Justice due knows no boundries.Tel: 202-331-7900

Tax-free Divisions of Controlled Corporations

Breaking up a corporation with subsidiaries can be hard to do. However, with the right legal help, you might be able to split apart your corporate group without any dire tax consequences to the companies or the shareholders.

Background: If a parent-subsidiary group of corporations meets the requirements of Section 355 of the tax code, a distribution of subsidiary corporation stock to the shareholders and security holders of the parent corporation does not result in a taxable gain or loss. However, in order for a corporate division to be tax-free, the separation must satisfy a legitimate business purpose. The “business purpose” test is independent of the other requirements for a tax-free division under Section 355.

The IRS issued two instructive rulings involving the business purpose test. In both of these instances, there will be continuing ties between the organizations after the division:

The first ruling involves a publicly traded software technology corporation that controls a subsidiary producing paper products. The software business is a high-growth operation that develops and markets products for various applications. On the other hand, the smaller paper products business grows at a slow to moderate rate.

Senior managers at the parent corporation devote more time to the software business because they believe it presents better opportunities. Meanwhile, managers at the subsidiary paper products company feel this lack of attention deprives the business of resources needed to develop. A spin-off of the paper products subsidiary will allow both sets of managers to better concentrate on their own operations. After the split, two directors will continue to serve on the boards of both the software technology company and the paper products company.

The IRS ruled that the distribution satisfies the business purpose requirement of Section 355. Reason: The separation of the two businesses is expected to enhance the success of each operation in a substantial way. (IRS Revenue Ruling 2003-74)

The second ruling concerns a publicly traded pharmaceutical corporation that also conducts a cosmetics business. The pharmaceutical business is a high-margin operation that develops, manufactures and markets specialty drugs. The cosmetics firm is a low-margin business that grows at a moderate rate by increasing its productivity and market share. Both of the businesses require substantial capital for reinvestment and research and development.

It was decided to spin off the stock of the subsidiary cosmetics business because the capital spending for both businesses outpaced the cash flow generated internally. So the two operations had to compete for a limited amount of capital in order to maintain the credit rating of the pharmaceutical firm. This competition made it difficult for both businesses to consistently pursue strategies that managers believe is prudent.

After the spin-off, the two entities plan to maintain transitional agreements for information technology, benefits administration, accounting and tax matters. The IRS determined that the division qualifies for tax-free treatment under Section 355. (IRS Revenue Ruling 2003-75)

What’s at stake when a corporation distributes stock in a spin-off? In addition to the numerous logistical and human resource issues, the tax consequences can be enormous for both the corporation and the shareholders. It is strongly recommended that you obtain legal assistance every step of the way in this complex undertaking.