Spin-Offs, Fiduciary Duty, and the Law

In recent years, merger and acquisition activity has captured the corporate headlines, reaffirming the popular view that bigger is better. Yet the benefits of such empire building are belied by evidence that corporate spin-offs generally add more value to a business or group of businesses. Indeed, the advantages of spin-offs have not been lost on some of the more astute corporate executives, and although mergers and acquisitions may make better copy, spin-offs have been quietly on the rise. Companies such as AT&T, General Motors, ITT, Sprint, Dun and Bradstreet, and Sears have successfully reaped the benefits of performing tax-free spin-offs pursuant to Internal Revenue Code ("I.R.C." or "Code") § 355, the principle means of effecting them. The largest benefit of a spin-off is that I.R.C. §355 creates a tax-free shelter under which no gain or loss is recognized by either the distributing corporation or the shareholders receiving the distribution, thus eliminating the double taxation which otherwise would be incurred. Section 355 and the applicable Treasury Regulations ("Regulations"), however, establish several requirements that must be met before a spin-off will qualify as tax-free. These requirements demonstrate that the IRS disfavors spin-offs.The main thrust of the requirements is to prevent spin-offs from being used as devices for extracting earnings and profits tax-free or at capital gain rates. For example, a primary hurdle to a tax-free spin-off is the business purpose test, a subjective test requiring that the spin-off be motivated by a real and substantial non-federal tax purpose germane to the business of the parent corporation, subsidiary, or affiliated group to which the corporation belongs. The IRS uses the subjectivity of the business purpose test as a "filtering" mechanism to disqualify many corporations that would otherwise fulfill the requirements for a valid spin-off.There are numerous reasons why a corporation might want to pursue a spin-off, all of them "real" and "substantial" and having nothing to do with federal taxation. For example, many corporations have found that spin-offs unlock value in their businesses, thereby rewarding shareholders. Other legitimate reasons for spin-offs include facilitating acquisitions, enhancing earnings from stock offerings, increasing management accountability, sharpening corporate fitness and focus, and increasing efficiency. In some circumstances, avoiding liability and providing takeover defenses may be appropriate justifications for spin-offs. In circumstances where these are not appropriate justifications, safeguards against entrenchment and state fraudulent conveyance laws have proven to be adequate deterrents to abuse.All of the above legitimate, non-tax rationales ultimately serve to enhance shareholder value and are therefore consistent with directors' and officers' fiduciary duty to their shareholders-namely, to maximize value. The current tax law, however, ignores this duty and often frustrates it. This Article proposes that I.R.C. § 355 and the accompanying regulations should be revised to facilitate rather than hinder corporate spin-offs. Part I reviews the history of the tax treatment of spin-offs and outlines the section 355 provisions, treasury regulations, and revenue rulings that currently govern spin-offs. Part II considers some improper motives for spin-offs, but argues that legal safeguards against entrenchment and state fraudulent conveyance laws adequately address abusive spin-offs. Part II examines the legitimate, non-tax rationales behind spin-offs within the context of management's fiduciary duty to maximize shareholder value. Finally, Part IV analyzes the reasons why the tax law should encourage spin-offs and suggests revisions to section 355 to facilitate them.