Recap on Recaps

To ensure that spin-offs don't get taxed, parents need to exert a little control.
Robert WillensSeptember 28, 2001

For a spin-off to qualify for tax-free treatment under Sec. 355, among other requirements, the distributing corporation must control the corporation whose shares it is distributing. This must occur immediately before the distribution.

Control, for this purpose, is set forth in Sec. 368(c). That section defines control as the ownership of stock possessing (1) 80 percent of the total combined voting power of all classes of stock entitled to vote and (2) 80 percent of the total number of shares of each class, if any, of non-voting stock (See Rev. Rul. 59-259). The section does not, however, require the ownership of any particular percentage of the value of the outstanding stock.

This odd definition of control allows a parent corporation to rather easily gain control of a partially-owned subsidiary in anticipation of a spin-off. The subsidiary, for example, can undertake a preliminary recapitalization in which it creates a new class of ”high” vote stock. The parent then swaps its existing stock for this newly created class of high vote stock (which encompasses 80 percent of the voting power of the sub’s outstanding stock). The parent then distributes the high vote stock to its shareholders in a tax-free spin-off.

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The spin-off qualifies because control of the subsidiary was obtained in a wholly tax-free transaction (a recapitalization is a reorganization under Sec. 368(a)(1)(E) and, hence, the stock swap is a non-recognition transaction under Sec. 354). If it was not so obtained, the spin-off would fail, on ”active business” grounds — if it occurred within five years of the ”control gathering” transaction (See Rev. Rul. 57-144).

The utility of a recapitalization — to garner the control needed for a spin-off — was certified by the IRS in Rev. Rul. 69-407. The ruling, however, warns that the recapitalization will only be ”respected” if it works a ”permanent realignment of voting control.” That’s the price for doing a spin-off on a tax advantaged basis: The distributed subsidiary is ”saddled” with a cumbersome capital structure, one that features two classes of common stock.

LTR 200135039 deals with a control gathering recapitalization and provides insight into just how permanent the realignment of voting control needs to be. There, the IRS solicited a representation from the distributed subsidiary regarding its intentions to alter its capital structure. In response, the subsidiary indicated that (for five years following the spin-off) it would not propose any plan or amendment providing for (1) the conversion of any class of stock, (2) a change in the voting rights of any class of stock, or (3) a change in the manner of election or duties of the board of directors.

Nevertheless, the IRS has recently issued several rulings that allowed some corporations to effect ”reverse” recaps, with the several classes of stock being combined into a single class. The corporations, including Conoco, Raytheon, Waddell & Reed, and AmSurg, had all previously been involved in spin-offs. In each case, company executives had to demonstrate that the reverse recapitalization was prompted by problems that could not have been foreseen at the time of the original recap.

Moreover, in each case, the reverse recapitalization was scheduled to occur more than three years from the time of the original recapitalization. Accordingly, despite the necessity that the control gathering recapitalization create a permanent realignment of voting control — if it’s to be respected — it would appear that managers at these businesses can look forward to simplifying the capital structure of their companies no later than five years from the date of the recapitalization. In some cases, where the complex capital structure leads to unforeseen problems, the restructuring may come as soon as three years after the recapitalization.