Numbered ticket in hand and waiting to renew your driver’s license, the lady sitting next to you says she is interested in investing in a spin off company. She likes the tax benefits, then she asks, “why are spin offs tax free?” Smiling knowingly, this is what you tell her …

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.

Read next: How Long Does a Spin Off Take?

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