In acquisition transactions, consideration is often composed of a combination of cash and equity from the buyer. Equity consideration is attractive for a number of reasons, including aligning the interests of both buyer and seller post-closing and giving the seller some tax deferral and the potential for additional upside as the business continues to succeed. Structuring the transaction to include a partial tax-free equity component, or “rollover,” is a crucial element in facilitating these transactions, potentially offering substantial tax benefits to the seller. This strategic maneuver allows the seller to avoid triggering immediate federal income tax liabilities on receipt of the equity consideration, ensuring the seller retains a larger portion of its cash proceeds from the sale. In this post, we will discuss common federal income tax considerations for achieving a tax-free equity rollover applicable to U.S. buyers and sellers. Additional federal income tax considerations would apply to non-U.S. parties, which are beyond the scope of this discussion and will only be briefly highlighted at the end.
Typically, a tax-free equity rollover – more accurately, a tax-deferred rollover – will be structured such that the buyer will purchase a portion of the property being sold, whether equity in a target company or assets, in exchange for cash and the remaining portion in exchange for equity of the buyer (or a parent entity of the buyer). In order for the latter part of the deal (i.e., the rollover) to be tax-free from a federal income tax perspective, it is typically structured as a contribution of the relevant property to the buyer or parent entity in exchange for equity of the buyer or parent entity (i.e., the Buyer Issuer). Accordingly, the ability to achieve a tax-free equity rollover for the seller and any challenges that must be overcome will primarily, but not exclusively, depend on the entity classification of the Buyer Issuer (e.g., partnership, C corporation, S corporation) for federal income tax purposes.
Buyers Classified as Partnerships
Tax-free equity rollovers are subject to relatively fewer restrictions if the Buyer Issuer is a partnership for federal income tax purposes. Contributions of property to a partnership are governed by Section 721 of the Internal Revenue Code of 1986 (IRC), as amended. Section 721 generally provides that no gain or loss is recognized for a contribution of property to a partnership in exchange for an interest in the partnership. These rules also apply to multimember limited liability companies (LLCs), which are by default classified as partnerships for federal income tax purposes (although LLCs can file tax elections to be classified differently). The exceptions to such tax-free equity rollovers under Section 721 generally cover more complicated and bespoke fact patterns that are less likely to be encountered in typical acquisition transactions. These include, but are not limited to, disguised sales, situations where the partnership is an investment company (as opposed to one that primarily holds business assets or real estate), and fact patterns involving related parties. Accordingly, while buyers and sellers should always consult with their tax advisors, it is relatively straightforward for a seller to transfer property, whether equity of an existing target company or assets, to a Buyer Issuer classified as a partnership in exchange for tax-deferred rollover equity.
Buyers Classified as C Corporations
Alternatively, if the seller desires to receive tax-deferred rollover equity in a Buyer Issuer classified as a C corporation for federal income tax purposes, any contribution to the Buyer Issuer in exchange for stock of the Buyer Issuer would be governed by Section 351 of the IRC. These rules have more requirements than those governing partnership contributions. The most common obstacle to a tax-free equity rollover into a C corporation is the requirement pursuant to Section 351 that any seller making a contribution to the C corporation must “control” the corporation immediately after such contribution (i.e., the Control Test). For this purpose, “control” means both ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.
In most transactions, it is unlikely that a seller would contribute property with sufficient value to become an 80 percent, or more, stockholder of the Buyer Issuer. Instead, achieving a tax-free equity rollover into a corporate Buyer Issuer would typically require the Buyer Issuer’s existing stockholder(s) to also make contributions to the Buyer Issuer that are contemporaneous with the seller’s rollover. For example, if the Buyer Issuer is a subsidiary corporation, its parent company can contribute cash to the Buyer Issuer in order to fund the cash portion of the purchase consideration. If done correctly, the Control Test would be measured based on the combined stock ownership of the seller and the Buyer Issuer’s other contributing stockholders immediately after the contributions.
Apart from the Control Test, and similar to Section 721, there are further exceptions to tax-free equity rollover treatment under Section 351, including but not limited to: receipt by the seller of non-qualified preferred stock, situations where the corporation is an investment company, or whether property contributed to the corporation is encumbered by liabilities in excess of such property’s tax basis.
Based on the foregoing, it is even more important for the parties to immediately consult their tax advisors to ensure that a tax-free equity rollover is possible when the buyer is classified as a C corporation; in particular, this would allow the tax advisors sufficient time to consider possible structures for the Control Test or other applicable rules under Section 351.
Special Issues for S Corporations
For federal income tax purposes, an S corporation is a type of corporation subject to special rules that allow it to be taxed as a flow-through entity in many respects, similar to a partnership. Most importantly, an S corporation generally is not subject to federal income tax at the entity level but instead allocates to its shareholders any income, gain, deduction or loss that is recognized by the S corporation.
Notwithstanding an S corporation’s similarities to a partnership in federal tax treatment, rollover by a seller into a Buyer Issuer that is an S corporation is generally subject to the same C corporation rules under Section 351. However, due to the special rules governing an S corporation, there are a number of additional considerations and potential issues when either the buyer or seller is an S corporation. Buyers and sellers should be particularly careful when a transaction includes an S corporation and should communicate with their tax advisors early. A detailed discussion of the S corporation-specific considerations is beyond the scope of this post, but some of the more common concerns are highlighted below.
Common Considerations and Pitfalls
As demonstrated by the foregoing discussion, there are several rules to navigate in order to properly structure a tax-free equity rollover for a seller. Beyond the items described above, following is a high-level list of certain considerations and pitfalls that buyers and sellers should keep in mind:
- For a buyer, any letter of intent (LOI) or term sheet should be appropriately open-ended or qualified with respect to the seller’s ability to achieve a tax-free equity rollover. In the early stages of a deal, certain critical facts or structuring considerations may not be obvious and a buyer could be placed in a challenging position if an LOI or term sheet unequivocally offers a tax-free equity rollover for the seller.
- A seller should inquire early on as to the Buyer Issuer’s classification for federal income tax purposes and entity structure. This is the first step in evaluating whether a tax-free equity rollover can be achieved – including situations where the seller might receive rollover equity in an entity (e.g., a parent or holding company) different from the one making the cash purchase component.
- It is not uncommon for the seller to receive rollover equity in a direct or indirect parent entity of the buyer. In that case, it is important to ensure that subsequent transfers of the property contributed by the seller to that parent entity do not inadvertently trigger federal income taxation or otherwise adversely impact the seller’s tax-free equity rollover into the parent entity.
- For a target company that is an S corporation, a buyer will typically request the transaction be structured to achieve a “step-up” in the tax basis of the underlying business assets. If the cash component of a transaction is structured as a sale of certain S corporation shares followed by an election under Section 338(h)(10) of the IRC (to obtain an asset tax basis step-up), the selling shareholders of the S corporation will not be able to achieve a tax-free equity rollover.
- Alternatively, if the transaction is structured as a sale of the business by an S corporation (i.e., the S corporation itself is the seller), receipt of rollover equity by the S corporation will not be completed tax-free to the S corporation shareholders if they decide to either distribute any of the rollover equity from the S corporation or economically participate in the rollover on a non-pro-rata basis (i.e., some of the shareholders receive more of the cash consideration while the rest hold onto a larger share of the rollover equity via their continuing ownership of the S corporation).
- Finally, if either buyer or seller is a non-U.S. entity, additional federal and non-U.S. tax rules may apply, including U.S. withholding tax implications relating to dispositions of U.S. trade or business assets or U.S. real property interests, including equity of a U.S. real property holding company.
The ability to achieve a tax-free equity rollover is a powerful tool for buyers and sellers when structuring transactions. However, given the complex rules involved, the importance of obtaining expert tax advice early in the process cannot be overstated.
Meet the Author
Kenneth Wang uses his many years of experience in both private practice and in-house tax departments for Fortune 200 companies to counsel clients on all aspects of U.S. tax law, including mergers and acquisitions, partnerships and joint ventures, fund formation, financing transactions, real estate transactions, business restructurings and reorganizations and international tax.