Tax-Free Corporate Spin-Offs (§ 355)

26 U.S.C. § 355 allows a corporation to distribute the stock of a subsidiary or division to its shareholders — a "spin-off" — without either the corporation or its shareholders recognizing gain or loss. Without § 355, a corporate distribution of subsidiary stock would trigger gain at the corporate level under § 311(b) and dividend income for shareholders; the statute carves out a carefully defined safe harbor for genuine business separations that meet strict statutory and regulatory requirements. The rules exist because Congress wanted to allow corporations to restructure by separating distinct businesses without a tax penalty, while simultaneously blocking shareholders from using corporate separations as a tax-free mechanism to distribute accumulated earnings and profits. The result is one of the most technically demanding areas of corporate tax — real-world spin-offs like eBay/PayPal, HP/HPE, and Kraft/Heinz involve enormous legal and accounting resources to navigate the requirements — but when the rules are satisfied, § 355 is the most powerful tax-free corporate restructuring tool in the code.

Current Law (2026)

§ 355 allows a distributing corporation to spin off a controlled subsidiary to its shareholders without gain recognition, if strict requirements are met.

Legal Authority

• 26 U.S.C. § 355 — Distribution of stock and securities of a controlled corporation
• 26 U.S.C. § 368 — Definitions relating to corporate reorganizations (Type D reorganization often paired with § 355)
• 26 U.S.C. § 311(b) — The gain recognition rule that § 355 overrides for qualifying distributions
• 26 U.S.C. § 355(e) — Anti-Morris Trust rule (Taxpayer Relief Act of 1997)
• 26 U.S.C. § 355 (DB) — Distribution of stock and securities of a controlled corporation: tax-free treatment is denied if, right after the split, any person ends up owning a 50% or greater interest from recent purchases (generally within 5 years), or if the distribution is part of a plan under which someone acquires 50% or more of a company during the 4-year window starting 2 years before the distribution; separate rules stop tax-free treatment when one company becomes a "disqualified investment corporation" using 1-year tests with 2/3 or 3/4 asset thresholds; taxpayers must notify the IRS about qualifying distributions, after which the IRS has 3 years to assess any tax deficiency
• 26 U.S.C. § 354 (DB) — Exchanges of stock and securities in certain reorganizations: special "nonqualified preferred stock" usually does not count as qualifying stock in a § 355 transaction, except in a recapitalization of a family-owned corporation (family ownership is tested over an 8-year span starting 5 years before the recapitalization, with a 3-year IRS assessment window after a failure)
• 26 U.S.C. § 361 (DB) — Nonrecognition of gain or loss to corporations: transfers of "qualified property" (stock, rights to receive stock, or certain obligations of the distributing corporation) to creditors count as distributions to shareholders for § 355 purposes; in a § 368(a)(1)(D) reorganization paired with § 355, the creditor-transfer rule applies only up to the adjusted basis of transferred assets reduced by assumed liabilities

Key Mechanics

A § 355 spin-off achieves tax-free separation through four requirements that must all be satisfied: (1) 80% control — the distributing corporation must own ≥80% of voting power and ≥80% of each class of nonvoting stock in the subsidiary before distribution; (2) active trade or business — both the distributing and controlled corporations must be engaged in an active trade or business immediately after distribution, and the business must have been actively conducted for at least 5 years before the transaction (not acquired in a taxable transaction during that period); (3) device restriction — the transaction cannot be principally a device to distribute earnings and profits while avoiding tax on dividends; and (4) business purpose — a genuine non-tax business reason (separating liability, enabling independent financing, resolving management disputes) must exist. Shareholders recognize no gain on receipt of the subsidiary stock; the distributing corporation recognizes no gain on the distribution. If any requirement fails, the entire distribution is taxable as a dividend.

How It Works

The threshold requirement is control: the distributing corporation must own stock possessing at least 80% of the total combined voting power and at least 80% of each class of nonvoting stock of the distributed corporation immediately before the distribution. If control was acquired in a taxable transaction within the 5-year pre-distribution period, the distribution is taxable — Congress closed the loophole of buying a subsidiary and immediately spinning it out tax-free.

The active trade or business requirement is often the most fact-intensive. Both the distributing corporation and the distributed corporation must have been actively conducting a trade or business (as distinguished from passive investment activities) for the full 5-year period before the distribution. The business cannot have been acquired in a taxable transaction within those 5 years. "Active conduct" requires more than mere ownership — the corporation must perform real management and operational functions, not simply hold assets and collect income. The IRS scrutinizes cash-rich or investment-heavy companies especially closely under this test.

The device test addresses Congress's concern that § 355 could be used to bail out corporate earnings at capital gains rates rather than dividend rates. Factors that raise device concerns: a large cash distribution as part of the transaction, business assets disproportionate in value to operating assets, and the distributees selling the stock shortly after the spin. Factors that rebut device concerns: pro-rata distribution to shareholders (so no one shareholder benefits disproportionately), corporate-level shareholders (who would pay dividends-received deduction on a taxable dividend anyway), and absence of plans for a subsequent sale.

Three forms of § 355 transactions: a spin-off distributes subsidiary shares pro-rata to all shareholders without any exchange — shareholders simply receive new shares of the subsidiary while retaining their parent shares. A split-off requires shareholders to exchange some parent shares for subsidiary shares — some shareholders "leave" the parent in exchange for the subsidiary. A split-up liquidates the distributing corporation, distributing two different subsidiaries to different shareholders; the parent disappears.

The Morris Trust rule — now codified in § 355(e) — is critical for M&A planning. Before 1997, a corporation could spin off a division and immediately merge the remaining parent with an acquirer, effectively selling the spun-off subsidiary tax-free. The Taxpayer Relief Act of 1997 added § 355(e), which imposes corporate-level gain recognition on the distributing corporation if, pursuant to a plan that includes the distribution, one or more persons acquire 50% or more of the stock of either the distributing or distributed corporation. The 50% ownership change can be traced through acquisitions made up to 2 years before or after the distribution. This significantly constrains "reverse Morris Trust" structures (where the distributed subsidiary, not the parent, is the merger target) and requires careful sequencing in any § 355 combined with an acquisition.

How It Affects You

If you're a shareholder of a publicly traded company that announces a spin-off: In a § 355 spin-off, you receive shares of the new subsidiary without paying tax at the time of the distribution — the IRS treats it as a tax-free reorganization. Your original cost basis in the parent company's stock is allocated between the parent and the spun-off subsidiary based on the relative fair market values of each immediately after the distribution. The parent company will publish the allocation percentage in press releases, 8-Ks, and sometimes IRS Revenue Rulings. Critically, your holding period for the new subsidiary shares "tacks" — if you held the parent stock for 3 years, the subsidiary shares are treated as having a 3-year holding period too, qualifying for long-term capital gains rates if you sell. The spin-off itself is not a taxable event, but selling the new shares is. Watch for the parent company's tax allocation guidance — using the wrong basis split in your tax return can significantly mis-state your gain or loss.

If you work at a corporation that is a spin-off target: Spin-offs typically happen for one of three reasons: unlocking hidden value (the market values the two businesses separately at more than the combined company), strategic focus (each business runs better as a standalone with a dedicated management team), or regulatory/antitrust requirements. From an employee perspective, the key implications are equity compensation treatment (outstanding stock options and RSUs are typically converted to equivalent instruments in the new company using the same FMV allocation ratio), retirement plan treatment (401(k) assets usually transfer to a new plan at the distributed company), and covenant treatment (employment agreements and non-competes often specify whether they follow the employee to the new company or stay with the distributing parent).

If you're advising a private company considering a spin-off to separate a division: § 355 applies to private companies as well as public ones, but the economics are different. For a private company, a split-off (where the founding shareholder exchanges parent shares for subsidiary shares) can be an effective estate planning and business succession tool — allowing a founder to separate two businesses between different family members without triggering gain. The 5-year active business requirement and the business purpose requirement apply identically. Private company § 355 transactions require IRS private letter ruling requests in most complex cases, because the cost of getting the analysis wrong — a fully taxable distribution — is prohibitive. Budget 12-18 months and substantial legal expense if pursuing a private company § 355.

State Variations

Most states conform to federal § 355 treatment for state corporate income tax purposes — the distribution is not subject to state corporate income tax if it qualifies federally. Shareholders' state tax treatment of the distribution parallels federal (no income recognized), but the basis allocation rules follow the federal split. California generally conforms. States with throwback rules or unitary reporting may treat the post-distribution business differently as separate entities file separate returns. State franchise tax and transfer taxes are a separate concern: spinning off real property into a subsidiary and then distributing the subsidiary's stock can trigger real estate transfer taxes in some states (PA, NY) — the transaction must be structured carefully to qualify for applicable reorganization exemptions at the state level.

Implementing Regulations

• 26 CFR § 1.355-1 — Distribution of stock and securities of a controlled corporation (general rules; defines "distribution," applies active-business requirement)
• 26 CFR § 1.355-2 — Additional requirements (business purpose requirement; device test factors and counter-factors; step transaction doctrine application)
• 26 CFR § 1.355-3 — Active trade or business (the 5-year active business test; what counts as active conduct; the service organization rules; anti-stuffing rules for assets acquired in taxable transactions within 5 years)
• 26 CFR § 1.355-4 — Non-pro-rata distributions (split-offs and split-ups; Section 302 interaction)
• 26 CFR § 1.355-7 — Recognition of gain on certain distributions of stock or securities in connection with an acquisition (the § 355(e) regulations; plan-of-reorganization rules; safe harbors; the 2-year lookback and look-forward)

Pending Legislation

• Spin-off tax reform proposals: Recurring Congressional interest in tightening § 355 to prevent "cash-rich split-offs" where a profitable parent retains cash while distributing a business division to shareholders. The Treasury has issued regulations limiting spin-offs where the distributed company holds substantial investment assets.
• § 355(e) scope discussions: Periodic proposals to expand the § 355(e) anti-Morris Trust rule to cover more acquisition structures, particularly in the context of private equity-sponsored transactions involving spin-offs.

Recent Developments

• IRS scrutiny of cash-rich split-offs: The IRS has intensified scrutiny of spin-offs where the distributing or distributed corporation holds substantial liquid or investment assets relative to operating assets. Revenue procedures and regulations have added anti-stuffing rules to prevent corporations from transferring cash into a subsidiary immediately before a spin-off to circumvent the active-business test.
• Major § 355 transactions continue: High-profile § 355 spin-offs remain a standard corporate restructuring tool. The statute's requirements and the IRS private letter ruling process (used for complex transactions seeking certainty) continue to define the architecture of large corporate separations in pharmaceuticals, technology, and industrials.
• § 355(e) and private equity: The intersection of § 355 with private equity acquisitions remains actively litigated and the subject of IRS guidance. PE sponsors structuring buy-and-spin or reverse Morris Trust transactions to aggregate portfolio companies must carefully navigate the § 355(e) plan-of-reorganization rules, particularly the 2-year window and the "pursuant to a plan" standard.