How Are Spinoff Shares Taxed?

You are considering investing in two upcoming spinoffs. “How are spinoff shares taxed?”  you ask your financial advisor. He methodically explains the two scenarios and suggests referring to Event Driven Daily as your general reference.

How are Spinoff Shares Taxed?

Spinoff shares are taxable or tax-free depending on the terms and conditions of the spin-off. Spin-off tax treatment is influenced by transaction specifics and jurisdiction. To properly address the question, how are spinoff shares taxed? we must examine the two scenarios:

Tax-Free Spin Off – Shareholders enjoy the benefits of a tax-free spin-off when the transaction meets the requirements of Section 355 of the Internal Revenue Code. The Section requirements are:

Business Purpose: The pending spin-off must be transacted for a valid business purpose. It cannot be used as a vehicle to avoid taxes.

Shareholder Control – The firm performing the spin-off, known as the parent company, must distribute 80% of the voting power and 80% of the non-voting stock (each class) of the spun-off company to the parent firm’s shareholders.

Active Business Trade – Five years prior to the spin-off, the parent company and the to-be-spun-off division or subsidiary must be an ongoing business concern. Immediately after the spin-off, both firms must be actively engaged in business or trade.

Continuity of Interest – Parent company shareholders must maintain a continued ownership interest in the new spun-off entity. Section 355 mandates at least 50% of the value of the distributed shares be held by parent firm shareholders post-spin-off.

Tax-Free Spin Off Scenario

• Company A (parent company) spins off its division, Company X (spin-off) and the transaction meets Section 355 requirements.
• Company A will receive the new Company X spin-off shares without incurring a tax obligation.
• The shareholders allocate their Company A tax basis between their current Company A shares and the newly received Company X spin-off shares.

How are spin-off shares taxed? A spin-off is tax-free when these requirements are satisfied. The tax basis of the parent firm is allocated between its existing shares and their portion of the new spin-off shares. The holding period is a blending of the new spin-off shareholding period and the parent company’s existing shareholding period.

Why are Spin Offs Tax Free?

Spin offs are tax free to encourage enterprise efficiency and foster economic growth. A spin off is when a company (the parent) divests or separates a division or subsidiary into an independently operated entity (the spin off). This corporate action can be tax free to the parent company shareholders provided the requirements of Section 355 of the Internal Revenue Code are met. To properly address the question, why are spin offs tax free? we must look at what positive externalities arise because of its favorable tax treatment and what requirements must be satisfied:

Positive Externalities

Efficient Enterprise Restructuring – Spin off tax free status can be a motivator for corporate restructuring. The parent firm and the spin off enjoy the benefits of alignment of their individual growth initiatives, improved efficiency, and dedicated market expansion.

Economic Efficiency – Favorable tax treatment for spin offs creates specialized firms that can be more responsive to market changes. Their newly granted focus allows them to heighten innovation within their specific industry and pursue growth opportunities more effectively leading to a more efficient economy.

Increased Shareholder Value – Spin offs have the potential to create shareholder value and favorable tax treatment facilitates their occurrence. Parent company shareholders receive shares in the new spin off that, because of the act of separation, can unlock untapped value. Shareholders receive an appreciating investment with a potentially more palatable risk profile.

Long-Term Investment Promotion – The removal of an immediate tax liability promotes long-term investment in the spin off and the restructured parent firm. Investors have two opportunities to focus on the long-term tangible benefits each company can yield going forward.

Why are spin offs tax free? Spin offs are tax free to promote a more efficient, more responsive, and highly innovative economy. The cost basis of stock spin off is an important determinant when the shares are sold.

What is the cost basis for stock spin off? The cost basis for stock spin off is the method used to allocate the original cost basis of the parent company stock between the new spin off shares and the parent company shares. This allocation determines the gains or losses of the shares when they are sold and is based on the fair market value of the parent and spin off shares immediately after the spin off.

Why are spin offs tax free? Tax free spin offs create positive economic attributes; however, the IRS wants to ensure this corporate event is not used as a tax avoidance vehicle. IRS Section 355 lays out the following mandatory requirements for a tax-free spin off:

Business Purpose – The spin off must serve a valid business purpose, for example, improving efficiency or satisfying a regulatory requirement.

Interest Continuity – To ensure post-spin off ownership continuity, parent company shareholders must maintain a significant interest in the spin off.

Business Interest Continuity – The new spun off entity must continue to operate as an ongoing business post-spin off. This provision eliminates the transfer of assets for preferable tax treatment.

Active Trade Requirement – The parent company and the spin off, as a prior appendage of the parent, must have been actively engaged in trade or business for five years prior to the spin off.

Taxable Spin Off Scenario

A spin-off is considered a taxable event if it does not meet Section 355 requirements meaning shareholders are taxed on any gains realized from the difference between the spin-off shares market value and the parent company’s share tax basis. The spin-off share-holding period begins on the day after the distribution.

• Company A (parent company) spins off its division, Company X (spin-off) but the transaction does not qualify under Section 355.
• The share distribution will be taxed, and shareholders will incur a tax liability based on the spin-off shares fair market value.

How Does Stock SpinOff Affect Tax for the company?

A stock spin off affects tax in several ways for the parent company and its shareholders. The spin off tax effect is dependent on whether the spin off is tax-free under Section 355 of the Internal Revenue Code. If it does not meet the Code’s requirements, it is considered a taxable event. To properly address the question, how does stock spinoff affect tax? We must examine the two tax implications and additional influences of a spin off:

Parent Company Tax Implications

Tax-Free Spin Off – IRS Section 355 allow a spin off to be tax-free to the parent company if the following requirements are met:

•  The parent company retains control of the newly formed spin off immediately prior to share distribution.
• The spin off must serve a valid business purpose. It cannot be used as a vehicle for tax avoidance.
• The parent company cannot use the spin off process as a transactional device to distribute earnings and profits.

Tax-Free Implication – The tax implication of a tax-free spin off is that the parent company does not experience any immediate gain or loss on the spin off shares distribution.

Taxable Spin Off - Spin offs that do not meet Section 355 requirements are considered taxable events and the parent company must recognize any capital gains, but not losses, on the distribution of spin off shares. The gain is the difference between the distributed spin off shares’ fair market value and the allocation of the parent company’s original cost basis.

How does stock spinoff affect tax? The tax on stock spin off affects the parent firm and its shareholders. Let’s look at the shareholder tax impact.

Additional Tax Influences

Holding Period – In a tax-free spin off, the parent company’s stock holding period is added onto the holding period of the spun off firm’s stock. This will determine whether any future sale of spin off shares will be treated as short-term or long-term capital gains.

For a taxable spin off, the holding period begins the day after the spin off shares are distributed to parent shareholders.

State Taxes – The impact of state taxes can vary based on jurisdiction. The prudent investor considers the relevant state statutes where the company and the investor are domiciled.

Do Spin-off Shares Have a Cost Basis?

Yes, spin-off shares have a cost basis. The cost basis is used to determine the gain or loss on the future sale of the shares.

Cost Basis: Tax-Free Spin Off – The cost basis of the original company shares is allocated between the original shares and the new spin-off shares. The allocation is based on the fair market value of the original shares and the spin-off shares at the time of the spin-off.

A ratio of the fair market value of each set of shares is calculated and combined to equal a total fair market value. The original shares cost basis is allocated based on the original share ratio percentage of the total fair market value and the spin-off cost basis is allocated to the spin-off shares based on its ratio percentage of the total fair market value.

Cost Basis: Taxable Spin Off – The taxable spin-off cost basis is the fair market value of the spin-off shares at the time of distribution. If the shares pay a dividend, these distributions are taxable and considered part of the fair market value.

How are spinoff shares taxed? The complex spin-off tax implications may or may not be taxable. Meeting Section 355 requirements and jurisdiction are major influences on the transaction’s tax treatment and shareholder net profits.

How Do I Make My Spin Off Tax Free?

You can make your spin off tax free by purchasing your spin-off shares within a Roth IRA or Roth 401(k) account. These retirement savings vehicles offer capital gains and dividend tax advantages. Here’s how it works:

Retirement Account Tax Treatment – Roth retirement account contributions are made with after-tax dollars meaning taxes have been deducted prior to your account deposit and subsequent investment.

Spin off Tax Treatment - Your spin off investment is made within your Roth IRA or Roth 401(k) account. Capital gains and dividends are not taxed within your account and if withdrawn as a qualified distribution, they are tax free.

Qualified Distributions – Roth withdrawals are tax free qualified distributions when the following criteria are met:

• Your account has been open for a minimum of five years.
• You are 59 ½ years old or permanently disabled.
• Funds are to be used for a first-time home purchase. The dollar limit is $10,000 per account holder. Two account holders on the same account can withdraw up to $20,000, provided all other requirements are met.

Contribution Rules and Limits – Roth accounts are investment accounts that have contribution and withdrawal requirements and limits. To successfully answer, how do I make my spin off tax free? the prudent investor familiarizes herself with the required criteria and obtains financial and tax advice prior to making an investment.

Read Next:

• How Long Do You Have to Reinvest to Avoid Capital Gains?
• How Long Do You Have to Hold Stock to Avoid Tax?