A common separation strategy used by companies includes divestiture of a portion of a company's operations that results in a new corporate entity. Also known as a spinoff, a business has the ability to create a new company that conducts separate operations from the parent company, which may prove to be more beneficial to its shareholders in terms of long-term profitability.

Spinoffs may also take place in an effort to reduce potential regulatory issues with the parent company, enhance the company's competitive advantage and/or diversify the corporation's investment portfolio. The new entity established during a spinoff is known as the subsidiary company, and in most cases, it is still owned by the shareholders of the parent business. Corporations implement a spinoff of the business instead of selling a portion of operations in an effort to avoid debilitating corporate taxation on the transaction.

How the Parent Company Is Taxed in a Spinoff

Under the Internal Revenue Code Section 355, most parent companies can avoid taxation on spinoff activity because no funds are provided in exchange for ownership. Instead, a spinoff involves the distribution of company stock of the subsidiary entity from the parent company on a pro-rata basis to shareholders. This makes the same shareholders of the parent company become owners of the subsidiary.

No cash is exchanged when the subsidiary is formed in a spinoff, and as such, no ordinary income or capital gains taxes are assessed.

How the Subsidiary Company Is Taxed in a Spinoff

Similar to the parent company tax benefits experienced in a spinoff, the subsidiary company can also avoid taxation during the transaction. Because the shareholders of the subsidiary company receive stock on a pro-rata basis from the parent company in lieu of cash for the sale of the company, ordinary income and capital gains taxes are not applicable.

Instead, the owners of the parent company become the owners of the subsidiary through the transfer of shares as a more cost-effective alternative than receiving compensation for the new company through a stock dividend.

Requirements for Maintaining a Tax-Free Spinoff

IRC Section 355 requires that the parent company and the subsidiary must meet stringent requirements to maintain the tax-free benefits of a spinoff, however. A spinoff remains a non-taxable event when the parent company retains control over at least 80 percent of the newly formed entity's voting shares and non-voting stock classes.

Additionally, both the parent and subsidiary companies are required to maintain engagement in the trade or business of the companies that had been conducted during the five years prior to the spinoff taking place. A spinoff may not be used solely as a mechanism for distributing profits or earnings of the parent or subsidiary companies, and the parent company may not have taken control of the subsidiary in a similar manner in the past five years of operations. If the parent or subsidiary does not meet the requirements set out in IRC Section 355, a spinoff is considered taxable to both parties at the applicable corporate tax rates.