In general, the following methods can be considered when disposing of an investment in a corporation:

* Sales or exchange of stock; and

* Sale of assets or asset distributions.

From the seller's perspective, a stock sale is preferable to a sale of assets, because it results in a capital gain as opposed to ordinary income. Although TRA 86 eliminates the tax rate differential for capital gains treatment, the offset of capital losses and capital gains still exists. Therefore, the realization of capital gains is still preferred. In addition, double taxation is avoided in a sale of stock. A sale of assets would be taxed at the corporate level, and the distribution of cash would be taxed at the shareholder level. A sale of stock results in tax only at the shareholder level.

To defer income on a sale, the installment sales method of income recognition may be used. This method is appropriate when at least one payment is received after the close of the tax year. Tax is paid only on the ratable profit percentage applied to each year's payment.

Reorganizations

Non-recognition of income can, however, sometimes be achieved if the business acquisition or dissolution is accomplished through a reorganization. To qualify for non-recognition of income, Sec. 368(a)(1) defines several types of tax-free reorganizations:

* "A"--a statutory merger or consolidation;

* "B"--an acquisition of stock in exchange for stock;

* "C"--an acquisition of assets in exchange for stock;

* "D"--a division whereby assets are transferred to another corporation;

* "E"--a recapitalization of a single corporation;

* "F"--a change in identify, form, or place of organization;

* "G"--a transfer of assets to a corporation pursuant to bankruptcy reorganization.

Types A, B, and C reorganizations refer to acquisitions of corporations; type D is a divisive reorganization or applies to a division such as a spin-off of a company. Types E and F refer to a continuing enterprise and type G only applies to reorganization out of bankruptcy.

A type A reorganization can be a hybrid transaction (taxable and tax- free). Such a transaction permits the use of non-voting stock and must meet a test of continuity of interest. Type A is the least well-defined of the three acquisition types.

In a type B transaction, an acquisition of stock in exchange for stock, no property may be exchanged in order to achieve tax-free status. No gains or losses are recognized to the seller. Stock exchanged must be voting common stock only, and the buyer must obtain 80% control of the corporation. In addition, the transaction must meet the following tests:

* Valid business purpose;

* Continuity of business enterprise; and,

* Continuity of interest.

An example of a valid business purpose is a company expanding into a new market through acquisition. Continuity of business enterprise means the business must continue to exist and not be liquidated. The last test, continuity of interest, requires that the stockholders of the selling corporation continue to have a "substantial equity" interest in the stock of the buying corporation.

In a type C reorganization, voting stock must be exchanged for "substantially all" of the assets of the selling corporation. "Substantially all" is defined as 90% of net assets or 70% of gross assets. This transaction is subject to the same tests of continuity and valid business purpose as type B. If property other than stock is received by the seller, a taxable transaction is created.

Partial Liquidation

In the 1990s, a more common form of reorganization may involve the contraction of an active corporate business. Such a transaction may be referred to as a Sec. 302 partial liquidation, where assets are distributed to stockholders. A partial liquidation is defined as a distribution "not essentially equivalent to a dividend" made under a plan and occurring within the tax year in which the plan was adopted. Therefore, a partial liquidation involves the contraction of an active corporate business.

Examples of valid business contractions include:

* Cancellation of a franchise;

* Termination of a product line; and

* Distribution of insurance proceeds resulting from a fire destroying a business.

In partial liquidations, cash or specific business assets may be distributed. The shareholder can recognize gains as capital gains. When the value of the assets exceed the basis of the assets, the shareholder can receive a stepped-up basis allowing greater depreciation in future years.

An alternative to a partial liquidation is a divisive reorganization or a Sec. 355 type D reorganization. A transaction must meet the following requirements to qualify:

* Valid business purpose;

* Continuity of interest;

* Plan of reorganization; and

* Continuity of business enterprise.

No gain or loss will be recognized at the shareholder level if certain requirements are met:

* Only stock is distributed;

* The transaction is not a means of distributing earnings and profits;

* Active business requirements of Sec. 355(b) are met; and

* All shares of the controlled company held by the distributing corporation are distributed.

An example of a divisive reorganization is a spin-off. A corporation may transfer part of its assets to a controlled corporation and distribute that corporation's stock to its own shareholders. In the past, no gain or loss was reorganized at the corporate level.

RRA 90 requires recognition of corporate level gain on a distribution of subsidiary stock or securities qualifying under Sec. 355 if, immediately after a distribution, a shareholder holds a 50% or greater interest in the distributing corporation attributable to stock acquired through purchase in the preceeding five-year period. The distributing corporation will recognize gain as if it had sold the subsidiary stock to the distributee at fair market value. This new provision is effective for distributions of stock after October 9, 1990. In the past, a corporation with one or more subsidiaries or divisions could distribute any or all of them as separate corporations to its shareholders without recognizing corporate level gain on the appreciation in the value of the subsidiaries.

A type G reorganization was added to the various types of tax-free reorganizations by the Bankruptcy Tax Act of 1980. This applies to a transfer of all or part of a corporation's assets pursuant to a bankruptcy reorganization plan as a result of a Chapter 11 proceeding. The rules are less stringent than those for types A, B, and C transfers.

Many tax attributes can be carried over in tax-free reorganizations, however, in some cases they are subject to limitations, particularly with regard to net operating losses (NOLs). The NOL is the most sought after attribute because it can be used to directly reduce taxable income. Sec. 382 provides special limitations with respect to NOL carryovers when there has been more than a 50% ownership change in the company with the NOL.

RRA 89 limited the ability of corporations to carryback NOLs in cases where the losses are created by interest deductions allocable to Corporate Equity-Reducing Transactions (CERT). A transaction that could be labeled a CERT would be an acquisition of at least 50% of the stock of another corporation. A CERT could also refer to an excess distribution, which is defined as a distribution exceeding 10% of the value of the corporation's outstanding non-preferred stock measured at the beginning of the corporation's tax year.

The NOL carryback is limited to the lesser of the corporation's interest expense attributable to the CERT or the excess of the corporation's interest expense in the loss limitation year over the average of its interest expense for the last three years. RRA 90 further limits the carryback of NOLs by broadening the definition of a CERT. A CERT now also includes the acquisition of stock of another corporation that was a subsidiary of an affiliated group. This provision is effective for acquisitions on or after October 10,1990.

Business managers are advised to keep the following matters in mind as they survey potential acquisitions or contemplate other changes in corporate ownership:

* To maintain the tax-free status in a type D reorganization, the change in ownership must be less than 50% over a five-year period. If these rules cannot be met, consider a partial liquidation (Sec. 302) which has other tax advantages over the type D reorganization.

* When planning an acquisition, particularly where tax benefits such as NOLs are targeted, consider the provisionsw with regard to CERTs. The NOL carryback may be unusable where the NOLs were generated by interest deductions as a result of a major stock acquisition, including subsidiaries of an affiliated group. The NOLs can be used, however, going forward. Therefore, the tax attributes will have value in the future.

* Capital gains are preferable to ordinary income: 1) because of the offset of capital losses; and 2) because of the probability that tax rate differentials for capital gains may return.

Therefore, a sale of stock is preferable to sale of assets when disposing of an investment in a corporation. In addition, the sale of stock avoids taxation at the corporate level.