Morris Trust Transactions

In a Morris Trust transaction, a regular tax-free spin-off to shareholders is immediately followed by a pre-arranged tax-free acquisition by a strategic buyer of the newly spun company (SpinCo). After the transaction is complete, the so-called “acquirer” has a minority (less than 50%) equity interest in the combined company.


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Transaction Structure

There are two type of Morris Trust transactions: the Regular Morris Trust and the Reverse Morris Trust. The latter is the more commonly used structure and involves the seller (ParentCo) spinning off the assets wanted by the buyer (the wanted assets) into a new company (SpinCo), which is immediately acquired by the buyer in a tax-free reorganization. In a Regular Morris Trust, ParentCo spins off the assets not wanted by the buyer (the unwanted assets) into SpinCo, and the buyer immediately acquires ParentCo (without SpinCo) in a tax-free reorganization.

The Reverse Morris Trust appears to be the more logical structure to accomplish the tax-free business combination. However, if the net assets wanted by the buyer include liabilities in excess of the seller’s inside basis in those assets, while the unwanted assets do not, the Regular Morris Trust is a more tax-efficient structure. The following example demonstrates when a Regular Morris Trust is useful:

Exhibit A – When to Use a Regular Morris Trust

Suppose the ParentCo wants to spin off a subsidiary in which the seller’s inside tax basis is low (perhaps the subsidiary was grown organically or acquired in a stock acquisition), and have the spun business (SpinCo) acquired in a subsequent Morris Trust transaction.

Prior to the spin-off, ParentCo also wishes to delever by “pushing down” debt to the subsidiary. However, if the amount of debt ParentCo pushes down to the subsidiary exceeds ParentCo’s inside basis in the subsidiary’s wanted assets, ParentCo will have a negative inside basis in the subsidiary just prior to the spin-off. The subsequent spin-off would then be taxable to the extent that ParentCo’s inside basis is negative, and ParentCo would recognize a gain equal in amount to the negative basis.

However, ParentCo itself is not subject to this negative basis restriction, and may be levered beyond its basis in the wanted asset basis without adverse tax consequences triggered by a subsequent spin-off. So, to achieve maximum monetization, ParentCo would instead incur a loan and spin off the unwanted assets, including the cash borrowings, into SpinCo. The buyer then acquires ParentCo, along with its new debt, in a Regular Morris Trust. SpinCo is then renamed to assume the previous corporate identity of ParentCo.

Generally speaking, a Reverse Morris Trust is the preferred structure, absent monetization needs that call for a Regular Morris Trust, because it is a mechanically simpler transaction that often avoids state transfer and similar taxes.

Tax Implications

To qualify for tax-free treatment, the spin-off must meet the conditions of Section 355 described in our lesson on spin-offs. Specifically, under Section 355(e), known as the anti-Morris Trust rule, a corporation that distributes stock of a subsidiary to its shareholders in an otherwise tax-free spin-off recognizes a taxable gain if 50% or more of the vote or value of either the distributing corporation’s stock or stock of the spun subsidiary is acquired as part of a plan that includes the spin-off. Section 355(e) considers such an acquisition occurring 2 years before or after the spin-off as “part of a plan”. However, if it can be demonstrated that the acquisition and spin-off were not part of a plan, no such tax will be imposed.

The implication of the anti-Morris Trust rule is that the acquirer must be smaller than the target company, so that it ends up with a minority (less than 50%) stake in the combined company. If a potential acquirer is only slightly larger than the target, however, it may be possible to either shrink the value of the acquirer via a dividend or share repurchase, or increase the value of the target by shifting leverage to the parent prior to the spin-off.

In any case, the distributing corporation should obtain a private letter ruling from the IRS in support of tax-free treatment of a contemplated Morris Trust transaction before proceeding with the transaction.

Violating the Anti-Morris Trust Rule

If SpinCo is acquired following the spin-off in a transaction not satisfying Section 355(e) requirements, ParentCo recognizes a taxable gain equal to the FMV of SpinCo stock distributed less ParentCo’s outside basis in that stock. On the other hand, if ParentCo is so acquired following the spin-off, it recognizes a taxable gain equal to the FMV of the assets distributed less its inside basis in those assets.

In either case, no tax is levied at the shareholder level because the spin-off itself remains non-taxable. So, even if the anti-Morris Trust rule is violated, there is only one level of tax. Recall that a taxable spin-off, by comparison, involves two levels of tax. However, if other provisions of Section 355 are violated by the acquisition, the tax-free nature of the spin-off itself could be compromised, resulting in two levels of tax.

Morris Trust vs. Straight Spin-Off

From the perspective of ParentCo’s shareholders, a Morris Trust business combination is generally preferable to a straight spin-off because the Morris Trust includes the incremental benefit of synergies.

Why Aren’t Morris Trusts More Common?

The Morris Trust structure has a clear advantage over straight spin-offs: synergies. So why does the frequency of spin-offs far exceed that of Morris Trusts? There are a number of reasons.

The difficulty in finding a strategic buyer that is smaller than the target, but not so small as to make the transaction unfeasible, is a big reason why Morris Trusts are not more common. If a potential buyer is too small to undertake a Morris Trust transaction alone, it might consider partnering with a financial sponsor (e.g. private equity investor) to fund the acquisition, but this adds another layer of complexity to an already complex transaction.

The combined company’s board and management team composition may be a sticking point in negotiations between buyer and seller. The acquirer naturally wants its management team to remain largely intact and seeks a majority number of board seats because, after all, it is technically the buyer. From the seller’s and/or target’s perspective, however, the acquirer is a minority participant in the combined business with little authority to dictate board or management team composition.

Additionally, a Morris Trust transaction represents an enormous change in the corporate structure of the buyer. Even if the deal is expected to be accretive to a prospective buyer’s shareholders, the buyer’s management team and/or its shareholders may have serious reservations about undertaking such a large (relative to the size of the buyer) transaction, especially when uncertainty surrounds the expected synergies.

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