DEFINITION of '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.

BREAKING DOWN 'Taxable 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. The subsidiary will become completely independent from the parent corporation, operating entirely on its own. If a parent corporation distributes 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 a taxation, they 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.

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.

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