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 spin-offs are not met. 
  • In a taxable spin-off 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. 

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 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, 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.

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.