The spinoff is a common strategy that companies use to divest a portion of its operations into a new corporate entity. Following the spinoff, the new company operates separately from its parent. Companies spin off divisions or businesses when they think a separation may improve long-term profitability, thus benefiting shareholders. Other reasons to spin off units include portfolio diversification, reducing regulatory burden and conflicts, and enhancing competitiveness.

In a spinoff, the new entity is known as the subsidiary company. In most cases, it still owned by the shareholders of the parent business. Though a company can divest by choosing to sell a portion of its operations, it might prefer the spinoff in order to avoid paying taxes on the transaction.

How the Parent Company Is Taxed in a Spinoff

Under Internal Revenue Code Section 355, most parent companies can avoid taxes when spinning off operations because no funds are exchanged in the transaction. In the spinoff, the parent will distribute shares of the new subsidiary on a pro-rata basis to its shareholders. This makes existing shareholders of the parent company the owners of the subsidiary. No cash is exchanged. As such, no ordinary income or capital gains taxes are due.

How the Subsidiary Company Is Taxed in a Spinoff

Likewise, the subsidiary company also avoids taxes in the transaction. Because the new shareholders of the subsidiary received stock on a pro-rata basis from the parent in lieu of cash, taxes for ordinary income and capital gains taxes are not applied. Instead, the owners of the parent become the owners of the subsidiary through the transfer of shares. This is more cost-effective than receiving compensation for the new company.

Requirements for Maintaining a Tax-Free Spinoff

Under IRC Section 355, several rules must be met for a divestiture to qualify as a tax-free spinoff. A spinoff is non-taxable when the parent retains control over at least 80 percent of the new entity's voting shares and non-voting class stock.

In addition, both parent and subsidiary must maintain the trade or business the companies had engaged in during the five years prior to the spinoff. A spinoff cannot be used solely as a way to distribute profits of the parent or subsidiary. The parent cannot have taken control of the subsidiary in a similar manner in the previous five years. If either the parent or subsidiary fails to meet the requirements of IRC Section 355, the spinoff is considered taxable to both parties at applicable corporate tax rates.