The 3 Primary Ways to Divide a Corporation Tax-Free: Spin-Offs, Split-Offs, and Split-Ups

By: Tyler B. Korn, Esq.

By permitting the division of a corporation through the distribution of stock (in one form or the other) without recognition of gain or loss at either the shareholder or the corporate level, Section 355 is one of the few remaining Internal Revenue Code provisions under which the tax-free movement of corporate assets can be accomplished.

There are three primary methods of dividing a corporation tax-free: (1) spin-off, (2) split-off, and (3) split-up. A spin-off is a pro rata distribution of a controlled corporation’s stock to the distributing corporation’s shareholders without requiring the shareholders to surrender any of their stock in the distributing corporation.

A split-off is a pro rata or non-pro rata distribution of a controlled corporation’s stock to one (or more) of the distributing corporation’s shareholders in exchange for stock held in the distributing corporation. (A split-off is identical to a spin-off, except that the shareholders of the distributing parent corporation surrender part of their stock in the parent in exchange for the stock of the subsidiary.)

In a split-up, there is a transfer of all the businesses of a distributing corporation to controlled corporations, followed by a distribution of the stock of the controlled corporations to the distributing corporation’s shareholders and the liquidation of the distributing corporation. The distribution of the controlled corporations’ stock to the distributing corporation’s shareholders can be either pro rata or non pro rata. In the case of a non-pro rata division, the overall effect of the split-up is to completely separate corporations, whereas in the case of a pro rata division, the split-up’s overall effect is to create a “brother-sister” relationship between subsidiaries.

In order for a distribution of stock of a controlled corporation to qualify as tax-free under Section 355 of the Internal Revenue Code, certain basic requirements must be met: (i) The distributing corporation must control the corporation whose stock or securities it distributes (“controlled corporation”) immediately before the distribution; (ii) The distributing corporation must distribute all of the stock or securities held by it in the controlled corporation immediately before the distribution; (iii) The transaction must not be used principally as a device for distributing the earnings and profits of either the distributing corporation or the controlled corporation; (iv) Immediately after the distribution both the distributing and the controlled corporations, or, in the case of a split-up, each of the controlled corporations must be engaged in the active conduct of a trade or business; (v) There must be a corporate business purpose for the distribution; and (vi) With certain exceptions, the distributing corporation must distribute only stock or securities of the controlled corporation to a shareholder with respect to his stock or to a security holder in exchange for his securities.

If a company fails to meet these requirements, its divisive transaction will not qualify as tax-free under Section 355 of the Code, and the result can be quite expensive. In the case of a failed spin-off, the distribution will be taxable as a dividend to the extent of the distributing parent’s earnings and profits. In the case of a failed split-off, the transaction will be taxed as either a sale or exchange of stock or a dividend under the redemption rules of Section 302 of the Code. In the case of a failed split-up, the corporation will be treated as having been liquidated or as having been liquidated and then re-incorporated.

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