There are various reasons why corporations engaged in more than one line of business would want to separate those businesses, ranging from internecine competition for capital to investor opinion and beyond. There are also various means of accomplishing a separation.

Most obvious is an outright sale of one of the businesses, which would bring in cash the corporation could use elsewhere. Alas, about 40% of the gain on a sale will be consumed by federal, state and local taxes. A more tax-efficient approach is a spinoff or splitoff of a business to the corporation's existing shareholders. In this case, the business to be disposed of is first incorporated -- the assets of the business, subject to its liabilities, are conveyed to a new corporation in exchange for all of the latter's stock. The new corporation's stock is then distributed to the original corporation's shareholders, either in proportion to their stake in the parent (in the case of a spinoff) or in exchange for it (in the case of a splitoff).

A spinoff or splitoff will be tax-free, assuming it satisfies the requirements set forth in Sec. 355 of the Internal Revenue Code. These are not burdensome. As long as both corporations are, immediately after the separation, engaged in the active conduct of at least one trade or business that has been actively conducted throughout the preceding five years, and the separation is carried out for one or more corporate business purposes, there will be no tax bill. Unfortunately, there will also be no cash returned to the original corporation.

Is there a way of separating a business that is tax-free and also returns cash to the distributing corporation? According to the Tax Code, the answer is yes, through a technique popularly known as a "sponsored spinoff."

In fact, there are two varieties of sponsored spin-offs from which to choose: the conventional sponsored spinoff, or CSS, and the more daring reverse sponsored spinoff, or RSS. The structural differences between the two formats are slight. But in most cases, the RSS will emerge as the more attractive alternative because the distributing corporation is not required to deploy the cash derived from the sale in any special manner to avoid tax consequences. In the case of a CSS, taxes can be avoided only if the distributing corporation employs the cash to repay its indebtedness and/or distributes such cash to its shareholders.

How do sponsored spinoffs work? Assume X Corp. conducts two businesses, A and B, with business A accounting for some 75% of X Corp.'s consolidated revenue and net income and most of its recognition in the marketplace. In a conventional sponsored spinoff, X would contribute the assets (subject to the liabilities) of business B to a new corporation in exchange for (i) all of the new corporation's stock and (ii) an amount of cash derived by the new corporation from a loan that it incurs at the time of its formation. The amount of the loan the new corporation can prudently incur is, of course, a function of business B's ability to generate cash with which to service the debt.

X Corp.'s gain from the transfer of business B to the new corporation is defined as the amount by which the sum of the value of the new corporation's stock and the cash X extracted from the new corporation exceeds X's adjusted basis in the properties of business B. Ordinarily, it would be recognized in an amount not in excess of the cash so extracted. However, such gain need not be recognized if, in pursuance of the reorganization plan, X distributes the cash to its shareholders and/or creditors. The amount of cash that can be distributed to X's creditors cannot exceed the net basis of the assets of business B transferred to the new corporation. Excess cash must be distributed to X's shareholders, through any combination of dividends and repurchases of X stock.

If X fails to distribute all of the cash received from the new corporation in pursuance of the plan, X will be forced, to the extent of such undistributed cash, to recognize its gain.

Now here's the "sponsored" part. Although this is not a prerequisite, a sponsor can be brought in to purchase, directly from the new corporation, as much as 49.9% of its stock. The interest so acquired must be kept, at least initially, to less than 50%, in order to ensure that the spinoff remains tax-free to the distributing corporation. The capital contributed by the sponsor, in exchange for its stock in the new corporation, can be used to defray debt the new corporation incurred to fund the cash distribution to X.

In the case of a reverse sponsored spinoff, the salient aspects of the transaction are identical to a CSS, but certain structural elements of the plan are subtly altered. Thus, in the RSS, X would borrow the same amount that the new corporation borrowed in the CSS case and would then transfer the assets, subject to the liabilities, of business A -- the larger of X's businesses -- and the proceeds derived from the borrowing to a new corporation in exchange for all of the new corporation's stock. Such stock would then be distributed by X to its shareholders in either a spinoff or splitoff transaction.

Here, the new corporation conducts the more prominent of the two businesses and also enjoys an infusion of capital attributable to the loan incurred by X that X (now conducting only business B) will be responsible for defraying. Here, too, a sponsor can be brought into the picture and, as in the CSS case, permitted to purchase up to 49.9% of X's outstanding stock directly from X. Later, when the transaction has "aged" sufficiently, the sponsor may increase its interest in X to a control position without compromising the tax-free nature of the spinoff. Here, however, the new corporation need not distribute the cash to its shareholders and/or creditors (in pursuance of the plan or otherwise) in order to avoid taxes. Such a distribution, as we saw with our analysis of the CSS, is necessary where the cash moves up the chain of corporations but, for reasons that are not readily apparent, is wholly unnecessary where (as in the RSS scenario) the cash traverses a downward path.

Accordingly, the RSS seems to accomplish the objectives that we established at the outset -- it allows for the "unwanted" business to be sold for cash without any accompanying tax consequences. Alberto-Culver Co. and Marshall & Illsley Corp. have recently employed this technique in connection with the disposition by these corporations of Sally Beauty and Metavante, respectively. It promises to gain popularity as the news of its availability spreads. - Robert Willens

Robert Willens is a managing director and tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School.

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