Taxable Spinoff Definition

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Taxable Spinoff Definition

What Is a Taxable Spinoff?

A taxable spinoff is a publicly listed company’s selling of a subsidiary or division that is subject to capital gains taxes. To qualify as a taxable transaction, the parent business must sell the division or the assets it includes directly. The sale’s earnings will be taxed as capital gains.

Key Takeaways

  • A taxable spin-off is a kind of business divestment in which the requirements of the Internal Revenue Code for tax-free spinoffs are not satisfied.
  • A taxable spinoff results in an increased tax liability for both the parent firm and the shareholders.
  • Changes to tax legislation enacted as part of the Tax Cuts and Jobs Act of 2017, such as reduced corporation tax rates, may influence businesses’ decisions to pursue taxable versus tax-free forms of corporate divestiture.
  • Most spinoffs are tax-free, and a corporation will follow IRS guidelines to achieve this.
  • The share price of both firms benefits when a section of a corporation is spun off.

Understanding Taxable Spinoffs

A spinoff happens when a parent firm splits a portion of its operations to form a new business subsidiary and distributes shares of the new entity to its existing shareholders. The subsidiary will be wholly autonomous from the parent company, working solely on its own. If a parent business distributes subsidiary shares to its shareholders, the distribution is normally taxed as a dividend paid to the shareholder.

Ordinary income tax equivalent to the fair market value of the stock acquired is applied on investors in this situation. Furthermore, the parent firm is taxed on the built-in gain (the amount the asset has gained) in the subsidiary’s shares.

In this situation, the tax is a capital gains tax on the difference between the fair market value of the distributed shares and the parent company’s inside basis in the stock. When cash is given in exchange for fractional shares in a spinoff, the fractional shares are normally taxable to the shareholders.

A taxable spinoff will provide the corporation liquid assets, generally in the form of cash. The disadvantage of this transaction is the reduction in income due to capital gains tax. A parent firm may contemplate a tax-free spinoff if it desires to avoid taxes. Section 355 of the Internal Revenue Code (IRC) exempts spinoff transactions from taxation, enabling a business to spin off or distribute shares of a subsidiary in a tax-free transaction for both shareholders and the parent firm.

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When a Spinoff Is Taxed

A spinoff is taxed when the parent firm sells the subsidiary altogether. This may involve the firm being purchased by another company or being sold via an initial public offering (IPO).

When cash is received instead of spinoff shares, the spinoff shares are normally taxable.

When such occurrences occur, two levels of tax must be paid. At the shareholder level, an ordinary tax equal to the fair market value (FMV) of the shares acquired would be levied. It is comparable to a dividend distribution in many aspects. A capital gains tax may also be levied on the stock sale at the business level, equivalent to the FMV of the shares less the corporation’s inside basis in the stock.

In certain situations, a spinoff may be taxed solely because it does not meet the tax-free spinoff standards outlined below.

Tax-Free Spinoff

A tax-free spinoff of a corporate unit may normally be accomplished in two ways. First, a corporation might simply distribute the new shares (or at least 80% of the division) on a pro-rata basis to current owners.

The second approach a corporation may prevent capital gains from divestiture is to provide current shareholders the choice of exchanging parent company shares for an equal stock position in the spun-off firm or keeping their existing stock position in the parent company. This implies that shareholders are free to invest in whatever firm they feel will provide the highest possible return on investment (ROI) in the future.

For corporations to be eligible to spin off tax-free, the IRS requires specific conditions. Control, device, active commerce or company, and distributes are examples.

Control rules state that companies must own stock with at least 80% of the total aggregate voting power of all classes of that corporation’s stock. There are other methods for defining voting power, but the capacity to elect directors is commonly used.

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Device criteria for tax-free spinoffs ensure that the spinoff cannot be utilized just to distribute earnings and profits. This is decided on a case-by-case basis and takes into account all factors of the spinoff.

The active trade clause requires both the current firm and the newly spun-off company to qualify as a “active trade or business” as soon as the merger is completed. This also necessitates that both companies be actively involved in business.

The IRS compels the pre-existing firm to distribute all stocks and securities owned in the newly spun-off company in certain manner under the distribution rules. Typically, the firm must transfer at least 80% of its shares to current owners on a pro-rata basis. The second includes the previously described stock options granted to shareholders, which allow them to participate in either the current or new firm.

Special Considerations

Because of the existence of a tax benefit under Section 355, most spin-offs are carried out to profit from it. Rather of incurring an extra tax burden via a taxable spin-off, firms may discover that it makes more sense to explore another type of divestment if the advantages exceed the higher tax.

This also implies that corporate income tax rates may impact corporations’ choices about when and how to sell. Cuts to corporate income tax rates in the United States under President Trump’s Tax Cuts and Jobs Act of 2017 may have shifted this arithmetic somewhat in favor of alternative types of divestitures, such as subsidiary stock sales or asset sales.

Real-World Example

In 2008, Altria Group Inc. (MO) broke out Philip Morris International Inc. (PM), spinning off 100% of the shares of Philip Morris. This was one of the biggest corporate spinoffs of all time. In this situation, each Altria shareholder got one share of Philip Morris stock for every share of Altria common stock that was outstanding.

They parted owing to shareholder payment worries as well as the rising pressure from smoking cases. On Altria’s website, however, it is stated that Philip Morris was spun off because “management believed that the spinoff would enable each of Altria’s international and domestic tobacco businesses to focus exclusively on realizing its own opportunities and addressing its own challenges, thereby building long-term shareholder value.”

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Altria sanctioned the separation on January 30, 2008. By March of the following year, Philip Morris shares had been given to Altria stockholders on record who owned shares on the distribution date. This was a non-taxable spinoff, since most spinoffs are done to benefit from tax breaks.

Is a Stock Spinoff Taxable?

Stock splits are often tax-free. If the spinoff is not taxed, there are several benefits for both the parent organization and the common shareholder.

Is a Spinoff Considered a Dividend?

The spinoff is comparable to a dividend in that it is given to the shareholder as a payout. The primary distinction is that a dividend pays the shareholder in cash, but a spinoff pays the shareholder in more stock shares.

What Is the Difference Between a Spinoff and a Split-off?

A “split-off” is a way of producing a tax-free spinoff that entails giving shareholders the choice of participating in either the spun-off firm or the pre-existing company. These terminology are intended to minimize misunderstandings when discussing the spinoff and whether the corporation distributes the shares pro-rata or provides shareholders the opportunity to select.

How Many Shares Do you Get in a Spinoff?

The number of shares you get in a spinoff depends on whether the firm executes a real spinoff or a split-off. In a split-off, you have the option of getting shares in the newly spun-off firm or maintaining your shares in the parent company.

The Bottom Line

Most corporations that spin off parts of their businesses do so tax-free. Because there are significant tax advantages to not selling a firm altogether, most businesses will comply with the IRS rules for tax-free spinoffs of sections of their business.

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