Disagreements happen. In the corporate context, one or more shareholders may share a different vision for the company than the other shareholders. Or, there may be acrimony amongst the shareholders for other reasons, as can often happen with family-run businesses. Regardless of the reason, sometimes shareholders simply want out.
Fortunately, the corporate income tax laws provide some tax-efficient options for shareholders who want to exit but who also want to take a piece of the company with them. Referred to as "divisive reorganizations," these tools are commonly used by tax professionals to help separate the shareholders and the company's businesses in a manner that does not hurt for tax purposes. Although a good divisive reorganization requires the taxpayer to meet various requirements, it can be a good option for corporate shareholders who want to continue a business line in separate corporate form away from a current company.
Corporate Income Tax
Generally, the usage of corporations (at least those without a valid S election) results in two levels of income tax. First, the corporation must pay income taxes on its profits (currently, a flat 21%). Second, if the corporation distributes its profits to its shareholders, those shareholders must pay a second-level tax referred to as a dividend. Depending on the shareholder's individual income tax circumstances, the dividend tax may be as high as 23.8% (which includes the 3.8% net investment income tax).
Example:
Adam and Beverly are equal 50% shareholders in Corporation C. In 2023, Corporation C had taxable income of $1 million. Corporation C must pay $210,000 of corporate income tax, leaving $790,000 of profits after tax. If Corporation C distributes this $790,000 equally to Adam and Beverly—i.e., $395,000 each—then they both must pay additional income taxes on the dividends. Assuming they are in the top tax brackets, Adam and Beverly would pay individual income taxes of $94,010 each, or $188,020 total. Thus, out of the $1 million of profits earned by Corporation C, $398,020 goes to the U.S. Treasury (roughly 40%) with the remainder to the shareholders.
Corporate Divisions
Let's take the above example a little further. Assume that Adam and Beverly are siblings. In addition, assume that Corporation C has been in the family for forty years and has two lines of business: manufacturing men's clothing and manufacturing women's clothing. Since their father passed some time ago, Adam has primarily run the men's clothing line, and Beverly has primarily run the women's clothing line.
Adam firmly believes that demand in men's clothing will take off in the next few years. Accordingly, Adam believes that all excess Corporation C capital should be diverted to expanding the men's clothing line in Europe. Unfortunately, Beverly does not share these same beliefs. Instead, Beverly believes that demand for women's apparel will far exceed the demand for men's apparel in the near term—therefore, she proposes that Corporation C use all of its excess capital to create brick-and-mortar stores in Texas that only sell Corporation C's women's clothing. After much debate, the two are at a crossroads and, unfortunately, their disagreement for the corporation's future has spilled negatively into Corporation C's bottom line.
Adam and Beverly have options. Through a corporate division known as a "split-up," Corporation C may transfer its men's clothing business to newly-formed Corporation Y, and its women's clothing business to newly-formed Corporation Z. After the transfers, Corporation C—which holds 100% of the stock in both Corporation Y and Z—can distribute all of the Corporation Y shares to Adam and all of the Company Z shares to Beverly. When Corporation C liquidates, Adam has 100% of the ownership of Corporation Y, and Beverly has 100% of the ownership of Corporation Z.
If the corporate division meets all of the other requirements for a tax-free reorganization, Corporation C does not recognize gain on the distribution of Corporation Y and Z stock (which is likely appreciated). Moreover, Adam and Beverly would not recognize gain on the receipt of Corporation Y and Z stock in exchange for their Corporation C stock. Perhaps most importantly, though, Adam and Beverly are now free to run and operate their respective businesses in the manner in which they want to do.
Although tax-free reorganizations seem deceptively simple, they often are not. As mentioned above, there are numerous requirements reorganizations must meet—both statutory and judicial—to qualify for tax-free treatment. If one of these requirements is not met, it is usually fatal to the tax-free reorganization. Also, if the transaction involves family members or related companies, courts will subject any analysis of the transaction to heightened scrutiny. Accordingly, taxpayers who wish to enter into these types of corporate reorganizations should not do so alone—rather, tax counsel and professionals should be involved throughout the process to better ensure the transactions are structured properly and to meet the corporate reorganization requirements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.