DEFINITION of Tax-Free Spinoff

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. 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 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.

BREAKING DOWN Tax-Free Spinoff

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 spin off 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.

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 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).