Question

Parent Corporation is a new client of yours. It is considering distributing to its shareholders the stock that it owns in Subsidiary Corporation. Parent Corporation would like this distribution to be tax-free or, failing that, subject to as little taxes as possible.

As advisor to Parent Corporation and its shareholders, what questions would you ask them, and why?

Answer 1

The questions that asked to Parent Corporation and its Shareholders are

Sec. 355 permits a Parent corporation to distribute the stock of controlled corporations(Subsidary) to its shareholders if certain requirements are met. In general, the requirements are:

(1) The Parent corporation must have control immediately before the distribution;

(2) the distribution is not principally used as a device for the distribution of earnings and profits;

(3) the Parent corporation and controlled corporation(Subsidary) are engaged in an active trade or business immediately after the distribution (with exceptions); and

(4) the Parent corporation distributes “all of the stock and securities in the controlled corporation held by it immediately before the distribution” Sec. 355(a).

Sec. 355(a) offers an exception to the “all of the stock and securities” rule. A Parent corporation can still receive tax-free treatment under Sec. 355 if (1) the Parent corporation distributes an amount of stock in the controlled corporation constituting control within the meaning of Sec. 368(c); and

(2) the Parent corporation establishes to the IRS’s satisfaction that retaining any controlled stock was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax.

Under the Internal Revenue Code Section 355, most parent companies can avoid taxation on spinoff activity because no funds are provided in exchange for ownership. Instead, a spinoff involves the distribution of company stock of the subsidiary entity from the parent company on a pro rata basis to shareholders, making the same shareholders of the parent company owners of the subsidiary. No cash is exchanged when the subsidiary is formed in a spinoff, and as such, no ordinary income or capital gains taxes are assessed.
Similar to the parent company tax benefits experienced in a spinoff, the subsidiary company can also avoid taxation during the transaction. Because the shareholders of the subsidiary company receive stock on a pro rata basis from the parent company in lieu of cash for sale of the company, ordinary income and capital gains taxes are not applicable. Instead, the owners of the parent company become the owners of the subsidiary through the transfer of shares as a more cost-effective alternative than receiving compensation for the new company through a stock dividend.