Taxable Spinoff

What Is a Taxable Spinoff?

A taxable spinoff is a divestiture of a subsidiary or division by a publicly-traded company, which will be subject to capital gains taxation. To qualify as a taxable transaction, the parent corporation must divest through direct sale of the division or the assets it contains. The profits made from the sale will be taxed as capital gains.

Key Takeaways

  • A taxable spin-off is a form of corporate divestiture where the conditions of Internal Revenue Code provisions for tax-free spinoffs are not met. 
  • In a taxable spinoff, both the parent company and the shareholders incur an additional tax obligation from the transaction. 
  • Changes to tax law under the Tax Cuts and Jobs Act of 2017, including lower corporate tax rates, may impact firms’ decision to pursue taxable versus tax-free modes of corporate divestiture. 
  • Most spinoffs are tax-free, and a company will fulfill the IRS requirements in order to ensure this.
  • Spinning off a portion of a company is usually beneficial to the share price of both companies.
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Spinoff

Understanding Taxable Spinoffs

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. The subsidiary will become completely independent from the parent corporation, operating entirely on its own. If a parent corporation distributes the stock of the subsidiary to its shareholders, the distribution is generally taxable to the shareholder as a dividend payout.

In this case, ordinary income tax equal to the fair market value of the stock received is imposed on investors. In addition, the parent corporation is taxed on the built-in gain (the amount the asset has appreciated) in the stock of the subsidiary.

The tax in this case is a capital gains tax equal to the fair market value of the distributed shares less the parent company’s inside basis in the stock. When cash is received in lieu of fractional shares in the spinoff, the fractional shares are generally taxable to shareholders.

A taxable spinoff will bring in liquid assets to the company, usually in the form of cash. The downside of this transaction comes from the decrease in income from the capital gains tax. If a parent company wishes to avoid taxation, it may consider a tax-free spinoff. Section 355 of the Internal Revenue Code (IRC) provides an exemption to taxing transactions from spinoffs, 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. 

When a Spinoff Is Taxed

A spinoff is taxed when the company outright sells the subsidiary. This can include the company being bought by another company or when the company is sold via an initial public offering (IPO).

When cash is received instead of shares in a spinoff, the shares of the spinoff are generally taxable.

When such events occur, there are two levels of tax that need to be paid. An ordinary tax would be applied at the shareholder level, which would be equal to the fair market value (FMV) of the stock received. In many ways, it is similar to a dividend payout. A capital gains tax may also be applied on the stock sale at the level of the company equal to the FMV of the stock, minus the company's inside basis in the stock.

There are also cases when a spinoff may be taxed simply because it didn't adhere to the tax-free spinoff requirements listed below.

Tax-Free Spinoff

There are typically two ways that a company can undertake a tax-free spinoff of a business unit. First, a company can choose to simply distribute the new shares (or at least 80%) of the division to existing shareholders on a pro-rata basis.

The second way a company can avoid any capital gains from divestiture is by giving current 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. This means the shareholders are free to choose whichever company they believe offers the best potential return on investment (ROI) going forward.

The IRS has certain requirements for companies to be able to spin off tax-free. They are control, device, active trade or business, and distributions.

Control requirements stipulate that the corporations must own stock possessing at least 80% of the total combined voting power of all classes of the stock of that corporation. There are different measures for determining voting control but are usually determined by the ability to elect directors.

Device requirements for tax-free spinoffs mean the spinoff cannot be used as a device for the sole purpose of distributions of earnings and profits. This is determined on a case-by-case basis and considers all aspects of the spinoff.

The active trade section requires both the pre-existing company and the newly spun-off company to qualify as what the IRS calls an "active trade or business" immediately once the deal is finalized. This also requires that both businesses are actively engaged in business.

The distribution requirements mean that the IRS requires the pre-existing company to distribute all stocks and securities held in the newly spun-off company in specific ways. Usually, this is for the company to distribute at least 80% of the shares to existing shareholders on a pro-rata basis. The second involves the stock options given to shareholders explained above, where they can choose either the pre-existing company or the new company to invest in.

Special Considerations

Because of the availability of a tax benefit under Section 355, most spin-offs are conducted in order to take advantage. Rather than incur an additional tax burden through a taxable spin-off, businesses may often find that it makes more sense to pursue some other form of divestiture if the benefits of the divestiture outweigh the additional tax incurred.

This also means that corporate income tax rates may influence firms’ decisions to divest and how. Cuts to corporate income tax rates in the U.S. under the Tax Cuts and Jobs Act of 2017, signed by President Trump, may have changed this calculus somewhat in favor of other forms of divestitures such as subsidiary stock sales or asset sales. 

Real-World Example

One of the largest corporate spinoffs of all time occurred in 2008, when Altria Group Inc. (MO) spun off Philip Morris International Inc. (PM), spinning off 100% of the shares of Philip Morris. In this case, each Altria shareholder received one share of Philip Morris stock for every share of outstanding Altria common stock.

They split due to concerns over payouts to shareholders as well as the mounting pressure of smoking lawsuits. However, on Altria's website, they state that they spun off Philip Morris as "management believed that the spinoff would enable each of Altria's international and domestic tobacco businesses to focus exclusively on realizing its own opportunities and addressing its own challenges, thereby building long-term shareholder value."

On Jan. 30, 2008, Altria authorized the spinoff. By March of the same year, Philip Morris shares were distributed to shareholders on record of Altria that held shares during the distribution date. This was a non-taxable spinoff example as most spinoffs are conducted in order to be tax-advantaged.

Is a Stock Spinoff Taxable?

Stock spinoffs are usually tax-free. There are many advantages for both the parent organization and the common shareholder if the spinoff is not taxed.

Is a Spinoff Considered a Dividend?

Since the spinoff is paid to the shareholder as a distribution, it is very similar to a dividend. The main difference between the two is that a dividend will pay the shareholder in cash, whereas a spinoff will pay the shareholder in additional stock shares.

What Is the Difference Between a Spinoff and a Split-off?

The method of creating a tax-free spinoff that involves presenting shareholders the options of investing in either the spun-off company or the pre-existing company is called a "split-off." These terms are used to avoid confusion when discussing the spinoff, and whether the company distributes the shares on a pro-rata basis, or gives shareholders the option to choose.

How Many Shares Do you Get in a Spinoff?

How many shares you receive in a spinoff is determined by whether the company performs a true spinoff, or if there is a split-off. In a split-off, you are able to choose between receiving shares in the newly spun-off company or keeping your shares in the parent organization.

The Bottom Line

Most companies who spin off portions of their companies will do so in a tax-free way. There are enormous tax benefits to not selling a company outright, therefore most companies will fulfill the IRS requirements for spinning off portions of their company in a tax-free way.

Article Sources
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  1. Federal Register. "Guidance Under Section 355(e) Regarding Predecessors, Successors, and Limitation on Gain Recognition; Guidance Under Section 355(f)."

  2. Invest.net. "Spinoff."

  3. Klasing Associates. "Tax-Free Spinoff."

  4. 115th Congress, 1st Session. "Tax Cuts and Jobs Act," Page 149.

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