Criteria For Tax-Free Dividend Payments
To be considered a tax-free dividend to shareholders, spin-offs must meet the criteria set by Section 355 of the Internal Revenue Code:
Control—The parent must have control of the subsidiary prior to the spin-off which is considered as 80% or more of voting and non-voting stock.
Active Business—Post spin-off, the parent and the subsidiary must be engaged in active trade or business that was actively conducted for five years prior to the spin-off. In addition, neither of those businesses may have been acquired during that period in a transaction where any gain or loss was recognized.
Business Purpose—The transaction must have a concrete business purpose. Increasing shareholder value is not a valid business purpose according the IRS. The most common business purposes include focus on core business, lack of strategic fit, debt reduction, value realization and regulatory reasons.
Device Test—A spin-off cannot be used as a tool to distribute earnings and profits to shareholders.
Continuity of Interest—The shareholders of the parent private company and the spun-off entity must keep a “continuity of interest” in both the parent private company and the spun-off subsidiary after the spin-off distribution is complete.
Continuity of Business—Both the parent private company and the spun-off subsidiary must continue their previous lines of business as they did pre distribution within reasonable means.
No Prior Acquisition—The parent could not have acquired this subsidiary within the past five years prior to the spin-off.
No Tax Avoidance—Governed under Section 368 of the Internal Revenue Code known for D reorganizations. As part of the tax-free status of the spin-off, the parent is unable to retain any stock in the subsidiary in an effort to avoid taxes. This clause finds its roots within the continuity of interest clause that mandates that parent private companies retain at least a 50% interest in all of their subsidiaries.
No Plan to Acquire Parent or Subsidiary—If there is an acquisition of 50% or more of the parent private company or subsidiary that was spun-off the acquiring private company will have to recognize the distribution of stock as a taxable capital gain if there was knowledge of this during the date of the spin-off.
Disqualified Distribution—If, after the distribution of stock, greater than 50% of the stock of the parent or the subsidiary is owned by a single entity or related group of parties within five years of the distribution, the distribution is disqualified of its tax-free status. As a result the distribution becomes a taxable capital gain of the new parent private company. The capital gain is based off the difference in the fair market value and the tax basis.