What is a Tax-Free Spinoff?

A tax-free spinoff occurs when a company divests a portion of its business in a manner that qualifies as a tax-free transaction under Section 355 of the Internal Revenue Code and thus does not require the company to pay capital gains tax on the divestiture.

How Does a Tax-Free Spinoff Work?

Assume Company XYZ has three divisions: the automotive division, the food division and the furniture division. The company no longer wants to be in the food business, so it decides sell it.

Company XYZ originally purchased the food division ('FoodCo') from Company ABC for $30 million seven years ago and has invested $10 million in the company since then. It figures that selling FoodCo will garner $100 million. Thus, Company XYZ would make a $60 million capital gain from the sale.

Typically, capital gains are taxable at the federal, state and local levels. But in a tax-free spinoff, a company does not incur a tax bill, which helps shareholders tremendously. How does a company do this? There are typically two ways, both of which involve no cash changing hands.

First, instead of an outright sale of FoodCo to another company, Company XYZ could just give all (or at least 80%) of its shares in FoodCo to its existing shareholders. Each Company XYZ shareholder gets shares of FoodCo in proportion to their ownership in Company XYZ -- in other words, a shareholder who owns 5% of the Company XYZ shares would get 5% of the FoodCo shares.

Second, Company XYZ could give shareholders the option to exchange their Company XYZ shares for shares of the food division (this is called an exchange offer). In either case, FoodCo becomes its own company with its own management and owners.

Why Does a Tax-Free Spinoff Matter?

The managers of any company, private or public, have a responsibility (and legal duty) to act in the best interests of the owners of the business -- the shareholders. Accordingly, it is in the best interest of the shareholders to preserve cash as much as possible, and that means minimizing tax bills for the company and its shareholders (who also would not pay capital gains taxes in a tax-free spinoff).

Notably, however, tax-free spinoffs usually do not result in the parent receiving a big check for sale proceeds as it would if it just conducted an outright sale of a division for cash. However, one rationale for a tax-free spinoff is that getting rid of the subsidiary will strengthen the remaining company and thus raise its stock price or even improve the outcome of a future stock offering. A spinoff might also rid the company of a division that is a regulatory hassle or is bringing down the company's overall credit rating (and thus ability to borrow money).

It is important to note that tax-free spinoffs are very complicated, and the IRS imposes several requirements on both the parent and spinoff company during and after the transaction, which, if not followed, can compromise a tax-free spinoff. When companies transfer debt during a spinoff, the process becomes even more complicated in terms of qualifying for tax-free treatment. This definition is only meant to simplify and explain them in broad terms.