Corporate Spin-Offs: A Well Planned Prescription for Ailing Companies
In the corporate world, trigger is not always better. Corporate spin-offs have become a popular way for companies to release shareholder value and achieve other business purposes. A spin-off involves the pro rata distribution of a controlled corporation's stock to the distributing corporation's shareholders without their surrendering any distributing corporation stock. Much of the popularity of spin-offs, especially when the alternative is a simple divestiture (selling part of a corporation's operations to a third party), can be traced to a company's ability to structure the transaction so it is tax-free. In fact, after the Tax Reform Act of 1986, a spin-off or other divisive reorganization is the only way a company can distribute appreciated property to shareholders without incurring a corporate-level tax. An added appeal is that corporations have considerable latitude in reporting spin-offs in their financial statements. This article reviews the tax and financial reporting guidelines that affect corporate spin-offs. To ensure maximum tax and accounting benefits, a working knowledge of both areas is essential to CPAs who are part of a management considering structuring, a spin-off, as well as to CPAs in public practice who may be asked to advise clients in similar circumstances. ENSURING TAX-FREE TREATMENT While IRC section 355 provides the statutory authority for tax-free treatment of corporate spin-offs, it is the regulatory hoops--particularly the all-important business purpose requirement--that can cause a company's distribution to fail section 355. The penalty for not meeting the section requirements--tax at both the corporate and shareholder levels--makes an advance IRS ruling (or the opinion of tax counsel) a company's prudent first step to ensure tax-free treatment. In April 1996, the IRS updated and expanded its section 355 guidance by releasing revenue procedure 96-30, which retains most of the guidance in superseded revenue procedure 86-41 but also provides companies with significant new help on the business purpose requirement. Key requirements. Section 355 includes four key requirements for tax-free treatment, and Treasury regulations section 1.355-2 adds two additional requirements business purpose and continuity of interest. 1. Controlled corporation. To qualify as a tax-free spin-off, the distributing corporation must distribute the stock of a controlled corporation (preexisting or newly created) to its shareholders. Provided the companies meet the active business requirement (see below), the distributing corporation has significant latitude in the assets it transfers to the controlled corporation For purposes of this requirement, control is defined as owning at least 80% of the voting power and at least 80% of the shares of each class of nonvoting stock. While this control may have existed for a long time or been obtained in exchange for the assets transferred, it must exist immediately before the distribution and must not have been obtained in a transaction in which the company recognized gain. If the distributing corporation acquires additional controlled corporation stock during the five years preceding the distribution in a taxable transaction, the shareholders treat the stock as boot. 2. Securities distribution. The distributing corporation generally must distribute all its controlled corporation stock and securities immediately before the transaction. Revenue procedure 96-30, however, allows the distributing corporation to retain a limited amount of the stock or securities if the stock is widely held, the retention satisfies a significant business purpose, the controlled corporation officers and directors are officers and directors of the distributing corporation, the retained stock and securities are disposed of as soon as possible (but no later than five years after the separation) and the distributing corporation votes the retained stock in the same proportion as the stock distributed. …