The prospects for Yahoo’s Alibaba spin-off are suddenly looking grim by Dan Frommer

The Internal Revenue Service just issued a major setback to Yahoo as it prepares to spin off its stake in Alibaba: Yahoo just revealed via a filing with the US Securities and Exchange Commission that its spinoff might not be so tax-free, after all.

The IRS notified Yahoo on Sep. 2 that it had “determined…not to grant” Yahoo’s request for a ruling saying that the proposed deal would satisfy requirements for a tax-free spin-off. The IRS did not formally declare the deal taxable, but it was enough of a signal that Yahoo has withdrawn its request.

The requirement in question is called the “active trade or business” requirement—basically, in this case, that a spun-off business include more than just some shares in another company. It is customary to spin off a small, relatively independent subsidiary; Yahoo’s choice was literally its Yahoo Small Business unit, which sells web hosting and marketing tools.

Yahoo’s filing says that “work proceeds” on the spin-off plan, and that its board will “continue to carefully consider” its options. (Its chief accounting officer also resigned last week.)

Yahoo shares fell 3% in after-hours trading, to around $30. But the bigger story is that they have declined about 40% since January, when the spin-off was announced, reflecting anxiety both over the Alibaba deal and Yahoo’s prospects for survival as a standalone online media company.

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