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:
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.
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.
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).
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.
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.
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.
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.