Spin-Off Transactions: Tax Issues and Section 355

Spin-off transactions, which involve a parent company separating parts of its business operations into a second publicly traded company, can offer potential tax advantages. Some spin-offs qualify for tax-free treatment while other spin-off transaction structures result in a taxable transaction.

In a spin-off transaction, the stock in the company being spun-off into a new public company (“SpinCo”) is distributed to shareholders of the parent company based on a set distribution ratio. The number of shares of SpinCo stock that the parent company shareholder receives depends on the number of shares of the parent company that they own.

Section 355 of the Internal Revenue Code outlines the rules for determining whether the distribution of stock in a spin-off transaction should be taxable. Transactions that resemble either (i) distributions of cash or other liquid assets or (ii) corporate-level sales will be taxable. The aim of Section 355 is to support legitimate spin-off transactions that separate operating businesses.

A number of considerations factor into whether a spin-off transaction qualifies for tax-free treatment. One requirement is for the parent company to distribute “control” of SpinCo. Any retention of stock by the parent company in the spin-off company must not be found to be part of a tax avoidance part. In order for the spin-off transaction to qualify as tax-free, the parent company cannot retain more than 19.9% of the shares of SpinCo following the closing of the spin-off.

Section 355 requires both the parent company and SpinCo to be engaged in an “active trade or business.” This prong requires that the parent company and spin-off company business were engaged in an active trade or business in the five-year period before the spin-off transaction.

Another requirement is that the spin-off transaction was motivated by a corporate business purpose. In other words, the distribution cannot simply be a “device” for distributing the earnings and profits of the parent company or SpinCo without paying taxes.

When either the parent company or SpinCo consists of mostly cash or other liquid, nonbusiness assets, the Internal Revenue Services (IRS) considers it a “cash rich” spin-off. Such a transaction would not be eligible for tax-free treatment under Section 355. If the value of the investment assets held by either the parent company or entity to be spun-off is at least two-thirds of the value of its total gross assets, the IRS is likely to classify it as a “cash rich” spin-off.

A company that is considering a spin-off transaction, and in particular whether the contemplated transaction structure would be tax-free, can submit a private ruling letter to the IRS. While the process can take many months, a favorable private letter ruling from the IRS can provide a high probability of assurance about the ultimate tax treatment of the transaction. A company can also obtain an opinion of tax counsel to get assurance on the tax results of the transaction.

The IRS offers a fast-track process for companies seeking a private letter ruling on an expedited basis. However, the company must display a strong business need for expedited review. If granted, the IRS will issue its private letter ruling within 12 weeks under the fast-track process.

Section 355 also imposes limitations with respect to post-spin acquisitions by the parent company or spin-off company. If a spin-off is determined to primarily be a “device” for distributing cash to shareholders at the capital gains tax rate, the spin-off will be taxable at both the corporate level and the shareholder level. A spin-off followed by an acquisition of the parent or spin-off company’s cash or stock may implicate the “device” rules under Section 355.

If there was a valid business purpose driving the spin-off transaction, and there was no agreement or substantial negotiations with respect to a subsequent acquisition in the one-year period leading up to the spin-off closing, then the IRS rules impose a six-month waiting period after the spin-off transaction closes before the acquisition can occur.