Revenue Ruling 79-18: Tax-Free Corporate Spin-Offs

Revenue Ruling 79-18 provides guidance from the Internal Revenue Service (IRS) on corporate reorganizations. It clarifies how a corporate division, known as a spin-off, can be executed without immediate tax consequences for the corporation or its shareholders. This ruling is relevant for businesses wishing to separate distinct operational lines for reasons such as greater management focus or enhanced access to financing.

The Transaction Addressed by the Ruling

The scenario in Revenue Ruling 79-18 involves a parent “Distributing Corporation” with two distinct businesses. To execute the spin-off, the Distributing Corporation establishes a new, wholly-owned subsidiary, the “Controlled Corporation.” It then transfers the assets and liabilities of one business into this new entity.

The Distributing Corporation then distributes all stock of the Controlled Corporation to its own shareholders on a pro-rata basis. This means each shareholder receives a proportionate share of the new company’s stock based on their existing ownership. The result is two separate companies where the original shareholders now own stock in both.

This transaction is a divisive “Type D” reorganization. The Distributing Corporation has divided its operations, with one business remaining in the original structure and the second housed within the new Controlled Corporation. The original shareholders now own shares in two separate companies, each focused on a single business.

Core Tax Principle of the Ruling

The principle of Revenue Ruling 79-18 revolves around the “control” requirement in a Type D reorganization. For a reorganization to be tax-free, Internal Revenue Code Section 368 requires that the original shareholders be in “control” of the corporation immediately after the transaction. Control is defined as owning at least 80% of the total combined voting power and at least 80% of all other classes of stock.

The ruling clarifies that for this type of spin-off, the control test applies to the shareholders’ ownership of the new Controlled Corporation immediately after the stock distribution. The shareholders of the Distributing Corporation must collectively own stock that constitutes control of the Controlled Corporation.

This confirms that the original shareholders do not need to maintain control of the Distributing Corporation after the spin-off for the transaction to qualify. This allows for scenarios where ownership in the Distributing Corporation might change as part of a larger plan. The ruling’s focus on control of the spun-off entity ensures the distribution can proceed without immediate tax implications if all other requirements are met.

Requirements for Tax-Free Treatment

For a spin-off to qualify for tax-free status under Internal Revenue Code Section 355, the following requirements must be met:

• A legitimate corporate business purpose must motivate the transaction, not solely tax avoidance. Examples of valid purposes include resolving management disputes, separating a risky business from a more stable one, or improving access to capital markets.
• Both the Distributing and Controlled corporations must be engaged in an “active trade or business” immediately following the distribution. These businesses must have been actively conducted for a five-year period leading up to the distribution, which prevents using liquid assets to create a new business just to spin it off.
• The transaction cannot be used principally as a “device” for the distribution of earnings and profits. This is to stop shareholders from bailing out corporate earnings at lower capital gains tax rates instead of receiving them as dividends. A pre-arranged plan to sell stock after the spin-off could be evidence of a device.
• The Distributing Corporation is required to distribute stock that constitutes “control” of the Controlled Corporation.
• A continuity of interest must also be maintained. This means the original shareholders of the Distributing Corporation must retain a significant equity stake in both the Distributing and Controlled corporations for a period after the transaction.