When a company you own stock in spins off a subsidiary, the corporate spinoff tax rules in Section 355 of the Internal Revenue Code generally let you receive the new shares without owing anything at the time of distribution. The catch is that your original cost basis has to be split between the two stocks, your holding period carries over, and if the transaction fails Section 355 the distribution becomes taxable as a dividend. Everything below assumes you’re a shareholder receiving spinoff shares, not the company executing one.
When a Spinoff Qualifies as Tax-Free
Section 355 allows shareholders to receive shares of a spun-off subsidiary without recognizing gain or loss, but only if the transaction meets several strict tests.1Office of the Law Revision Counsel. 26 US Code 355 – Distribution of Stock and Securities of a Controlled Corporation The parent has to distribute stock representing at least 80% of the subsidiary’s voting power and 80% of each class of nonvoting stock.2Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations Both the parent and the subsidiary must be actively conducting a trade or business that has been running for at least five years before the distribution. The transaction cannot be primarily a device to distribute earnings and profits, and there has to be a legitimate corporate business purpose for the separation beyond tax benefits.
You don’t have to evaluate these tests yourself. Companies typically obtain either a private letter ruling from the IRS or a formal tax opinion from counsel before proceeding, and that opinion is disclosed in the SEC filings that accompany the spinoff. If the filing says the distribution is intended to qualify under Section 355, that’s the treatment you should expect.
What Happens If the Spinoff Doesn’t Qualify
If Section 355 isn’t met, the distribution is treated as a taxable dividend to the extent of the parent’s earnings and profits. Anything beyond that amount is a return of capital that reduces your basis in the parent stock, and once basis is exhausted, the remainder is capital gain. The parent corporation also recognizes gain on the built-in appreciation of the subsidiary’s stock. This is the outcome companies structure hard to avoid, which is why the advance tax opinion matters and why the filings spell out the intended treatment before the record date.
Splitting Your Cost Basis Between the Two Stocks
In a qualifying spinoff, no tax is due at distribution, but Section 358 requires you to allocate your original basis in the parent stock between the two holdings based on their relative fair market value immediately after the distribution.3Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees That allocation determines your taxable gain or loss when you eventually sell either stock.
An example. You bought 100 shares of the parent at $50, giving you a total basis of $5,000. After the spinoff, the parent trades at $40 and the new company trades at $10. The parent represents 80% of the combined value; the spinoff represents 20%. You’d allocate $4,000 of basis to the parent and $1,000 to the spinoff shares. If you bought lots at different times and prices, run the calculation separately for each one.
You don’t have to compute the percentages from scratch. The parent is required to file IRS Form 8937 reporting the organizational action and its effect on basis, and to provide a copy to every shareholder of record.4Internal Revenue Service. Instructions for Form 8937 – Report of Organizational Actions Affecting Basis of Securities Most companies also post a cost basis guide on their investor relations site with the specific allocation percentages. Pull that document before you file taxes for any year in which you sell either stock.
Your Holding Period Carries Over
If you held the parent stock for more than a year, that long-term holding period transfers to the spinoff shares. Section 1223 treats a Section 355 distribution as an exchange for holding period purposes, so the time you held the parent counts toward the new shares.5Office of the Law Revision Counsel. 26 US Code 1223 – Holding Period of Property Selling the spinoff shares the day after distribution still gets you long-term capital gains rates, provided your original parent position was long-term.
Cash in Lieu of Fractional Shares
Distribution ratios rarely divide evenly into every shareholder’s position. When yours doesn’t, you receive cash instead of a fractional share, based on the average trading price of the new stock shortly after distribution. That cash is a taxable event, typically reported as capital gain rather than a dividend, and the gain is calculated using the portion of your original basis allocable to the fractional share. It’s usually a small number, but it belongs on your return.
The Anti-Acquisition Rule
Section 355(e) adds a second layer of risk that outlives the distribution itself. If someone acquires a 50% or greater interest in either the parent or the spinoff as part of a plan connected to the distribution, the parent loses tax-free treatment at the corporate level. Any such acquisition within a four-year window centered on the distribution date is presumed to be part of a plan unless the company proves otherwise.1Office of the Law Revision Counsel. 26 US Code 355 – Distribution of Stock and Securities of a Controlled Corporation
For you as a shareholder, the direct tax hit here falls on the corporation, not on the individual investor’s basis or holding period. But the rule shapes what either company can do for roughly two years after separation. The tax matters agreement between parent and spinoff typically includes restrictions and indemnification provisions to keep either side from taking actions that would trigger the tax. If one company is later acquired, expect the deal structure and timing to reflect these constraints.
Where to Find the Tax Treatment Before Distribution
The new company files a registration statement with the SEC, usually on Form 10, which becomes its foundational disclosure document.6U.S. Securities and Exchange Commission. Form 10 – General Form for Registration of Securities An information statement filed as an exhibit to the Form 10 gets mailed to parent company shareholders before the distribution date, and it lays out the intended tax treatment, the conditions the transaction is designed to satisfy, and the tax opinion or ruling the parent obtained. The SEC reviews the filing for adequate disclosure but does not evaluate the merits of the transaction.
Between announcement and distribution, look for three documents: the information statement inside the Form 10, the tax matters agreement filed as an exhibit, and the cost basis guide the parent publishes on its investor relations site after distribution. Those three give you the intended Section 355 treatment, the restrictions that protect it, and the allocation percentages you’ll need to record your new basis. Everything else about the mechanics happens automatically inside your brokerage account.