How to Spin Off a Controlling Stake in Another Company Tax Free

Lehman Brothers tax expert Robert Willens says preliminary, "tailoring" steps must be accomplished.
Robert WillensJune 26, 2001

When a corporation that owns less than 80 percent of the stock of another corporation seeks, nonetheless, to accomplish a tax-free spin- off of that stake, certain preliminary, “tailoring” steps must be accomplished.

Most notably, the owning company must gain control of the subsidiary and, in addition, if the spin-off is to be successful, such control must be attained in a wholly tax-free transaction.

These requirements can be met most efficiently if the subsidiary can be enlisted to assist in this endeavor.

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What’s required is a preliminary recapitalization in which the subsidiary alters its capital structure and creates two new classes of stock; a high vote class (representing at least 80 percent of the total combined voting power of all of its stock entitled to vote) and a low vote class. Next, the owning company swaps its existing stock for the newly-created class of high vote stock which it will then distribute to its shareholders in a tax-free spin-off.

The control requirement has been met because control, for this purpose, means ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote— the law, oddly, does not require that any particular percentage of the value of such outstanding stock be owned. Moreover, because the recapitalization—an ‘E’ reorganization—is a wholly tax-free transaction (see Sec. 354), the parent has attained such control in a manner “permitted” by the spin-off rules.

However, the I.R.S., in exchange for this privilege, requires that the recapitalization work a “permanent realignment” of voting control. Thus, the ruling it issues the owning company will be conditioned upon a representation to the effect that there is no plan, intention or understanding to eliminate the “tiered” voting structure by, for example, combining the classes, through a second recapitalization, into a single class.

Fortunately, as we have repeatedly seen (in the case of Waddell & Reed and Raytheon for example), the I.R.S.’s position is not without some flexibility, at least in cases where unanticipated changes in market or business conditions make it impractical for the corporation to keep its promise regarding the permanence of the tiered voting structure.

The most recent example of this permissiveness can be found in LTR 200125083. There, a preliminary recapitalization enabled the owning corporation to effectuate a successful spin-off of its portfolio stake in another corporation.

Later, however, it became clear that the spun-off company’s capital structure was causing it problems. Thus, due to the volatility of its stock, it was facing a “de-listing” problem: One of the classes created in the recapitalization was facing such de-listing (which the taxpayer characterized as a “serious” problem) because it was perilously close to breaching the Minimum Market Value Public Float (MVPF) requirements imposed by the stock exchange.

Accordingly, the taxpayer requested permission to effectuate a second recapitalization—in which it would combine the classes into a single class—because, in that posture, it would be much easier to meet the MVPF.

The I.R.S. assented—it said that the second recapitalization would not adversely affect the spin-off—but only on a showing that the de- listing problem was totally unanticipated and, in addition, the taxpayer was required to make a “last resort” representation; that the second recapitalization was the least expensive and most convenient way of solving the de-listing problem.

Finally, although it’s not clear whether such an interval is an absolute pre-requisite, the Service was comforted by the fact that fully three years will have elapsed between the time of the spin-off and the completion of the second recapitalization. Accordingly, those taxpayers who have created unwieldy capital structures for the purpose of facilitating a spin-off may well be able to reverse the process, without damage to the spin-off, through the consummation of a second recapitalization.

However, as this ruling indicates, the Service will hold the taxpayer to a rather rigorous burden of proof before it signs on the dotted line.

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