Taxes and Business Decisions 349would own the former subsidiary in the same proportions in which they owned
the parent. Morris, as the majority owner of the new corporation, could then
give further shares to Brad, enter into a buy-sell agreement with him, or sell
him some shares. In any case, upon Morris’s death, Brad would succeed to un-
questioned leadership in this corporation. Lisa would stay as a minority stock-
holder or, if she wished, sell her shares to Morris while he was alive. Lisa would
gain control of the former parent corporation upon Morris’s death.
In the second scenario (known as a split-off ), after the formation of the
subsidiary, Brad would sell his shares of Plant Supply to that parent corpora-
tion in exchange for stock affording him control of the subsidiary. Lisa would
remain the only minority stockholder of the parent corporation (Brad’s interest
having been removed) and would succeed to full ownership upon Morris’s
death through one of the mechanisms discussed earlier.
Unfortunately, when Morris brought his ideas to his professional advisers,
he was faced with a serious tax objection. In both scenarios, he was told, the
IRS would likely take the position that the issuance of the subsidiary’s stock to
its eventual holder (Morris in the spin-off and Brad in the split-off ) was a tax-
able transaction, characterized as a dividend. After all, this plan could be used
as another device to cash out the earnings and profits of a corporation at favor-
able rates and terms. Instead of declaring a dividend of these profits, a corpo-
ration could spin off assets, with the fair market value of these profits, to a
subsidiary. The shares of the subsidiary could then be distributed to its stock-
holders as a nontaxable stock dividend, and the stockholders could sell these
shares and treat their profits as capital gain. The second scenario allows Brad
to receive the subsidiary’s shares and then make a similar sale of these shares
at favorable rates and terms.
As a result, the Code characterizes the distribution of the subsidiary’s
shares to the parent’s stockholders as a dividend, taxable to the extent of the
parent’s earnings and profits at the time of the distribution. This would cer-
tainly inhibit Morris if he were the owner of a profitable C corporation. It
would be less of a concern if his corporation were operating as an S corpora-
tion, although even then he would have to be concerned about undistributed
earnings and profits dating from before the S election.
Recognizing that not all transactions of this type are entered into to dis-
guise the declaration of a dividend, the Code does allow spin-offs and split-
offs to take place tax-free, under the limited circumstances described in
Section 355. These circumstances track the scenarios concocted by Morris, but
are limited to circumstances in which both the parent and subsidiary will be
conducting an active trade or business after the transaction. Moreover, each
trade or business must have been conducted for a period exceeding five years
prior to the distribution and cannot have been acquired in a taxable transaction
during such time. Since Morris’s corporation acquired the molding business
only two years previously and such transaction was not tax free, the benefits of
Section 355 are not available now. Short of another solution, it would appear