What it is:
A taxable spinoff occurs when a company divests a portion of its business in a manner that does not qualify as a tax-free transaction under Section 355 of the Internal Revenue Code.
How it works/Example:
For example, let's assume that Company XYZ has three divisions: the automotive division, the food division, and the furniture division. Company XYZ no longer wants to be in the food business, so it decides to spin off that division into its own company and then sell it.
Assume that Company XYZ originally purchased the food division ("FoodCo") from Company ABC for $30 million. It invested an additional $10 million in FoodCo since the original purchase. Company XYZ figures that FoodCo can be sold today for $100 million -- a $60 million capital gain.
Why it matters:
There are ways to reduce the tax implications of a spin off.
For example, Company XYZ could just give 80% or more of its shares in FoodCo to its existing shareholders, with each Company XYZ shareholder getting shares of FoodCo in proportion to his or her ownership in Company XYZ. In other words, a shareholder who owns 5% of Company XYZ shares would get 5% of the FoodCo shares.
In either case, FoodCo becomes its own company with its own management and owners.
When deciding how to spin off a company, the managers of the parent company have a responsibility (and legal duty) to act in the best interests of the shareholders. It is usually 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 would not have to pay capital gains taxes in a tax-free spinoff). However, priority #1 is protecting the parent company as a going concern, which may put access to cash ahead of tax planning.
It is important to note that spinoffs are very complicated, and the IRS imposes several requirements on both the parent and spinoff company during and after the transaction. When companies transfer debt during a spin-off, the process becomes even more complicated.