The discussion around the dinner table turns to spin off stocks. Your neighbor says he’s found a pending spin off and asks, “how does stock spinoff affect tax?” Not sure of the answer, you open your computer, the research begins, and this is what you two discover.
How Does Stock SpinOff Affect Tax?
A stock spin off affects tax in several ways for the parent company and its shareholders. The spin off tax effect is dependent on whether the spin off is tax-free under Section 355 of the Internal Revenue Code. If it does not meet the Code’s requirements, it is considered a taxable event. To properly address the question, how does stock spinoff affect tax? We must examine the two tax implications and additional influences of a spin off:
Parent Company Tax Implications
Tax-Free Spin Off – IRS Section 355 allow a spin off to be tax-free to the parent company if the following requirements are met:
- The parent company retains control of the newly formed spin off immediately prior to share distribution.
- The spin off must serve a valid business purpose. It cannot be used as a vehicle for tax avoidance.
- The parent company cannot use the spin off process as a transactional device to distribute earnings and profits.
Tax-Free Implication – The tax implication of a tax-free spin off is that the parent company does not experience any immediate gain or loss on the spin off shares distribution.
Taxable Spin Off - Spin offs that do not meet Section 355 requirements are considered taxable events and the parent company must recognize any capital gains, but not losses, on the distribution of spin off shares. The gain is the difference between the distributed spin off shares’ fair market value and the allocation of the parent company’s original cost basis.
How does stock spinoff affect tax? The tax on stock spin off affects the parent firm and its shareholders. Let’s look at the shareholder tax impact.
Shareholder’s Tax Implications
Tax-Free Spin Off – Parent company shareholders do not experience any immediate taxes upon receipt of the newly formed entity shares.
Tax Basis Allocation – The tax-free treatment does not absolve shareholders from tax basis allocation. The parent company recipients must allocate their parent company share tax basis between the parent firm and the spun off entity based on the fair market value of the two companies at the time of the spin off.
Taxable Spin Offs – In a taxable spin off, shareholders must recognize and report the fair value of their spin off shares as a taxable dividend, in relation to the parent company’s earnings and profits. Any excess distributed above the parent firm’s earnings and profits is considered a return of capital, which reduces the tax basis of the parent company shares and is treated as capital gains.
Additional Tax Influences
Holding Period – In a tax-free spin off, the parent company’s stock holding period is added onto the holding period of the spun off firm’s stock. This will determine whether any future sale of spin off shares will be treated as short-term or long-term capital gains.
For a taxable spin off, the holding period begins the day after the spin off shares are distributed to parent shareholders.
State Taxes – The impact of state taxes can vary based on jurisdiction. The prudent investor considers the relevant state statutes where the company and the investor are domiciled.
How does stock spinoff affect tax? The tax treatment of stock spin off has different implications depending on whether the spin off is tax-free or taxable. The parent firm and its shareholders avoid an immediate tax event when the spin off qualifies as a tax-free transaction. If the spin off is taxable, the parent company recognizes a gain, and shareholders experience a taxable event as their spin off shares are considered dividends and treated as ordinary income.
