Many companies are opting to spin-off BUs instead of selling and taking a tax hit. 

The spin cycle’s on high. Lately corporations with struggling or shining business units have been testing the market to see how receptive investors are to spinning off those units. In the past week alone, McGraw-Hill said it was exploring a separation with its struggling educational business and Hewlett-Packard is currently exploring a full or partial separation with its PC unit.

And amid stock prices that are hitting levels not seen in a year or more (or in H-P’s case, six years), companies see it as a good time to separate. While some are repurchasing stock or getting active in M&A, others are looking to spin.

Ultimately what they are doing is sidestepping a tax hit by an outright sale of the unit. A spin off of a business is a tax-free transaction for the parent and shareholders under Section 355 of the Internal Revenue Code. This is opposed to an actual sale of the business to a third party, which would generate a sizeable capital gain and with a large tax hit.

“Distributing the company to shareholders allows companies to avoid paying corporate level taxes,” said William Cavanagh, a partner at Chadbourne & Parke in Manhattan.

Spin off surge.
As of the end of June, there has been a record amount of spin offs, according to Bloomberg, “the most of any half-year period since Bloomberg began tracking the data more than a decade ago.” The number also exceeds the total from all of last year and is rising at an annual pace of 274, setting the stage to eclipse the record of 230 set in 2006, Bloomberg said.

Mr. Cavanagh said this was a reversal of the trend to “form conglomerates” for growth and value. “Now they’re splitting up.” And splitting up the company can certainly add value. A good example is Motorola’s spinoff of Motorola Mobility in early 2011. Shareholders are reaping the benefits of this move as Google looks to merge with Motorola Mobility. Google bid $12.5bn for the company, which is a 63 percent premium over the company’s share price — a clear win for Motorola and its shareholders. 

Still, there are rules to follow, particularly if the spinoff is to be sold later on. If a spin-off fails to meet all of the Section 355 requirements, the company can be liable for the full taxes on the company distribution, without receiving the cash that could be used to pay the tax bill, according to advisory firm Spin-off Advisors. Shareholders would also be taxed upon the receipt of an ordinary income dividend.

Another factor, although not specifically stated or often challenged by the IRS, is the period of time that some spin offs must wait after the spin off before it can be acquired. “There is not really a hard and fast rule regarding how soon after a spin a firm can be bought without jeopardizing the tax-free status of the spin-off,” said Joe Cornell, CFA and Principal at Spin-off Advisors. “Lawyers tell people you need to wait a year. But that is not the case.” Mr. Cornell said that in the 15 years he has been advising clients on spin offs, he has never seen the IRS “challenge the tax-free nature of a spin.” However, added, it is generally thought that one year is a safe harbor period of time.

There also cannot be any “substantive negotiations” between parent company and spin-off acquirer, according to Chadbourne’s Mr. Cavanagh. For example, Google cannot have encouraged Motorola in any plans to spin out Motorola Mobility. Otherwise they would have to wait a specified period of time, as mentioned above.

So what will happen to McGraw-Hill and H-P separations remains to be seen. For companies with good fundamentals, they could be bought within six months, according to Spin-off Advisors. However, given the state of both McGraw-Hill and H-P (a struggling education business on the one hand and a bit stagnant PC sales on the other) that might not be the case.