What Is a Tax-Free Spinoff?

A tax-free spinoff refers to a corporate action in which a publicly traded company spins off one of its business units as an entirely new company without tax implications. This type of transaction is deemed to be "tax-free" because the parent company is still able to divest the business it wants to separate from, but the company does not incur capital gains tax on the divestiture, which would be the case in an outright sale of the business unit to another company.

This can be contrasted with a taxable spinoff.

Key Takeaways

  • A tax-free spinoff is when a corporation carves out and separates part of its business as a new standalone entity, but the separation does not subject the parent firm to paying taxes.
  • The first method of conducting a tax-free spinoff is for the parent company to distribute shares in the new spinoff to existing shareholders in direct proportion to their equity interest in the parent.
  • The second method is for the parent company to offer existing shareholders the option to exchange their shares in the parent company for an equal proportion of shares in the spinoff company.

How Tax-Free Spinoffs Work

A spinoff occurs when a parent corporation separates part of its business to create a new business subsidiary and distributes shares of the new entity to its current shareholders. If a parent corporation distributes stock of a subsidiary to its shareholders, the distribution is generally taxable as a dividend to the shareholder.

In addition, the parent corporation is taxed on the built-in gain (the amount the asset has appreciated) in the stock of the subsidiary. 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.

There are typically two ways that a company can undertake a tax-free spinoff of a business unit. In either case, the spun-off company or subsidiary becomes its own publicly traded corporation with its own ticker symbol, board of directors, management team, etc.

First, a company can choose to simply distribute all the shares (or at least 80%) of the spun-off company to existing shareholders on a pro rata basis, instead of outright selling the subsidiary to another. For example, if an investor-owned 3% of ABC corporation and ABC was spinning off XYZ corporation, s/he would receive 3% of the shares issues for XYZ.

Secondly, a company may choose to undertake the spinoff by issuing an exchange offer to current shareholders. With this method, current shareholders are given 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. The shareholders are free to choose whichever company they believe offers the best potential return on investment (ROI) going forward.

This second method of creating a tax-free spinoff is sometimes referred to as a split-off to distinguish it from the first method.

Taxable vs. Tax-Free Spinoffs

The difference between a tax-free spinoff and a taxable spinoff is that a taxable spinoff results if the spinoff is done by means of an outright sale of the subsidiary company or division of the parent company. Another company or an individual might purchase the subsidiary or division or it might be sold through an initial public offering (IPO).

The manner in which a parent company structures the spinoff and divests itself of a subsidiary or division determines whether the spinoff is taxable or tax-free. The taxable status of a spinoff is governed by Internal Revenue Code (IRC) Section 355. The majority of spinoffs are tax-free, meeting the Section 355 requirements for tax exemption because the parent company and its shareholders do not recognize taxable capital gains.

While a company's first responsibility in determining how to conduct a spinoff is its own continued financial viability, its secondary legal obligation is to act in the best interests of its shareholders. Since the parent company and its shareholders may be subject to sizable capital gains taxes if the spinoff is considered taxable, the inclination of companies is to structure a spinoff so that it is tax-free.

There are any number of reasons why a company might wish to spin off a subsidiary company or division, ranging from the idea that the spinoff can be more profitable as a separate entity to the need to divest the company to avoid antitrust issues. There are detailed requirements in IRC section 355 that go beyond the basic spinoff structure outlined above. Spinoffs can be quite complicated, especially if the transfer of debt is involved. Shareholders may, in that case, wish to seek legal counsel on the possible tax consequences of a proposed spinoff.