29 Jul Tax Implications of Spin-offs
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).
- “Continuity of Interest” must be maintained by both parent and sub shareholders for a four year period beginning at least two years prior to the spin-off. Continuity of interest requires maintaining a minimum of 50% equity ownership interest in both parent and sub entities. A change of control to <50% during this time could create a tax liability. This is often referred to as the anti-Morris Trust rule.
- Following the spin-off both the parent and the sub must continue in an active business or active trade.
- Parent and sub must have been engaged in legit or “active trade or business” for the five years preceding the spin-off. In other words, they must not have been created for the sole purpose of the spin-off. In addition, neither party could have been acquired during the five year period in a taxable event.
- Parent must maintain tax control of the spin-off of at least 80% of the vote and all value of every class of sub stock.
- At the time of the spin-off the parent must surrender tax control of the sub with <80% vote and value.
- The spin-off must not be used as a dividend distribution “device.” It must have a valid business purpose.
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.