Corporations that operate more than one business, either directly or through subsidiaries, may sometimes find that it is necessary to separate those businesses. There are many reasons why this could occur; however the most common reason is to provide a resolution to conflicts between shareholders regarding management and the direction of the corporation. This is especially challenging when shareholders equally share in the ownership and voting rights of the business.
The end result to situations like this can vary, from shareholder lawsuits forcing a resolution, to the failure and liquidation of the business when a resolution cannot be reached. This results in unfavorable economic and tax consequences to the shareholders, which can be particularly harsh in the current high-tax climate.
Here is an example:
There is a need to inject a substantial amount of capital into YZ Corporation in the near future to maintain the competitive advantages that several of the corporate business units have recently enjoyed. Shareholder Y is unwilling to equally share in the capital injection, which has created some animosity with shareholder Z. In addition, Shareholders Y and Z are having a disagreement about the direction and management of the business units. This has led to hindered growth in the overall corporate business, which has resulted in lost revenue for the current year.
If Y and Z cannot come to an agreement, but each still maintain a strong desire to continue on with the business, then a spin-off should be considered. That way, the shareholder disputes can be resolved and corporate financing needs can be addressed. A spin-off is a tax-free transfer of control, where a selected portion of the exiting assets are transferred to a newly formed company that is now majority-owned by Shareholder Y. The remaining assets stay within the existing company that is now majority-owned by Shareholder Z. In effect, the business is split into two separate companies that now allow each shareholder to run and maintain majority control of their own separate business. The shareholder conflict has been resolved at no tax cost.
In order to achieve and maintain this favorable tax-free treatment, the following conditions must also apply:
- Continuity of business enterprise – Each company must continue to conduct the same business activity that was occurring prior to the reorganization.
- Continuity of shareholder interest – Shareholders Y and Z will continue as shareholders of the two remaining corporations (although in different proportionate ownerships).
- Business purpose – The primary purpose of the reorganization is to provide separate ownership of the two businesses between the shareholders. This resolves the management conflict and facilitates shareholder Z’s injection of capital into the existing business.
Spin-offs are a useful tool to help resolve shareholder conflicts, but can also be considered in other situations to improve the borrowing capacity of the resulting separate corporation. They can also be useful in extracting assets from a corporation without the taxes that would normally apply to such removals. With diverse uses, spin-offs have become the most significant method to transfer appreciated assets from corporations to shareholders tax-free.