Spin-off vs. Split-off vs. Split-up: Avoiding Tax & Risk in Acquisitions

There are numerous strategies for creating entity structures to protect from tax and risk when selling C-corp businesses and their assets.

Here we discuss three: spin-offs, split-offs & split-ups as tax and risk mitigation tools in mergers & acquisitions.

If the explanations below aren't sufficient, the following graphic should help as a visual:

[caption id="attachment_27415" align="aligncenter" width="1024"]

Choosing between a spin-off, a split-off or a split-up can be helpful in avoiding tax and risk in mergers & acquisitions.[/caption]

Avoiding taxable events by corporate structuring is and always should be part of the strategy of business sales and divestitures.

In most instances, when assets change hands someone is taxed.

Certain corporate structuring options allow for tax avoidance and other favorable terms for the business to continue forward with less risk and better overall options.

Avoiding tax from a C-corporation can be a major strategy when it comes time to sell companies and their assets.

If the portion to be sold is part of a large corporation, an asset sale would most likely trigger taxable events at the entity level and the shareholder or owner level.

If the portion to be sold is operated in a separate corporation, the stock can be sold, creating only a single taxable event.

The benefit of creating different entities is not only favorable from a tax perspective, but is also helpful when different shareholders require differing needs.

Finally, separating legal and operating risk between entities helps protect shareholders from the undue risk associated with having all your eggs in one basket.

In most "break-up" situations, the assets from the single D corporation (or "distributing" corporation) are transferred to multiple C corporations, which are also referred to as "controlled corporations."

The stock of the "controlled" companies can be distributed to the shareholders of the distributing corporation, all tax free.

Spin-off

The distributing corporation contributes assets to a newly formed controlled corporation. This is done in return for stock of the controlled corporation. The stock in the controlled corporation is then distributed pro-rata to its shareholders.

Tax Implications of Spin-offs

Under Section 355 of the Internal Revenue Code (IRC), spin-offs are usually considered tax-free. In other words, no taxable event is recognized by the parent entity or its existing shareholders. There are very specific requirements under Section 355 which must be qualified in order for a spin-off to be properly structured so as to maintain its tax-free status (when we use the word "sub" we are referencing the spin-off entity).

• "Continuity of Interest" must be maintained by both parent and sub shareholders for a four year period beginning at least two years prior to the spin-off. Continuity of interest requires maintaining a minimum of 50% equity ownership interest in both parent and sub entities. A change of control to <50% during this time could create a tax liability. This is often referred to as the anti-Morris Trust rule.
• Following the spin-off both the parent and the sub must continue in an active business or active trade.
• Parent and sub must have been engaged in legit or "active trade or business" for the five years preceding the spin-off. In other words, they must not have been created for the sole purpose of the spin-off. In addition, neither party could have been acquired during the five year period in a taxable event.
• Parent must maintain tax control of the spin-off of at least 80% of the vote and all value of every class of sub stock.
• At the time of the spin-off the parent must surrender tax control of the sub with <80% vote and value.
• The spin-off must not be used as a dividend distribution "device." It must have a valid business purpose.

Other Spin-off Advantages

• A registered spin-off’s shares can be marketed in a secondary public offering at a later date without the need for an expensive Initial Public Offering (IPO).
• In a registered spin-off only a small percentage of the private company shares are distributed as a dividend. Because the majority of the shares remain under the private company’s control, the new public company is retained by the private firm’s shareholders.
• At the time of a registered spin-off the newly-formed public company is provided an existing base of shareholders. Having an immediate active shareholder base, eliminates one of the most time-consuming steps of preparing a private company to go public.
• Shareholders in the private company are allowed, subject to volume limitation in Rule 144, to sell their securities in the public market. By being allowed to include their shares in the registration for public stock distribution, the private company shareholders are able to have a liquid exit, albeit with some limitations on volume, of their shares in the business.

In some instances, a spin-off may not qualify for the tax-free treatment. In this case there may be two separate levels of tax. First, ordinary income tax may be exacted at the shareholder level equal to the fair market value of the sub stock received. This is similar to a dividend payout. Second, a capital gain tax may be exacted on the sale of the stock at the parent entity level equal to the fair market value of the sub stock less the parent's inside basis in the sub stock. When cash is received in lieu of fractional shares in the spin-off, the fractional shares of the spin-off are generally taxable to shareholders.

Split-off

The distributing corporation contributes assets to a newly formed controlled corporation. This is done in return for stock of the controlled corporation. The stock in the controlled corporation is then distributed to one or more of its shareholders in redemption of stock in the distributing corporation.

Split-up

The distributing corporation contributes all of its assets to two or more controlled corporations. This is done in return for stock of the controlled corporation. The stock in the controlled corporation is then distributed to shareholders in a single liquidation event of the distributing corporation.

Conclusion

Diversifying assets when it comes time to sell a company is important from many perspectives, especially if you wish to legally avoid as much tax as possible when doing M&A. With the increase of capital gains tax rates, and the significant increase in businesses for sale due to retiring baby boomers selling their companies, now is certainly the time to begin talks with an M&A advisor about divesting business assets.

In a registred spin-off transaction a private company goes public by issuing shares of its common stock to an existing publicly-traded company. The common private shares are then formally registered with the SEC with a registration statement. Shares are issued in the form of a stock dividend on a pro-rata basis to shareholders of the private company from the public company.

A registered spin-off entity will subsequently apply for its own ticker symbol with the end result being two publicly-traded companies, including their own common shareholders.

‍