Spinoffs and mergers.

The IRS has issued revenue ruling 96-30 (an update of revenue ruling 75-406), which addresses the tax status of a transaction in which corporation D distributes the stock of corporation C (preferably as a tax-free spinoff), and shortly thereafter C's shareholders exchange their stock for the stock of unrelated corporation Y in a tax-free merger.

At issue is whether the form of the transaction will be respected. If, in substance, D is treated as the exchanging shareholder in the merger, D would be viewed as having distributed the Y stock to its shareholders in a fully taxable transaction.

The ruling said the form selected would be respected (even if the spinoff was part of a D corporation reorganization, which imposed a control-immediately-after test), because

* At the time of the spinoff, there had been no negotiations regarding the acquisition of C by Y, even though an acquisition of C was a possibility recognized by management.

* The C shareholders voted on the merger after the spinoff (the merger could not be consummated without shareholder approval), and they were free to vote for or against the merger.

Observation: This ruling is restrictive because it adds to revenue ruling 75-406 (which places heavy emphasis on the shareholder vote factor) the prohibition on pre-spinoff negotiations. It suggests that a spinoff-merger will not attain tax-free status when the spinoff's purpose is to facilitate a merger in which the acquirer (Y) does not want its stock to be held by D in a concentrated block but, instead, wants such stock to be widely dispersed among D shareholders. This scenario also should meet the standards for tax-free treatment, notwithstanding the implications of revenue ruling 96-30. --Robert Willens, CPA, managing director at Lehman Brothers, New York City.