Valuation of goodwill and going concern important in matters involving insolvency and change of ownership.

• Author: Schwab, Carl E.

In an era of economic recession and uncertainty, it is common for troubled companies to take drastic steps to maintain operational viability. Such measures are seldom tax motivated, but may often have significant tax ramifications. Consider the following example.

Example: Company A, a large manufacturing operation with four equal, unrelated shareholders ($1, $2, $3 and $4), acquired all of the stock of company B, a complementary operation, in a bargain purchase consummated in 1988. The acquisition was financed with long-term debt--part of which was taken back by T, B's seller. Following the acquisition, B was liquidated into A under the provisions of Sec. 332. No Sec. 338 election was made.

In early 1992, A (which experienced net operating losses (NOLs) in 1989, 1990 and 1991)found itself in serious financial difficulties, and had to drop its profit margin to maintain its market share. As a result, A's debt burden was more than its operating income could bear. Its balance sheet showed a negative net worth.

Given the circumstances, $2; $3 and $4 decided to sell their shares in A to SI. Prior to this change of ownership, A had approached T with a proposal for reduction of the amounts still owed T for B's purchase. Simultaneous with the sale of shares from the other shareholders to $1, T agreed to a reduction of the purchase price. With this reduction of debt, and management changes imposed by SI, A made a turnaround and began generating income in 1992.

In analyzing these transactions, two main tax issues are presented. First, the sale of shares by $2, $3 and $4 to SI constitutes a more-than-50-percentage-point change in A's ownership, thus limiting its ability to use its NOL carryovers under Sec. 382. The amount of this annual limitation is the value of the A stock immediately before the change in ownership multiplied by the applicable long-term tax-exempt rate (Sec. 382(b)(1)).

Second, T's agreement for a reduction of purchase price is a forgiveness of indebtedness under Sec. 108. The treatment of this discharge of indebtedness to A varies, however, depending on whether A was insolvent immediately prior to the debt forgiveness;

If insolvent (defined under Sec. 108(d)(3) as the excess of liabilities over the fair market value (FMV) of assets. A will not have to recognize gross income by reason of the discharge, to the extent of its insolvency (Sec. 108(a)(1)). Instead, A must reduce its tax attributes, to the extent of its insolvency, in the...