When a parent company creates a spinoff company from one of its businesses or divisions, how it structures the spinoff determines whether the new business 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.
A company’s first responsibility in determining how to conduct a spinoff is its own continued financial viability. However, 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 capital gains taxes if the spinoff is considered taxable, many companies attempt to structure a spinoff so that it is tax-free.
Key Takeaways
- The taxability of a spinoff depends on how the parent company structures it. There are two methods for a parent company to conduct a tax-free spinoff.
- The first is distributing shares in the spinoff in direct proportion to their equity interest in the parent.
- The second is for the parent to offer existing shareholders the option to exchange their shares in the parent company for an equal proportion of shares in the spinoff.
- A taxable spinoff happens via an outright sale of the subsidiary, which can include another company buying it or it being sold via an initial public offering (IPO).
Tax-Free Spinoffs
There are two basic structures, or means, for a parent company to conduct a tax-free spinoff. Both result in the spinoff becoming its own legal entity. This means it is a publicly-traded company separate from the parent company, although the parent may hold a substantial amount of stock (up to 20%) in the newly created company.
Tax-Free Spinoff Method One
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. Thus, if a stockholder owns 2% of the shares of the parent company, they receive 2% of the shares of the spinoff company.
Tax-Free Spinoff Method Two
The second tax-free spinoff 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. Thus, shareholders have the choice of maintaining their existing stock position in the parent company or exchanging it for an equal stock position in the spinoff company. Shareholders are free to choose whichever company they believe offers the best potential return on investmenr (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 Spinoff Structure
A taxable spinoff occurs when there is 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). In this case, it may result in a significant capital gain tax liability for both the parent company and its shareholders.
A company might wish to spin off a subsidiary company or division because the spinoff may be more profitable as a separate entity. In other cases, the parent may need to divest the company to avoid antitrust issues.
It’s worth noting that spinoffs can be quite complicated, especially if the transfer of debt is involved. Therefore, shareholders may wish to seek legal counsel on the possible tax consequences of a proposed spinoff.
Important
Detailed requirements for creating a spinoff company are found in the Internal Revenue Code Section 355.
Spinoff Example
Several blue-chip companies have pursued spinoffs including General Electric, Kellogg, and Johnson & Johnson. For example, in 2024 General Electric plans to spinoff GE Vernova, its power unit division, in a tax-free transaction. After the spinoff, GE Vernova will have new shares listed on the New York Stock Exchange under the ticker “GEV.”
When the spin-off date was announced, Scott Strazik, CEO of GE Vernova stated, “Today’s milestone demonstrates the progress our team is making toward spinning off GE Vernova as an independent company driving both electrification and decarbonization. We’re focused on delivering for our stakeholders while positioning our company for long-term success, and we are excited to launch GE Vernova on the New York Stock Exchange.”
What Is a Spinoff?
A spinoff is a type of divestiture. It is a new, separate company that is created when a parent company distributes shares in a subsidiary division to shareholders of the parent company. The goal of a spinoff is to create a business that is worth more as a separate entity than it would be as a part of the parent company.
What Is the Purpose of a Spinoff?
Companies may have many reasons for conducting a spinoff, such as streamlining operations, increasing shareholder value, decreasing debt, and increasing profits. In this way, a company may be looking to focus on its core business and become more cost-effective in its operations.
Are Spinoffs Taxable?
Most often, spinoffs are tax-free. A parent company will usually structure a spin-off to avoid capital gains tax liability and reduce the tax burden for shareholders. However, a spinoff is taxable when the parent company sells the subsidiary outright, either through an IPO or in a sale to another company.
The Bottom Line
While most spinoffs are tax-free, there are some cases where they are taxable. When spinoffs are taxable, a company will sell the subsidiary outright either through an IPO or in a sale to another company. Because reducing taxes serves the interest of both the company and the shareholders, tax-free spinoffs continue to be the most common type of structures used.
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