How a Reverse Morris Transaction Works: Section 355 Tests and Basis

A Reverse Morris Trust is a corporate transaction that lets a parent company hand a business unit to a specific buyer without paying corporate-level capital gains tax on the transfer. It works by chaining two tax-favored moves: a tax-free spin-off of the business into a new subsidiary (usually called SpinCo), followed immediately by a merger of SpinCo with the buyer. The structure only works when the parent’s former shareholders end up owning more than half of the combined company, which in practice means SpinCo has to be the larger party.

The whole arrangement lives inside Section 355 of the Internal Revenue Code, which permits a corporation to distribute the stock of a subsidiary to its shareholders tax-free if a series of requirements is met.¹ Miss any one of them and the entire transaction becomes fully taxable at the corporate level.

The Three Steps

An RMT moves through three phases in a specific order. The sequence is not decorative; scrambling it or skipping a piece can blow the tax-free treatment for the parent and every one of its shareholders.

Step One: Forming SpinCo

The parent transfers the assets and liabilities of the business it wants to divest into a newly formed subsidiary. In exchange, the parent receives all of SpinCo’s stock. SpinCo now exists as a standalone entity, legally and operationally separate, ready to be distributed and merged.

SpinCo cannot be a shell propped up for the occasion. Both SpinCo and the parent must have been running an active trade or business for the entire five-year period ending on the distribution date.¹ If the business being transferred was acquired in a taxable purchase during that window, it doesn’t count.

Step Two: Distributing SpinCo Stock

The parent distributes all of SpinCo’s stock to its own shareholders. Afterward, those shareholders hold stock in two independent companies: the original parent and SpinCo. Nobody surrenders any parent stock, and nobody recognizes taxable gain on receipt of the SpinCo shares.¹

Most RMTs use a pro-rata distribution, meaning each parent shareholder gets SpinCo stock in proportion to existing holdings. The statute doesn’t actually require pro-rata treatment. Exchange offers, where shareholders swap parent stock for SpinCo stock, also qualify.¹

Step Three: The Merger

Immediately after the distribution, the third-party buyer merges with SpinCo. Structurally, the buyer merges into SpinCo (or a SpinCo subsidiary), so SpinCo is the surviving legal entity. The buyer’s shareholders exchange their old stock for shares in the combined company, and the parent’s former shareholders, who just received SpinCo stock, now hold shares in that same combined entity.

The critical constraint: the parent’s former shareholders must own more than 50% of the combined company when the dust settles. If the buyer’s shareholders end up with 50% or more, the earlier spin-off blows up under Section 355(e) and the parent recognizes gain as if it had sold SpinCo for fair market value.¹

Timing matters. The merger agreement is usually negotiated and signed before the spin-off, but the merger doesn’t close until after the distribution. The parent’s shareholders must hold SpinCo stock as an independent investment, even briefly, before the merger takes effect.

Why the Size Relationship Is Everything

The defining feature of a Reverse Morris Trust, and the reason for the word “reverse,” is that SpinCo must be bigger than the buyer. Section 355(e) taxes any spin-off that is part of a plan under which one or more people acquire a “50-percent or greater interest” in either the parent or SpinCo.¹

“50-percent or greater interest” means stock carrying at least 50% of total voting power or at least 50% of total value. Hitting either threshold triggers the provision.¹ To stay safe, the parent’s former shareholders must hold more than 50% of both voting power and total value in the combined entity after the merger. The buyer’s contribution cannot equal or exceed half of the combined company’s value.

The statute also creates a presumption. If anyone acquires a 50-percent-or-greater interest in the parent or SpinCo within a four-year window centered on the distribution (two years before through two years after), the acquisition is presumed to be part of the same plan as the spin-off. The presumption can be rebutted, but the burden falls on the taxpayer.¹

The Other Section 355 Tests

The 50% rule is the headline requirement, but it isn’t the only one. Section 355 imposes several overlapping tests, each aimed at a different kind of abuse. Failing any single test converts the entire transaction into a taxable event.

Five-Year Active Business

Both the parent and SpinCo must be actively running a trade or business immediately after the distribution, and each business must have been actively conducted for the full five-year period before the distribution date.¹ A business acquired in a taxable transaction during that window doesn’t count. If the parent bought a company three years ago and tries to spin it off, the test fails. The IRS looks for genuine operations, customers, revenue, and employees, not assets parked in a corporate wrapper.

Business Purpose

The spin-off must serve a real, substantial business purpose beyond federal tax savings. The regulations define this as a “corporate business purpose” genuinely connected to the operations of the parent, SpinCo, or their affiliated group.² Shareholder-level financial planning goals don’t count unless they happen to overlap completely with a corporate purpose.

Purposes that pass IRS scrutiny include enabling the merger with the buyer, resolving regulatory conflicts between the parent’s business lines, improving access to capital markets, or letting each entity’s management focus on its core operations. The regulations also apply a “no less drastic alternative” test: if the corporate purpose could be achieved through some other transaction that doesn’t involve distributing SpinCo stock, the distribution doesn’t qualify.²

The Device Test

The spin-off cannot be used primarily as a device for distributing corporate earnings at capital gains rates instead of ordinary dividend rates. The RMT raises a natural red flag here because a pre-arranged merger can resemble a disguised sale. Two features push back. First, the statute says stock sales after the distribution aren’t treated as evidence of a device unless they were negotiated or agreed upon beforehand.¹ Second, a strong non-tax business purpose plus the 50% shareholder-retention requirement work as counter-evidence that the transaction isn’t primarily a cash-extraction device.

Continuity of Interest

The parent’s shareholders must maintain a continuing equity stake in both the parent and SpinCo after the separation. There is no single bright-line percentage in the Section 355 regulations, though IRS examples suggest 50% continuity is safe and 20% is not. In practice, the 50% floor Section 355(e) imposes already forces continuity well above any danger zone.

The Purchased-Stock Rule

Section 355(d) is a separate trap. It targets situations where someone acquired parent or SpinCo stock by purchase within the five years before the distribution and holds a 50-percent-or-greater interest immediately after. If that happens, the distribution is “disqualified” and the parent recognizes corporate-level gain. Tax-free exchanges under Section 351 or 355 don’t count as “purchases” for this purpose; the concern is market acquisitions for cash.¹

What Happens to Shareholder Basis

If you receive SpinCo stock in the distribution, your original basis in the parent company stock gets split between the parent shares you still hold and the new SpinCo shares you just received. The split is based on relative fair market values on the distribution date.³

Suppose you held $10,000 of basis in parent stock, and on the distribution date the parent’s stock represents 60% of the combined market value while SpinCo represents 40%. Your basis becomes $6,000 in the parent and $4,000 in SpinCo. Nothing is owed now. You’re reallocating basis you already had, and any gain gets deferred until you sell. Companies typically publish the allocation percentages on IRS Form 8937 after the distribution.

How It Compares to the Alternatives

A Taxable Sale

The simplest alternative is selling the subsidiary outright: the parent sells SpinCo’s stock or assets to the buyer, takes the cash, and pays corporate capital gains tax on the difference between the sale price and its basis. In long-held subsidiaries, that basis is often extremely low, making the taxable gain enormous. At a 21% federal corporate rate, a $10 billion sale of a subsidiary with a $1 billion basis generates roughly $1.89 billion in federal tax alone, before state taxes.

A taxable sale gives the buyer a stepped-up basis in the purchased assets, which produces higher depreciation deductions going forward. The immediate tax bill on the parent side almost always overwhelms that future benefit, which is why the RMT exists.

A Plain Section 355 Spin-Off

A regular spin-off under Section 355 separates the parent and SpinCo into two independent public companies with no merger involved. The parent’s shareholders hold stock in both entities and both go their separate ways. No buyer is in the picture.

The RMT adds the merger step for companies whose goal isn’t just separation. They want to deliver SpinCo to a specific strategic partner. Without the RMT structure, arranging a merger right after the spin-off would violate Section 355(e) and make the entire spin-off taxable. The RMT’s careful sizing and sequencing is what lets a pre-arranged merger coexist with tax-free treatment.

Why Companies Use the Structure

The primary driver is eliminating the corporate-level tax that a direct sale would trigger. When a parent has held a subsidiary for decades, the built-in gain can be staggering. Qualifying the transaction under Section 355 defers that gain entirely at the corporate level.¹ Shareholders will eventually recognize gain when they sell their shares, but deferral is valuable on its own: money that would have gone to the IRS stays invested in the business.

The second driver is strategic. An RMT lets the parent hand a non-core business to a partner that can extract more value from it, without the price discount and uncertainty of a competitive auction. The parent’s shareholders receive stock in a combined entity that benefits from the buyer’s operational fit, and the buyer gets the business without paying a control premium in cash. Hewlett Packard Enterprise’s merger of its software business with Micro Focus, and Lockheed Martin’s combination of its information systems division with Leidos, followed this playbook.

Where These Deals Break

The structure’s complexity creates multiple failure points. A few come up repeatedly.

The size ratio shifts. Market moves between announcement and closing can change the relative values of SpinCo and the buyer. If the buyer’s stock rises significantly or SpinCo’s drops, the parent’s shareholders can end up below the 50% threshold. Deal documents include protective mechanisms — collars, exchange ratio adjustments, termination triggers — but these can’t always keep up with a fast-moving market.

The active business test fails. If the IRS concludes that SpinCo’s business wasn’t truly actively conducted for the full five years, or that it was acquired in a taxable transaction within the window, the entire spin-off becomes taxable.¹ This tends to come up when the parent has done acquisitions, divisional reorganizations, or asset transfers during the five-year period that muddy the record of who was running what.

The business purpose doesn’t hold up. The IRS can challenge the stated purpose, especially when the tax savings dwarf any claimed operational benefit. If the only realistic reason for the spin-off is to avoid tax on what is functionally a sale, the structure fails.² Board resolutions, financial advisor presentations, and regulatory analyses documenting the purpose matter enormously here.

Antitrust review blocks the merger. If the FTC or DOJ blocks the deal or demands divestitures that alter the economics, the parties may end up with a completed spin-off but no merger. The parent has already distributed SpinCo to its shareholders and cannot easily undo that. The spin-off itself may still qualify as tax-free, but the strategic purpose is lost.

The Regulatory and Filing Footprint

Beyond the tax code, an RMT triggers a wave of federal filings that stretch the timeline. Most RMT transactions take roughly 9 to 18 months from announcement to closing.

SpinCo typically registers its shares with the SEC on Form 10, which functions like an IPO prospectus and requires audited financials, a business description, and executive compensation disclosures. The buyer files a Form S-4 registration statement covering the merger, and its shareholders usually must vote to approve the deal after the SEC clears the S-4.

If the transaction’s value exceeds the Hart-Scott-Rodino size-of-transaction threshold ($133.9 million for 2026), the parties must file pre-merger notification with the FTC and DOJ and observe a waiting period before closing. Filing fees range from $35,000 for deals under $189.6 million to $2.46 million for transactions of $5.869 billion or more.⁴ A “second request” for additional information from the agencies can extend the waiting period substantially.

The distributing corporation must also include a detailed statement with its tax return for the year of distribution, identifying the controlled corporation, every significant shareholder who received stock, the distribution date, and the aggregate fair market value of the distributed shares.⁵

In practice, most companies executing an RMT also seek a private letter ruling from the IRS confirming that the spin-off and merger will qualify. A PLR isn’t legally required, but the stakes are so high — a failed transaction can generate billions in unexpected tax — that both parties typically insist on it as a closing condition. The IRS requires the applicant to represent that no one will acquire a 50-percent-or-greater interest in the parent or SpinCo as part of a plan including the distribution.⁶ Obtaining the ruling takes several months and adds legal cost, but the certainty is worth it on deals of this magnitude.

1
Office of the Law Revision Counsel. 26 USC 355 – Distribution of Stock and Securities of a Controlled Corporation
2
eCFR. 26 CFR 1.355-2 – Limitations
3
Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees
4
Federal Trade Commission. New HSR Thresholds and Filing Fees
5
eCFR. 26 CFR 1.355-5 – Records to Be Kept and Information to Be Filed
6
Internal Revenue Service. 26 CFR Part 1 – Guidance Under Section 355(e)