You are considering investing in two upcoming spinoffs. “How are spinoff shares taxed?” you ask your financial advisor. He methodically explains the two scenarios and suggests referring to Event Driven Daily as your general reference.
How are Spinoff Shares Taxed?
Spinoff shares are taxable or tax-free depending on the terms and conditions of the spin-off. Spin-off tax treatment is influenced by transaction specifics and jurisdiction. To properly address the question, how are spinoff shares taxed? we must examine the two scenarios:
Tax-Free Spin Off – Shareholders enjoy the benefits of a tax-free spin-off when the transaction meets the requirements of Section 355 of the Internal Revenue Code. The Section requirements are:
Business Purpose: The pending spin-off must be transacted for a valid business purpose. It cannot be used as a vehicle to avoid taxes.
Shareholder Control – The firm performing the spin-off, known as the parent company, must distribute 80% of the voting power and 80% of the non-voting stock (each class) of the spun-off company to the parent firm’s shareholders.
Active Business Trade – Five years prior to the spin-off, the parent company and the to-be-spun-off division or subsidiary must be an ongoing business concern. Immediately after the spin-off, both firms must be actively engaged in business or trade.
Continuity of Interest – Parent company shareholders must maintain a continued ownership interest in the new spun-off entity. Section 355 mandates at least 50% of the value of the distributed shares be held by parent firm shareholders post-spin-off.
Tax-Free Spin Off Scenario
- Company A (parent company) spins off its division, Company X (spin-off) and the transaction meets Section 355 requirements.
- Company A will receive the new Company X spin-off shares without incurring a tax obligation.
- The shareholders allocate their Company A tax basis between their current Company A shares and the newly received Company X spin-off shares.
How are spin-off shares taxed? A spin-off is tax-free when these requirements are satisfied. The tax basis of the parent firm is allocated between its existing shares and their portion of the new spin-off shares. The holding period is a blending of the new spin-off shareholding period and the parent company’s existing shareholding period.
Taxable Spin-Off - A spin-off is considered a taxable event if it does not meet Section 355 requirements meaning shareholders are taxed on any gains realized from the difference between the spin-off shares market value and the parent company’s share tax basis. The spin-off share-holding period begins on the day after the distribution.
Taxable Spin Off Scenario
- Company A (parent company) spins off its division, Company X (spin-off) but the transaction does not qualify under Section 355.
- The share distribution will be taxed, and shareholders will incur a tax liability based on the spin-off shares fair market value.
Do Spin-off Shares Have a Cost Basis?
Yes, spin-off shares have a cost basis. The cost basis is used to determine the gain or loss on the future sale of the shares.
Cost Basis: Tax-Free Spin Off – The cost basis of the original company shares is allocated between the original shares and the new spin-off shares. The allocation is based on the fair market value of the original shares and the spin-off shares at the time of the spin-off.
A ratio of the fair market value of each set of shares is calculated and combined to equal a total fair market value. The original shares cost basis is allocated based on the original share ratio percentage of the total fair market value and the spin-off cost basis is allocated to the spin-off shares based on its ratio percentage of the total fair market value.
Cost Basis: Taxable Spin Off – The taxable spin-off cost basis is the fair market value of the spin-off shares at the time of distribution. If the shares pay a dividend, these distributions are taxable and considered part of the fair market value.
How are spinoff shares taxed? The complex spin-off tax implications may or may not be taxable. Meeting Section 355 requirements and jurisdiction are major influences on the transaction’s tax treatment and shareholder net profits.
