sale, or other device.Y However, it frustrates the Congressional
policies favoring shareholder nonrecognition treatment to subject target

221. The Clinton Administration has taken a small step toward this requirement by
proposing that certain preferred stock be characterized as boot. As discussed in note 103,
enactment of this proposal should not affect preferred stock's privileged status as good
consideration for continuity purposes. Thus, a statutory merger solely for such preferred stock
would be tax-free at the corporate level, but taxable at the shareholder level.

222. The Clinton Administration has already taken a large step in this direction with
its "short-against-the-box" proposal, which would tax any appreciation in stock that is subject
to a "constructive sale." See Revenue Reconciliation Bill of 1996. § 9512 (submitted to
Congress on March 19, 1996).



Florida Tax Review

shareholders remaining fully invested in the combined entity's equity to
taxation at the whim and fancy of their fellow shareholders. Thus, the Tax
Court's decision in Seagram is the correct result and should be codified.

The wisdom of Seagram should extend to the shareholder conduct
and integrated transaction cases. The results of those cases are defensible on
the narrower grounds of step transaction-rather than the continuity of
interest doctrine-and their holdings should be so limited.

The same rationale should apply with even greater force to a section
338 transaction. As the legislative history to that section indicates, Congress
intended that the subsequent conduct of the target's majority shareholder
would not subject the target to corporate-level tax. In confirming the exemp-
tion of the corporate parties to a qualified stock purchase and merger from
the modem continuity doctrine, Congress surely did not intend to frustrate the
policies supporting minority shareholder nonrecognition by subjecting them
to taxation on the involuntary receipt of possibly illiquid acquiror stock.
Thus, the anti-Yoc Heating regulations should permit tax-free treatment to
minority shareholders that receive acquiror stock in the second-step merger.

The concept of remote continuity should be put to bed once and for
all. To hinder the acquiror's use of target assets following an otherwise valid
reorganization only frustrates legitimate business planning. Congress'
piecemeal anti-Groman and anti-Bashford legislation should be interpreted as
a cautious correction of a complex statute, rather than a policy statement that
transactions not specifically addressed are prohibited. Moreover, continued
adherence to a doctrine as formalistic as the remote continuity doctrine only
invites abuse.

Continuity's sustained utility depends not only upon a restricted
mandate but also upon a clear assignment. Accordingly, its equity require-
ment should be set as an absolute threshold that is objectively determinable
at the time of the acquisition. 223 An absolute threshold would cure uncer-
tainty, improve administrability, and eliminate inconsistent treatment,
although it would not be perfect. Even if it is imposed at the lower thresholds
established by the courts (e.g., between the 16% that was insufficient in Kass
and the 25% that was sufficient in Miller), it would perpetuate the inevitable
conflict with the policies that favor nonrecognition for target shareholders
who receive acquiror stock in a reorganization busted for lack of continuity
(and are taxed, in addition to indirectly bearing the target-level tax on
recognized gains). Nevertheless, in the absence of a statutory mechanism to

223. This proposal has some commonality with the Clinton Administration's
proposal to tax the distributing corporation on a § 355 transaction if a four-year (two before,
two after)/50% continuity threshold is not met. The proposal is described in general terms in
note 87.

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1996] Devolution & Inevitable Extinction of the Continuity of hterest Doctrine 257

tax only the target corporation on such an asset transfer, a low absolute
threshold would minimize the conflict.

Although any regulatory solution to the continuity mess would be
controversial, these limitations would bring continuity closest to its historical
source and in line with the relevant tax policies. These improvements are
within the Treasury's power.

VI. CONCLUSION

Continuity is an endangered doctrine. Having wandered from its
natural role of distinguishing at the corporate level between taxable asset
sales and tax-free reorganizations, the modem continuity doctrine is now
vulnerable to predators. Congress attacked the doctrine by significantly
limiting remote continuity, and the Service thinned the doctrine further with
the anti-Yoc Heating regulations and its rulings ignoring continuity concerns
in mutual savings and loan association mergers. Most recently, the Seagram
court preyed on the wearied and over-extended doctrine, and the Service has
indicated that it may join the chase. Continuity must adapt or face extinction.

Continuity should devolve to its original form and again serve the
important but modest function of disqualifying reorganizations that resemble
taxable asset sales. The Service should confirm the demise of remote
continuity and the inapplicability of continuity to the shareholder conduct and
integrated transaction cases, and it should modify' the anti-Yoc Heating
regulations to allow tax-free treatment to minority shareholders. Finally,
continuity should be expressed by an absolute equity threshold, determinable
at the time of the acquisition and binding on taxpayers and the Service alike.