Why Are Some Spin-Offs Taxable and Some Are Tax-Free?

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Why Are Some Spin-Offs Taxable and Some Are Tax-Free?

The way a parent business arranges the spinoff and divests itself of a subsidiary or division impacts whether the spinoff is taxed or not. Internal Revenue Code (IRC) Section 355 governs the taxable status of a spinoff. Because the original firm and its shareholders do not register taxable capital gains, the majority of spinoffs are tax-free, satisfying the Section 355 conditions for tax exemption.

Key Takeaways

  • A spinoff’s taxability is determined by how the parent business constructs it, and there are two ways for a parent firm to undertake a tax-free spinoff.
  • The first option is to distribute shares in the spinoff in proportion to their ownership stake in the parent.
  • The second option is for the parent to provide current shareholders the option of exchanging their parent company shares for an equal percentage of the spinoff shares.
  • A taxable spinoff occurs when a subsidiary is sold altogether, which may involve another firm purchasing it or selling it via an initial public offering (IPO).

While a company’s first legal requirement in selecting how to perform a spinoff is to ensure its own financial sustainability, its secondary legal obligation is to operate in the best interests of its shareholders. Because the parent business and its shareholders may face significant capital gains taxes if the spinoff is deemed taxable, corporations want to arrange a spinoff such that it is tax-free.

Tax-Free Spinoffs

A parent business may perform a tax-free spinoff using one of two basic models. Both result in the spinoff becoming its own legal entity—a publicly listed corporation independent from the parent firm—though the parent may retain a significant proportion of shares in the newly formed company (up to 20%).

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The first way is for the parent firm to distribute shares in the new spinoff to current shareholders in direct proportion to their ownership holding in the parent. If a shareholder holds 2% of the parent company’s shares, he obtains 2% of the spinoff company’s shares.

The second tax-free spinoff technique is for the parent business to give current shareholders the option of exchanging their parent company shares for an equivalent amount of spinoff company shares. As a result, shareholders may choose to keep their current stock holding in the parent business or exchange it for an equal equity stake in the spinoff firm.

In the second scenario, shareholders are allowed to choose whatever firm they feel will provide the highest prospective return on investment (ROI) in the future. To differentiate it from the previous technique, this second way of forming a tax-free spinoff is frequently referred to as a split-off.

Taxable Spinoffs

If the subsidiary firm or division of the parent company is sold entirely, the spinoff is taxable, with potentially significant capital gains tax liabilities for both the parent company and its stockholders. The subsidiary or division might be purchased by another firm or a person, or it could be sold in an initial public offering (IPO).

A firm may seek to spin off a subsidiary company or division for a variety of reasons, ranging from the belief that the spinoff would be more lucrative as a distinct organization to the requirement to sell the company to avoid antitrust difficulties.

The Internal Revenue Code (IRC) section 355 has precise criteria that go beyond the basic spinoff structure indicated above. Spinoffs may be highly difficult, particularly when debt transfers are involved. As a result, shareholders may choose to obtain legal advice on the potential tax implications of a planned spinoff.

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