A corporate spin-off qualifies for tax-free treatment under Section 355 only when it clears every one of a stacked set of requirements: the parent must control the subsidiary by at least 80 percent, both companies must have actively run their businesses for the full five years before the distribution, the separation must serve a real corporate business purpose unrelated to federal tax savings, the deal cannot function as a device to distribute earnings and profits, historical ownership and business operations must continue in both entities afterward, and no disqualifying acquisition of a 50 percent interest can be tied to the transaction. Missing any single requirement converts the distribution into a taxable event at the shareholder level, the corporate level, or both.
The Three Structures Section 355 Covers
The requirements apply the same way across all three forms the statute recognizes. In a spin-off, the parent distributes subsidiary stock pro-rata and shareholders keep their parent shares on top. In a split-off, some shareholders trade parent stock for subsidiary stock; Section 355 applies whether or not shares are surrendered.1Office of the Law Revision Counsel. 26 U.S. Code 355 – Distribution of Stock and Securities of a Controlled Corporation In a split-up, the parent transfers everything into two or more subsidiaries, distributes their stock, and liquidates.
The 80 Percent Control Test
Immediately before the distribution, the parent has to control the subsidiary within the meaning of Section 368(c). That means owning at least 80 percent of the total combined voting power of all classes of voting stock and at least 80 percent of the total shares of every other class of stock.2Office of the Law Revision Counsel. 26 U.S.C. 368 – Definitions Relating to Corporate Reorganizations This is a bright line. Slipping below 80 percent in either category, by any amount, disqualifies the transaction.
The Distribution Requirement
Once control is established, the parent has to actually get the subsidiary stock into shareholders’ hands. The statute offers two paths: distribute all of the subsidiary stock and securities the parent holds, or distribute enough to constitute control under the same 80 percent definition and satisfy the IRS that keeping the rest was not motivated by tax avoidance.3Office of the Law Revision Counsel. 26 U.S.C. 355 – Distribution of Stock and Securities of a Controlled Corporation Most companies distribute 100 percent, because any retained shares invite the IRS to question motive.
Active Trade or Business for Five Years
Both the parent and the subsidiary have to be actively running a business right after the distribution, and each business must have been actively conducted for the entire five-year period before the separation date.4Internal Revenue Service. Revenue Ruling 2007-42 This is where many proposed spin-offs collapse. The five-year rule exists to stop companies from buying or building a business shortly beforehand just to satisfy the requirement.
“Active conduct” is stricter than the phrase sounds. The corporation itself must perform substantial management and operational functions through its own officers and employees. Outsourcing most operations to independent contractors puts the requirement in doubt.5GovInfo. Treasury Regulation 1.355-3 – Active Conduct of a Trade or Business Holding investments, collecting rent without providing significant services, or simply owning property does not count.4Internal Revenue Service. Revenue Ruling 2007-42
A business that expanded during the five years can still qualify if the expansion was a natural growth of an existing line rather than entry into something new. The IRS evaluates this on a facts-and-circumstances basis, looking at whether the new activity shares the same fundamental character as what preceded it.6Federal Register. Guidance Under Section 355 Concerning Device and Active Trade or Business
A Real Corporate Business Purpose
Every Section 355 distribution has to be driven by a real and substantial corporate business purpose that is not federal tax savings. The regulations are explicit that a shareholder’s personal planning goals, standing alone, do not qualify. The purpose has to be tied to the business needs of the distributing corporation, the controlled corporation, or the affiliated group.7eCFR. 26 CFR 1.355-2 – Limitations
Purposes the IRS has accepted include resolving shareholder disputes, complying with regulatory requirements that block certain combinations, improving access to capital markets by giving each business its own stock, and letting management teams focus on distinct operations. The test in each case is whether the separation addresses a problem that could not be solved without dividing the corporation.
State and local tax savings can qualify as a business purpose, but only if the federal tax reduction is not greater than or substantially the same as the non-federal savings. When the two run in parallel, the IRS treats the stated purpose as a federal tax motivation in disguise.7eCFR. 26 CFR 1.355-2 – Limitations
The Device Test
A legitimate business purpose doesn’t end the analysis. The IRS separately asks whether the spin-off is being used as a device to distribute the corporation’s earnings and profits tax-free. Without this rule, a company could load one entity with cash, spin it off, and let shareholders sell that stock at capital gains rates instead of taking a taxable dividend.
Several factors weigh toward finding a device. A pro-rata distribution, where every shareholder receives subsidiary stock in exact proportion to existing holdings, looks like a dividend. A prearranged sale of either the parent or subsidiary stock after the distribution is stronger evidence, since the spin-off then reads as a step toward cashing out. Asset composition matters too: one entity holding mostly cash, investments, or other non-operating assets while the other holds the operating business points toward earnings extraction.6Federal Register. Guidance Under Section 355 Concerning Device and Active Trade or Business
Factors cutting the other way include a strong corporate business purpose, continued operation of both entities, and the absence of any post-distribution sale plans. The analysis weighs the factors together. A distribution can be treated as a per-se device when one entity’s nonbusiness asset percentage exceeds two-thirds and the other’s is below 30 percent.6Federal Register. Guidance Under Section 355 Concerning Device and Active Trade or Business
Continuity of Interest and Business Enterprise
Section 355 is designed to facilitate a reshuffling of existing ownership, not a sale. Continuity of interest enforces that idea by requiring the people who owned the parent before the spin-off to keep a meaningful collective equity stake in both companies afterward. If pre-distribution shareholders walk away from one entity, the deal reads as a sale and the continuity test fails.8GovInfo. Treasury Regulation 1.355-2 – Limitations
Continuity of business enterprise looks at the companies rather than their shareholders. After the distribution, each entity must either continue its historical business or use a significant portion of its historical business assets in an active trade or business. Selling the core operations right after the spin-off, or pivoting to something unrelated, calls the whole transaction into question.7eCFR. 26 CFR 1.355-2 – Limitations
Ownership Changes That Trigger Corporate Tax
Two provisions can impose tax on the distributing corporation even when every shareholder-level requirement is met. Both target combinations of a spin-off with a change in ownership that Congress viewed as economically equivalent to a taxable sale of the subsidiary.
Section 355(d)
If any person holds a 50-percent-or-greater interest in either the distributing or controlled corporation immediately after the distribution, and that interest consists of stock acquired by purchase within the preceding five years, the distribution is disqualified. The subsidiary stock loses qualified-property status, and the distributing corporation recognizes gain as if it had sold the stock at fair market value.9Office of the Law Revision Counsel. 26 U.S.C. 355(d) – Recognition of Gain on Certain Distributions of Stock or Securities in Controlled Corporation The shareholders still receive their stock tax-free; the corporation absorbs the entire tax. The rule was aimed at leveraged buyout structures that acquired a company, spun off a division, and extracted value without corporate-level tax.
Section 355(e)
Section 355(e) reaches a wider pattern. When one or more persons acquire a 50-percent-or-greater interest in either the distributing or controlled corporation as part of a plan that includes the distribution, the distributing corporation again recognizes gain on the subsidiary stock.10Office of the Law Revision Counsel. 26 U.S.C. 355(e) – Recognition of Gain on Certain Distributions of Stock or Securities in Connection With Acquisitions
The statute creates a rebuttable presumption that any acquisition of 50 percent or more during the four-year window beginning two years before the distribution is part of such a plan. A third-party acquisition of majority control within two years after the spin-off shifts the burden to the taxpayer to prove the deals were unrelated.11Office of the Law Revision Counsel. 26 U.S. Code 355 – Distribution of Stock and Securities of a Controlled Corporation – Section: 355(e)(2)(B) The provision was the response to the Morris Trust technique, where companies would spin off a division and immediately merge one of the resulting entities with an outside party.
Acquisitions that don’t change any individual shareholder’s proportionate ownership, internal transfers between the distributing and controlled corporations, and transactions that leave both entities in the same affiliated group are excluded from the calculation.10Office of the Law Revision Counsel. 26 U.S.C. 355(e) – Recognition of Gain on Certain Distributions of Stock or Securities in Connection With Acquisitions
What Happens If Any Requirement Fails
Failing a Section 355 requirement removes tax-free treatment entirely, and the consequences reach both sides of the transaction. For shareholders, the distributed stock is treated as a property distribution under Section 301: taxable as a dividend to the extent of the corporation’s earnings and profits, then a basis reduction, then capital gain. That outcome is exactly what the device test polices against.
Even when Section 355 does apply, shareholders who receive property beyond the permitted stock and securities face tax under Section 356. Gain is recognized to the extent of cash or other property received. The tax-free rules also do not apply when the principal amount of securities received exceeds the principal surrendered, when the subsidiary stock was acquired by the parent in a taxable transaction within the preceding five years, or when the distribution includes nonqualified preferred stock received in exchange for common stock.12Office of the Law Revision Counsel. 26 U.S. Code 355 – Distribution of Stock and Securities of a Controlled Corporation – Section: 355(a)(3)
Because the stakes are large and several of the tests are judgmental, corporations planning a spin-off often request an IRS private letter ruling on specific issues, including the business purpose and device analyses.13Internal Revenue Service. Revenue Procedure 2025-30 A ruling is not required, but it gives boards and shareholders a level of certainty that the requirements above have been met before the transaction closes.