A financial segment about spin-off stocks catches your eye and, with a remote in hand, you turn it up. The segment title is “Is a Stock Spin-off Taxable?” The advisor states that understanding the tax implications is critical to making informed decisions and here’s what prudent investors should know.

Is a Stock Spin-off Taxable?

A stock spin-off is 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 and to address Is a stock spin-off taxable? we must examine the two scenarios, here’s the breakdown:

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 can not 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.

Is a stock spin-off taxable? A stock 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 share holding period and the parent company’s existing share holding period.

Taxable Spin-off 

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.

Taxable Spin-off Scenario

  • 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.

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

Read next: What is the Holding Period for a Spin-Off?

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