Tax-Free Spin-Offs
Let’s say you owned 5,000 shares of stock in Acme Power & Light Company. For some reason, this particular utility also owns a tiny chain of jewelry stores. The Power & Light CEO talks to the Board of Directors and says If the utility company decided to sell the subsidiary, it could go to someone like Warren Buffett, who would typically buy the business for cash. The problem is, the IRS will charge the utility company a capital gains tax on the sale of the business if it has appreciated in value. If the subsidiary has been part of the corporation for very long, it has almost certainly increased in value over the holding period. With most companies in the 21% tax bracket as of 2021, it means that the management will only receive about 79% of what the subsidiary is worth on an after-tax basis. If the utility company decided to issue a tax-free spin-off to the stockholders, it would instead incorporate the jewelry store as its own stand-alone business, give it a new CEO, its own Board of Directors, corporate offices, etc. It would print up stock certificates and, in many cases, distribute them to the existing stockholders of the Power & Light company on a pro-rata basis. If you owned 5% of the utility company stock, you would receive 5% of the total stock in the new jewelry store. In some cases, the company will have an IPO for the subsidiary first, selling a set percentage to the public, such as 10% or 20% of the shares, and then spin-off the remaining stock to its stockholders. When Philip Morris spun-off Kraft Foods a couple of decades ago, this was the route it chose to take.
Benefits of Tax-Free Spin-Offs
Why should you, as a stockholder, prefer the tax-free spin-off? Here are three reasons: Most of the time, tax-free spin-offs really are win-win situations for everyone involved. There have been several historical cases of once-small subsidiaries being spun-off and going on to grow so quickly, they dwarf the former parent company, enriching the original shareholders.
