When Should You Consider a Tax-Free Spinoff?

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Sometimes, large businesses come to a point where they feel the need to split up and reorganize in order to maximize profits. Other times, shareholders and former business partners may have such fundamentally different views of the future of the organization that they feel the need to go their separate ways. Unfortunately, most of the time when large companies’ “spinoff” part of the business into a smaller company, there are major tax ramifications for the company and its shareholders. For this reason, the concept of a “tax-free spinoff” is incredibly appealing to many clients who have consulted with our knowledgeable dual Licensed Tax Attorneys & CPAs at the Tax Law Offices of David W. Klasing. However, while tax-free spinoffs come with a huge positive, they also come with downsides, including the uncertainty of not knowing if all the requirements were met and the tax-free aspect of the spinoff has been approved until potentially months after the reorganization is completed.

What Is a Tax-Free Spinoff?

Most of the time, when a publicly-traded company sells off part of its organization to another company, there are large tax consequences that follow. Not only will the distribution be taxable as dividends for the shareholders, but the parent corporation is also taxed on the built-in gain in the stock of the subsidiary. Section 355 of the IRS Code, however, details a complicated process by which you can avoid paying most of these taxes. This option can be appealing in situations where the former partners and controlling shareholders wish to split-off from each other in as amicable a way as possible, and without the tax implications most such splits would have. However, you should never make this choice without first consulting with an experienced dual licensed Tax Attorney & CPA like those at the Tax Law Offices of David W. Klasing who can advise you on the myriad of requirements you must meet to become eligible for a tax-free spinoff and whether it truly makes sense in your situation.

If your company decides to go through with a tax-free spinoff, there are two different ways you can go about it in terms of how the shareholders are affected, the latter of which is also sometimes known as a “split off” to distinguish it from the former. The first possibility is for the company to simply distribute most (at least 80%), but usually all, the shares of the spun-off company to existing shareholders on a pro rata basis. In the second type of tax-free spinoff, also known as the “split off,” shareholders in the parent company are offered a choice between continuing to hold shares in the parent company or exchanging some or all of the shares held in the parent company for shares in the subsidiary. Usually, the parent company will offer some sort of incentive for the shareholders to choose to take the shares in the new company. If you are a shareholder facing the prospect of a tax-free spinoff that could impact your shares in the company, reach out to a battle-tested Tax Attorney CPAs right away for the best advice.

What Factors Should I Consider in Deciding Whether to Pursue a Tax-Free Spinoff?

Generally speaking, a tax-free spinoff is the best way to split one company into two companies without incurring the massive tax liabilities that will usually fall on the original corporation and its shareholders alike. As such, it is always a good idea to consider such a spinoff before deciding to sell a part of your business and face the tax consequences that follow. However, as noted above, there are a number of very stringent, multi-factor requirements, both statutory and non-statutory, that must be met in order for the spinoff to ultimately be tax-free. If you fail to meet these requirements, you could end up paying all the taxes you would have paid in a normal deal plus potential fines and other penalties from the IRS.

The biggest issue in all of this is that some of the requirements that must be met under Section 355 and elsewhere cannot possibly be resolved clearly before the spinoff goes through. For example, as one Tax Attorney noted on his blog, the “device test” under Section 355 cannot possibly be fulfilled before the spinoff because it involves aspects relating to behavior that occurs during and after the spinoff. The basic gist of the device test is that the spinoff cannot be used principally as a “device” for the distribution of the earnings and profits of the original company or the newly formed company. This legal requirement is intended to prevent a shareholder from removing corporate income that might otherwise have been distributed as a dividend by selling stock from the new company after its incorporation

Such a sale could theoretically occur months after the spinoff goes through, and both companies could end up facing the massive tax liabilities that they were hoping to avoid if the device test, or one of the many other complicated tests required for approval, is found to have not been met. As such, you are always taking somewhat of a risk with this approach, but an experienced Tax Attorney & CPA like those at the Law Offices of David W. Klasing can help you determine the extent of this risk in your situation. If you decide to go through with the spinoff, we can also make sure everything is done properly to mitigate the possibility of a late surprise where the spinoff is suddenly not as tax-free as you expected it to be.

If You Are Considering the Possibility of a Tax-Free Spinoff, Consult First with Our Knowledgeable Tax Attorneys

In many cases, a tax-free spinoff can be the best possibility of splitting one company into two companies without incurring massive tax liabilities. However, because of the plethora of complex rules and regulations that must be complied with, including some that will not be ultimately determined until after the matter has been decided and you cannot take it back, there are downsides to consider as well. The best thing you can do if you are considering such a move is to reach out to our experienced dual licensed Tax Attorneys and CPAs at the Tax Law Offices of David W. Klasing so we can assess the particulars and give you the best possible advice. Call our office at (800) 681-1295 to schedule a consultation.

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