The basics of a tax-free spin-off transaction
Section 355 of the Internal Revenue Code provides a powerful tool in corporate restructurings.
Under the U.S. corporate income tax system, there is generally a tax imposed both at the corporate level and at the shareholder level. Upon distribution of appreciated property to its shareholders, a corporation generally recognizes taxable gain as if it had sold the property for fair market value, and the shareholders will generally recognize taxable gain upon receipt of the distributed property. However, if the requirements for a tax-free "spin-off" under Section 355 are met, a corporation and its shareholders will generally not recognize gain upon the distribution of stock of a controlled subsidiary to the shareholders.
There are several types of transactions commonly referred to as “spin-offs.” A spin-off occurs where one corporation (i.e., a parent) distributes stock of a controlled corporation (i.e. a subsidiary) to its shareholders, generally on a pro rata basis. A split-off occurs where the parent distributes stock of the controlled corporation to some of its shareholders in exchange for their stock in the distributing parent. A split-up occurs where the parent distributes stock of two (or more) controlled corporations in complete liquidation.
In order for a spin-off to qualify under Section 355, several requirements must be met. These requirements derive from not only the statute itself, but also from regulatory and common law principles.
Control immediately before the distribution: The parent must be under the control of the controlled corporation immediately before the distribution. "Control" exists if the parent owns at least 80 percent of (a) the total combined voting power of all classes of stock entitled to vote, and (b) each class of non-voting stock of the controlled entity.
Distribution of control: The parent must distribute either all of the stock (or securities) it held in the controlled entity immediately before the distribution, or an amount of stock (or securities) constituting "control." If the distributing parent retains any stock, it must establish that the retention was not for tax avoidance purposes.
Active trade or business: This element looks to whether an active trade or business (ATB) was conducted both prior to the distribution and after the distribution. Immediately after the distribution, the parent and controlled entity must be engaged in an ATB. As a general matter, in order for an ATB to exist, the corporation itself must perform "active and substantial management and operational functions." Prior to the distribution, the subject trade or business must have been "actively conducted throughout the 5-year period ending on the date of the distribution". In order to satisfy this five-year look-back, neither the trade or business nor control of a company conducting the trade or business may have been acquired by the distributing parent or the controlled company in a transaction in which gain or loss was recognized in whole or part during the five -year period. However, expansion of the business, either organically or by acquisition, will not destroy this requirement provided that the change is "not of such a character as to constitute the acquisition of a new or different business."
No device: The transaction must not be used "principally as a device for the distribution of earnings and profits" of either the parent or controlled corporation. This requirement exists to prevent a distribution to a corporation's shareholders (which might otherwise constitute a dividend taxed at ordinary rates) being converted into a tax-free distribution of the controlled company’s stock followed by a sale of the stock taxed at preferential capital gain rates. Treasury regulations provide a list of factors which are considered to be evidence that a transaction is and is not a tax avoidance device.
Valid business purpose: The transaction must be motivated in substantial part by a real and substantial corporate business purpose, other than the avoidance of federal income tax. The business purpose must be that of the corporation as opposed to the corporation's shareholders. If the corporate business purpose is capable of being carried out in a way that does not involve the distribution of the controlled company’s stock and which is neither impractical nor unduly expensive, then the spin-off will fail this requirement. A valid corporate business purpose will serve as evidence that the transaction is not a tax avoidance device. The IRS has provided guidance by providing a non-exhaustive list of examples that can be indicative of a valid corporate business purpose.
Continuity of interest: The shareholders of the parent must own, in the aggregate, an amount of stock establishing a "continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation." An example in the Treasury regulations suggests that the shareholders of the parent should own at least 50 percent of both the parent and controlled corporations after the spin-off. Another example suggests that this requirement is satisfied when, after the distribution, all of the stock of the parent is owned by one of the parent’s two historic shareholders, and all of the stock of the controlled corporation is owned by the second of the parent's two historic shareholders.
Continuity of business enterprise: Section 355 contemplates the continued operation of the business or businesses that existed prior to the separation. This continuity of business enterprise requirement is generally satisfied when the parent and controlled corporations continue the parent's historic business or, if the parent has more than one line of business, a significant line of the parent's business. Alternatively, this requirement is generally satisfied if the parent and controlled corporations use a significant portion of the parent's historic assets in a business.
There are several other nuances, rules and limitations that may apply in a Section 355 transaction which are beyond the scope of this article, including those imposed by Section 355(d) — addressing “disguised sales” — and Section 355(e) — addressing “prohibited plans”. As can be seen, structuring a transaction to qualify as a Section 355 spin-off transaction requires a great deal of planning and considerable attention to the detailed rules and exceptions applicable to these types of transactions. However, the potential tax savings can also be considerable.