What Is a Tax-Free Spin-Off?

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In the modern business world, corporate restructuring is a common occurrence. Whether it involves selling off pieces of the company, breaking them off into subsidiaries, or simply reorganizing the management structure, there are often tax consequences to these type of restructuring decisions. For this reason, it is never a smart idea to go forward with a corporate restructuring plan for your large or small business without first consulting with an experienced dual license Tax Attorney and CPA like those at the Tax Law Offices of David W. Klasing. One of the options we may advise you about is a tax-free spinoff, a way of restructuring your company without incurring high tax liability in the process.

Basics of a Tax-Free Spin-Off

A tax-free spinoff occurs when a corporation carves out and separates part of its business to form a new standalone entity, but the separation does not subject the parent firm to paying taxes. Normally, if a parent corporation sells its subsidiary to an outside company, the distribution is taxable as a dividend to the shareholder. In addition, the parent corporation is taxed on the built-in gain in the stock of the subsidiary. However, Section 355 of the Internal Revenue Code (IRC) provides an exemption to these distribution rules, allowing a corporation to spin off or distribute shares of a subsidiary in a transaction that is tax-free to both shareholders and the parent company. This can present a major incentive over selling the company to another corporation, where large amounts of taxes will be assessed.

What are the Requirements for a Tax-Free Spinoff Under Section 355?

Under Section 355, there are four major requirements for a spinoff to qualify as tax-free: control, device, active trade or business, and distribution. For the control requirement to be met, the corporation must own stock possessing at least 80% of the total combined voting power of all classes of the corporation’s stock. Voting control is generally determined by the ability to elect directors, but it can be more complicated in some cases. The device requirement means that the spin-off cannot be used merely as a device for the distributions of earnings and profits, which is determined on a case-by-case basis by a review of all the circumstances surrounding the transaction, including whether the distributions are made pro rata.

Section 355 also requires that for the no-tax provisions to apply, both the pre-existing company and the newly spun-off company must qualify as “an active trade or business” immediately after the transaction goes through. The sub-requirements to be considered an active trade or business include that both businesses are actively engaged in some sort of business or commerce. Finally, the pre-existing company generally must distribute all the stocks and securities it holds in the newly spun-off company in the ways described in the section below.

Furthermore, aside from the statutory requirements, there are also an array of non-statutory requirements, like continuity of interest, in order for the spinoff to be considered non-taxable. The statutory and non-statutory requirements are extremely dense and complicated, and you should never try to execute a tax-free spinoff without the advice of a skilled dual licensed Tax Lawyer and CPA like those at the Tax Law Offices of David W. Klasing who can make sure that all of the requirements are met so that you do not face penalties or other trouble from the IRS down the line.

How Does a Tax-Free Spin-Off Work?

There are two major ways that a company can choose to deal with shareholders and their stakes in the existing and new companies in order to undertake a tax-free spinoff in compliance with Section 355. The first possible avenue is for the company to distribute at least 80%, but typically all, of the shares of the spun-off company to existing shareholders on a pro rata basis. In this scenario, these shares of the existing company will essentially be transformed into equal shares on the newly spun-off company. Alternatively, a company could spin-off by giving its shareholders the option to exchange shares of the parent company for an equal stock position in the spun-off company or to maintain their existing stock position in the parent company, and the shareholders can elect in which of the companies they wish to maintain their stock. This second method of creating a tax-free spinoff is referred to as a “split-off” to distinguish it from the first method.

As a shareholder, there are numerous considerations that you should undertake when the prospect of a spin-off is raised, including making sure that it is done in the proper manner so that you do not incur additional tax liability. These matters can often be quite complicated, particularly where there are large amounts of debt involved. If you find yourself in this situation as a shareholder, it is wise to seek outside legal counsel from a skilled dual licensed Tax Attorney & CPA like those at the Tax Law Offices of David W. Klasing.

If You or a Company You Own Stock in Are Considering a Tax-Free Spinoff, Contact Our Battle-Tested Tax Attorneys for A Consultation

Tax-free spinoffs sound quite appealing at first glance but can be complicated & risky to properly pull off. However, by consulting with an experienced, dually licensed Tax Attorney and CPA like those at the Tax Law Offices of David W. Klasing before going through with the spinoff, you can ensure that you will be given the best advice about the pros and cons as well as our guidance through the process. To set up a consultation, contact our firm today at (800) 681-1295.

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