Rollover Equity in Private Acquisitions: Tax and Deal Terms

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Rollover equity is the portion of a seller's stake that stays in the business after a sale, usually as equity in the buyer's holding company. Sellers often want tax deferral on that slice. Buyers often want the sellers' incentives aligned after closing. Those two goals only meet if the structure actually qualifies for nonrecognition and if the deal documents say what happens to the rolled equity later. The tax-deferred paths in most private deals are Section 721 (a contribution to a partnership) and Section 351 (a contribution to a corporation). Cash and other boot, and the disguised-sale rules under Section 707, are where deferral shrinks. The commercial terms, including tag and drag rights, put rights, and the valuation of the rolled equity, are where sellers give away value even when the tax structure is clean.

Two tax-deferred structures: Section 721 and Section 351

Section 721(a) generally provides that no gain or loss is recognized by a partner or the partnership when property is contributed to a partnership in exchange for a partnership interest. In a typical private equity structure, the buyer forms a partnership or LLC taxed as a partnership (HoldCo). The rolling sellers contribute target equity (or, after a restructuring, interests in a disregarded entity) to HoldCo in exchange for HoldCo units. If the contribution is respected as a contribution of property for a partnership interest, Section 721 can defer tax on that portion of the deal. The cash portion of the purchase is a separate sale, and it is taxable.

Section 351(a) generally provides that no gain or loss is recognized if property is transferred to a corporation solely in exchange for stock, and if the transferors are in control of the corporation immediately afterward. Control, for this purpose, means Section 368(c) control: at least 80 percent of the total voting power of all classes of voting stock, and at least 80 percent of the number of shares of each class of nonvoting stock. In a rollover into a corporate HoldCo, the rolling sellers and any other transferors of property must meet that 80 percent test together, immediately after the exchange. If the buyer contributes only cash, cash-only transferors may not count as "property" transferors for the control group in the way sellers hope. The control test has to be modeled, not assumed.

Which statute applies is a function of the holding company the buyer actually uses. A partnership HoldCo points toward Section 721. A corporate HoldCo points toward Section 351, including the control test and the rules on nonqualified preferred stock under Section 351(g). I have seen term sheets say "tax-deferred rollover" before anyone has decided whether HoldCo is a partnership or a corporation. That is not a tax plan. It is a hope. The structure should be settled in the letter of intent stage, alongside any pre-closing F reorganization needed to get the target into the right form. For process context, see what middle-market sellers should expect from LOI to close and our private equity and M&A page.

Boot, and why cash next to rollover is not always simple

Under Section 351(b), if a transferor receives stock and also other consideration (boot), the transferor recognizes gain realized, but not loss, up to the fair market value of the boot. Cash is the usual form of boot. The result is partial deferral: tax on the cash, deferral on the qualified stock, assuming the rest of Section 351 is met.

Partnership rollovers do not use the Section 351(b) boot rule in the same way, but the economic result can look similar because of the disguised-sale rules. Section 707(a)(2)(B) and Treas. Reg. § 1.707-3 address transfers of property to a partnership and transfers of money or other consideration to the contributing partner that are, in substance, a sale. If the contribution and the distribution are properly treated as a sale in whole or in part, Section 721 does not shelter that portion.

Treas. Reg. § 1.707-3(c) supplies a timing presumption that sellers should take seriously. If the contribution and a transfer of money or other consideration occur within two years of each other, the transfers are presumed to be a sale unless the facts clearly establish otherwise. Transfers more than two years apart are presumed not to be a sale, again subject to the facts. A cash payment at closing, next to a contribution of the same property, is the easy case: that cash is modeled as sale proceeds. The harder cases are deferred distributions, debt-financed distributions, purchase-price adjustments, and tax distributions that look like disguised purchase price. There are regulatory exceptions, including certain debt-financed distribution rules and operating-cash-flow distributions, but they are technical and fact-specific. I do not treat them as a blanket excuse to move cash around the rollover.

The practical drafting point is to identify, in the tax exhibit or the contribution agreement, what is a sale for cash and what is a contribution for units, and then to keep later cash movements consistent with that story. If the parties want additional cash out within two years of the contribution, the CPA should test the disguised-sale presumption before the distribution is promised in the HoldCo agreement.

What sellers should negotiate on rollover equity

Tax deferral is only half of the rollover discussion. The units or shares the seller receives are a minority (or at least non-control) interest in a company the buyer will govern. The documents will say how that interest can be forced out, how the seller can tag along, whether the seller can put the interest, and what the interest is worth at grant and at exit.

Tag-along (tag) rights let the rolling sellers sell a proportionate share if the sponsor sells its interest. Without a tag, the sponsor can exit and leave the sellers in a new cap table they did not choose. Drag-along (drag) rights let the sponsor force the rolling sellers to sell when the sponsor sells, usually so a buyer of the sponsor's interest can acquire 100 percent. Drag rights are market in sponsor deals. The seller points worth negotiating are the drag's trigger (a sale of control, or something broader), whether the drag requires the same form and amount of consideration for all sellers, and whether the rolling sellers can be required to take more deferred or contingent consideration than the sponsor takes. I also want clarity on indemnification and escrow in a dragged sale, so the rolled equity is not a back-door expansion of the original deal's indemnity.

Put rights, where they appear, give the seller a contractual path to sell the rolled equity back to the company or the sponsor at a defined time or on defined events. They are less automatic than tag and drag in many middle-market documents. If a seller's reason for rolling is liquidity later, a put, or at least a structured exit waterfall, needs to be in the paper. A right that can be deferred indefinitely, or valued solely by the sponsor, is not much of a right.

Valuation of the rolled equity should be express. Sellers should push for the rolled units to be valued at the same per-unit or per-share equity value used to price the cash sale, so that a 20 percent rollover means 20 percent of the equity value, not 20 percent of the units after a cheap-issue to the sponsor or after a management pool that dilutes only the sellers. Points I flag in the term sheet:

1. Same heading price for cash proceeds and rolled equity, before any separately bargained management incentive pool.

2. Whether the management incentive pool, if any, dilutes everyone or only the rolling sellers.

3. Vesting or forfeiture on rolled equity. Rolled equity that is really purchase-price consideration should not vest like a compensatory grant unless the seller agrees to that, with eyes open, and with the tax consequences reviewed.

4. Tax distributions on passthrough HoldCo units, so the seller can pay tax on allocated income that is not accompanied by cash.

5. Information rights and, where appropriate, a board observer or consent right on related-party deals, because minority sellers otherwise learn about value only at exit.

6. How a later recapitalization, preferred layer, or incentive issuance will affect the sellers' percentage and liquidation preference.

If those points are left to a form LLC agreement circulated after signing, the tax deferral may work and the commercial deal may still be a bad one.

A process I want sellers (and buyers) to follow

1. In the letter of intent, state the rollover percentage, the HoldCo form (partnership or corporation), and the intended nonrecognition statute.

2. Have the CPA model Section 721 or Section 351, including the 80 percent control test if HoldCo is a corporation, and the disguised-sale analysis for any cash, debt, or near-term distribution.

3. Coordinate any target restructuring, including an F reorganization for an S corporation, so the property being contributed is the property the statute requires.

4. Paper the contribution and the sale as separate legs, with values that match the allocation schedule.

5. Negotiate tag, drag, put or exit rights, valuation, tax distributions, and dilution in the same term sheet as the price.

6. Read the HoldCo agreement before signing the purchase agreement, or at least before the rollover becomes irrevocable.

I advise on the transaction documents and the corporate or LLC arrangements that have to match the tax plan. I do not replace the CPA. On rollover equity, the useful work is making the contribution, the cash sale, and the minority-rights package consistent before anyone is committed.

Want to run your scenario by me? info@robertsandwillie.com or (469) 910-4017. Sending a message does not create an attorney-client relationship.

Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.