Equity Rollovers in Connection with the Sale of a Business

An equity rollover (that is, a transfer by a seller of some or all of the seller’s interest in a business being sold in exchange for a direct or indirect post-sale interest in that business) can play a useful role in structuring a sale.  In some cases, a buyer may want one or more owners, such as a founder or other key manager, to stay on board with an incentive to facilitate the business’s post-sale success.  At times, a seller may wish to own an equity interest in an enterprise with attractive growth potential.  A purchaser may also want to limit the cash required to purchase the business, or a seller may hope to reduce the tax liability from gain on the sale (as discussed below).  Whatever the motivations in a given case, sellers should consider income tax implications when contemplating an equity rollover as part of the sale of a business.

In a given situation, the form of an equity rollover intended to be tax-advantageous to a seller depends on factors such as the nature of the acquiring entity and the entity being acquired, the parties’ goals, and the details of their business deal.  For example, whether each of the acquirer and the acquired entity is treated for tax purposes as a corporation or a partnership, the parties’ expectations about control and the seller’s participation in management, and whether the acquirer expects a full (i.e., in the full dollar amount of the value the acquirer assigns to the purchased business) basis step-up in the acquired assets can all play a role.

This article highlights several federal income tax[1] issues for sellers and illustrates the importance of considering whether to implement an equity rollover and the tax implications thereof. Although each specific situation needs to be analyzed in light of its specific facts, the general principles outlined herein have broad application to many different combinations of factors that motivate sellers and buyers.  In the discussions below, the background facts assumed, unless otherwise specifically noted, are that one or more sellers own an operating business organized as an LLC[2] and a sale to a third-party buyer is being negotiated.  It is also assumed that a cash sale of the business would produce a taxable gain for each seller.[3]

Taxable vs. Nonrecognition Rollovers

A proposal by a buyer (sometimes referred to as a “rollover,” although it is not the kind of rollover that this article focuses on) that a seller re-invest some sale proceeds into an acquiring (or related) entity should be carefully vetted, because although implementation of such a proposal may result in an ownership structure similar to the rollovers described below, such an arrangement would likely be treated as a taxable sale in its entirety followed by an investment of some of the cash proceeds.  That is, a seller could agree to a “rollover” that results in full taxation, but without full use of the cash proceeds.  Some sellers might make the choice to do so, but such a choice should be based on knowledge of the proposed method of acquisition and its tax impact on the seller.

In an equity rollover in connection with the sale of a business, a seller usually utilizes at least one of two “nonrecognition” provisionsof the Internal Revenue Code[4]: Section 721, relevant to transfers to partnerships, and Section 351, relevant to transfers to “controlled” corporations.  This control requirement, discussed below, makes Section 351 less flexible than Section 721, although structuring an acquisition so that the required control will exist is often possible if other considerations allow sufficient flexibility.

Nonrecognition Rollover to Partnership

Section 721 provides that no gain or loss is recognized by a partnership or its partners upon a contribution of property to the partnership in exchange for an interest in the partnership.  Therefore, if the requirements of Section 721 are met, a contribution of appreciated property to a partnership in exchange for a partnership interest does not result in immediate taxable gain to the contributing partner.

A simple example illustrates the operation of Section 721 to achieve nonrecognition for the portion of a seller’s equity “rolled over” into the acquirer.  An LLC, owned 90% by its founder and 10% collectively by several other owners who are not candidates for an equity rollover, is to be acquired by a partnership such as a private equity fund,[5] and the value of the LLC’s entire business is $10 million.  The founder’s tax basis for the 90% LLC interest is $500 thousand.  If the partnership purchased the founder’s entire interest in the LLC for $9 million in cash[6], the founder would recognize $8.5 million of taxable gain ($9 million minus $500 thousand tax basis) on the sale of the 90% interest.  If, alternatively, the partnership paid $7.65 million cash for 85% of the founder’s 90% interest and issued a partnership interest valued at $1.35 million for the other 15%, then the founder would recognize $7.225 million of taxable gain ($7.65 million, representing 85% of $9 million, minus $425 thousand, representing 85% of the founder’s tax basis) on the cash sale, and would not recognize gain for tax purposes on receipt of the partnership interest.  The founder would recognize $1.275 million less in taxable gain as compared with a cash-only sale (even if such sale is followed by re-investment of proceeds). This unrecognized gain would be preserved in the tax basis of the partnership interest received, although it potentially can be deferred until disposition of the interest, and depending on future events it is possible that the deferred gain will never be subject to income tax.[7]

Nonrecognition Rollover to Corporation

Section 351 provides that no gain or loss is recognized by a transferor upon a transfer of property to a corporation by one or more persons solely in exchange for stock[8] in such corporation if immediately after the exchange such person or persons are in “control” of the corporation.  Control of a corporation for this purpose is generally defined as ownership of at least 80% of the voting power of all voting stock of the corporation and at least 80% of the number of shares of each class of non-voting stock.

Because Section 351, unlike Section 721, includes a “control” requirement, a combined sale and contribution transaction with a corporate acquirer analogous to the example above utilizing a partnership acquirer would not allow for nonrecognition of gain by the founder unless the founder, together with any other contemporaneous transferors of property in exchange for stock, are in control of the corporation immediately post-transfer.  Frequently, an acquirer is too large, or an interest to be rolled over is too small, for the required control to exist.  However, alternative methods may achieve a similar result for the founder even in the case of a corporate acquirer.

For example, the acquiring corporation might purchase 85% of the founder’s 90% LLC interest for $7.65 million in cash and then contribute that LLC interest, together with the interests purchased from other owners, to a newly-formed corporation in exchange for stock.  The founder would contribute the remaining 15% of the 90% LLC interest to the new corporation in exchange for stock.  The founder would, as in the partnership example above, recognize $7.225 million of gain on the cash sale.  Since the corporate acquirer, together with the founder, would collectively own all of the new corporation’s stock, they would be treated as being in “control” of the new corporation immediately post-transfer, and the founder’s transfer could qualify for nonrecognition of gain under Section 351.  As in the partnership example above, the founder would recognize $1.275 million less in taxable gain in comparison with a cash-only sale (even if such sale is followed by a re-investment of a portion of the proceeds).  This unrecognized gain would be preserved in the founder’s tax basis in the stock received, although it potentially can be deferred until disposition of the stock, and depending on future events it is possible that this gain will never be subject to income tax.

Retention of Equity

At times, a seller may be able to accomplish a result that is similar, in terms of nonrecognition of gain, to an equity rollover under Section 721 or Section 351, without relying on either provision.  If, for example, the seller sells part of the LLC interest for cash and simply retains the remainder, the cash sale would produce taxable gain, whereas merely retaining an LLC interest one already owns is ordinarily not a taxable event.  This method is simple from a structuring standpoint, but frequently does not fit with the parties’ other plans (for example, if the acquired business will be integrated into the business of an acquiring entity).

Conclusion

Use of Section 721 or Section 351 (or a combination) to facilitate qualification of a rollover for nonrecognition treatment frequently will be dependent on factors such as whether (and in what form) the acquiring entity already exists, whether (and at what time) the acquired business will be combined with other businesses, and plans for a future sale of the acquired business.  If the parties are able to reach agreement on these and similar issues, a significant amount of flexibility exists for planning an equity rollover into either a partnership or a corporation in connection with the sale of a business.  This flexibility can at times involve creation of additional partnerships or corporations and sequential transactions intended to qualify for nonrecognition of gain.  These principles may be applied to multiple sellers, as well as to some, but not all, of the sellers in a transaction.  And they may be applied, with important nuanced differences in result, to the sale of a business treated for tax purposes as a corporation, a partnership or a disregarded entity.  As always, it is worthwhile to seek input from a tax attorney along with that of corporate attorneys when negotiating and documenting the sale of a business.