What is a spinoff?

A spinoff transaction occurs when a company issues additional shares of one or more different securities to its existing shareholders. The issuing company is known as the ‘parent company’. Any resulting securities are known as ‘daughter companies’. In this transaction, the parent company will typically discuss with the IRS the appropriate tax consequences of this transaction. Then, it will tell existing shareholders what percentage of their cost basis in the parent security they can allocate to the daughter security.

Some more explanation

In essence, the company estimates what percentage of the money used to purchase the original security would have gone towards the new security had that new security existed at the time of the original purchase. This then becomes the cost basis for the existing shareholders of the daughter security. If the shareholder of the daughter security sells it, any amount above this cost basis will be considered a capital gain. Conversely, the cost basis of the parent security is reduced by the amount allocated to the daughter company. The holding period for the daughter company and parent company is the same.

The remaining basis fraction is the percentage of the cost basis that the parent company retains. You can use the parent’s price/share to substitute for the remaining basis fraction, but the remaining basis fraction tends to be more reliable.

Some things you should know about spinoffs

Most spinoffs involve nasty fractions. Instead of, say, one daughter company share per parent company share, the number is usually something like:

1.0 parent shares to 0.0334288789232 daughter shares

Naturally, most shareholders will receive fractional shares of the daughter company. These shares are usually sold off immediately and automatically by most brokers. This is where cash-in-lieu comes from. That is the cash you get instead of the fractional share of the stock you are entitled to. Of course, different brokers get different prices for this fractional share. The market for newly spunoff companies is volatile. This market price has nothing to do with the cost basis of either the parent or daughter company.

The market price of daughter companies is important when there is more than one spunoff entity. Even though the total basis given to all daughter companies is set, the way this is divided is not set. The market price for the daughter companies sets a ratio which is then used to determine the respective cost basis of the daughter companies.