Under Section 355 of the Internal Revenue Code (IRC), spin-offs are usually considered tax-free. In other words, no taxable event is recognized by the parent entity or its existing shareholders. There are very specific requirements under Section 355 which must be qualified in order for a spin-off to be properly structured so as to maintain its tax-free status (when we use the word “sub” we are referencing the spin-off entity).
In some instances, a spin-off may not qualify for the tax-free treatment. In this case there may be two separate levels of tax. First, ordinary income tax may be exacted at the shareholder level equal to the fair market value of the sub stock received. This is similar to a dividend payout. Second, a capital gain tax may be exacted on the sale of the stock at the parent entity level equal to the fair market value of the sub stock less the parent’s inside basis in the sub stock. When cash is received in lieu of fractional shares in the spin-off, the fractional shares of the spin-off are generally taxable to shareholders.