Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Reverse Morris Trust Works in Tax-Free Spinoffs
Transcript
- Lucas: There's a deal structure that nobody talks about outside the tax law journals, but it's quietly reshaping how mid‑cap companies shed divisions without taking a massive tax haircut. It's called the Reverse Morris Trust — and it's having a moment in 2026. Luna: I've heard the term, but I'll be honest — I couldn't explain how it actually works. Is it something only the really big firms use? Lucas: Historically it was a big‑cap tool — think AT&T spinning off WarnerMedia, or DuPont splitting into three. But what's interesting this year is that you're seeing $500 million to $2 billion industrial companies use it. I was looking at a deal that closed in March: a mid‑cap packaging firm wanted to sell its rigid plastics division to a larger competitor. If they'd done a straight asset sale, the capital gains tax on the sale — the step‑up in basis — would have been around 21 percent of the gain. The CFO estimated that would have been a tax bill north of $140 million. Luna: Ouch. So they wanted to avoid writing that check. Lucas: Exactly. So instead of a straight sale, they used a Reverse Morris Trust, or RMT. The basic move is: first, the parent company spins off the unwanted division into a standalone publicly traded C corporation. That spinoff is tax‑free to shareholders under Section 355 of the tax code. Then, immediately after the spinoff, that newco merges into the buyer. The buyer issues its own stock to the parent's shareholders as consideration. The whole thing is structured so that the parent's shareholders end up owning less than 50 percent of the combined entity — that's the 'reverse' part — but the IRS treats it as a tax‑free reorganization. Luna: Hold on — less than 50 percent? I thought the original Morris Trust required the seller's shareholders to own more than 50 percent to keep the tax deferral. Lucas: That's the old rule. The classic Morris Trust — which dates back to a 1966 court case — required the seller's shareholders to control more than 50 percent of the voting power of the combined company after the merger. That was fine if the seller was the bigger party. But what if the buyer is bigger? Then the seller's shareholders wouldn't hit that threshold. The IRS fixed this in 2011 with a regulation that allows the reverse version: as long as the buyer's shareholders end up with more than 50 percent — which is usually what happens in a buyer‑larger deal — the transaction qualifies. Luna: So the 'reverse' just means the buyer ends up on top, ownership‑wise. Got it. Lucas: Right. And the beauty is that the seller's deferred gain — the appreciation in the division from when the parent originally bought it or built it — carries over into the combined company's stock. The parent's shareholders don't pay tax until they sell those shares. Effectively, the seller gets to defer a tax bill that could have been 20‑plus percent of the gain, sometimes indefinitely. Luna: But the IRS doesn't just let you do this for fun. There have to be rules. Lucas: Three big ones. First, the business purpose test: the spinoff must have a genuine corporate business purpose — not just tax avoidance. Second, the continuity of interest rule: at least 50 percent of the consideration paid by the buyer must be its own stock, not cash. And third, the active trade or business requirement: the spun‑off division has to have been a separate, active business for at least five years before the deal. That last one trips up a lot of carve‑outs, because if the parent has been running the division as an integrated part of the company, the IRS might argue it's not a standalone business. Luna: So you can't just slice off a random cost center and call it a division. Lucas: Exactly. You need separate books, separate management, a separate customer base. In the packaging deal I mentioned, the rigid plastics unit had its own P&L, its own plant managers, its own supply contracts — it looked like a standalone business even though it was wholly owned. That made the five‑year test easy to pass. Luna: But what about the risk? If the IRS challenges the tax opinion after the deal closes, the seller could end up owing the tax plus penalties and interest. That's a huge liability. Lucas: That's the real nail‑biter in RMTs. You typically get a private letter ruling from the IRS before the deal to confirm the tax treatment. That ruling is binding on the IRS — but it can take six to nine months to get one. In the current environment, where the IRS staffing is thin, some advisors are closing deals without a ruling, relying on a legal opinion from a major law firm. That works until it doesn't. Luna: And we've seen cases where that backfired. Lucas: There was a 2024 Tax Court case — I think it was a technology carve‑out — where the IRS successfully challenged the active‑trade requirement. The taxpayer ended up owing $30 million in tax plus penalties. The court said the division hadn't been operated as a separate business for the full five years because the parent had shared sales force and IT systems. So the RMT unraveled. Luna: So the lesson is: if you're considering an RMT, you need to document the separation from day one. Run the division as a separate entity for at least five years before you even think about selling. Lucas: Exactly. And that's why the structure tends to favor larger companies that have had a divisional structure in place for a long time. It's harder for a private equity‑backed platform that's been aggressively acquiring and integrating add‑ons — those divisions often don't have a clean five‑year track record as separate businesses. Luna: We've talked a lot about the seller's perspective. What's in it for the buyer? Why would a buyer agree to a structure that defers the seller's tax gain? Lucas: The buyer gets to acquire the business using its own stock without raising cash — that's a big deal if the buyer's stock is highly valued or if credit markets are tight. Plus, the buyer takes a carryover basis in the assets, which means they inherit the seller's low tax basis. That's a disadvantage in the short term because they get less depreciation and amortization going forward. But in an RMT, the buyer often negotiates a lower purchase price to compensate for that — because the seller is saving so much on taxes, they can afford to sell for a slightly lower price. Luna: So it's a win‑win: seller defers tax, buyer gets a lower price. But the buyer also gets stuck with the carryover basis. That can hurt if they plan to sell the division again soon. Lucas: Right — that's the trade‑off. If the buyer expects to hold the division for a long time, the lower basis doesn't matter as much. But if they're a financial buyer planning a three‑ to five‑year hold, the foregone depreciation can be meaningful. In those cases, the buyer might insist on a partial cash component to step up the basis on a portion of the assets. Luna: And that's exactly the kind of complexity that makes RMTs an art form. It's not just a tax election — it's a negotiation about how much basis step‑up each side is willing to give up. Lucas: One last thing — a quick honest note. This show exists because a small group of listeners chips in monthly through buy me a coffee dot com slash fexingo. It's ad‑free, listener‑supported, and that's what funds covering niche structures like the RMT in depth. If these conversations have moved your work forward in some small way, the link is easy to find. Luna: Yeah, I think that's worth a pause. We dig into topics that most business podcasts gloss over because they don't have the runway, and that's only possible because of that direct support. Lucas: So with that said — back to the RMT. There's one more angle that's particularly relevant in mid‑2026: the pending corporate tax rate debate. If Congress raises the corporate rate later this year, the tax savings from an RMT become even more valuable. We're already seeing a rush of filings for private letter rulings before any law change takes effect. Luna: Because once the rate goes up, the deferred gain becomes more expensive to recognize later. Lucas: Exactly. If you can lock in a deferred gain at today's 21 percent rate — even though you don't pay it now — you're effectively hedging against a higher future rate. Some tax advisors are actually modeling scenarios where the rate goes to 25 percent, and the net present value of the deferral jumps by roughly 15 percent. Luna: So for a CFO sitting on a division they've wanted to sell for years, the RMT might be the smartest move in 2026 — not just because of the tax deferral, but because of the political uncertainty around rates. Lucas: And the window might not stay open forever. The IRS has signaled it might tighten the active‑trade rules for spinoffs. There's also a pending revenue ruling — expected later this year — that could limit the use of RMTs in certain industries. So if you're considering one, the time to start the documentation process is now, not next quarter. Luna: Which brings us back to the five‑year clock. You can't fast‑forward that. Lucas: You can't. So the companies that will benefit most from the RMT wave are the ones that started building clean divisional structures years ago — the ones that treated their business units like separate companies long before the sale was on the table.