Most transactions have their share of hiccups. Some cases are more serious than others.
Generally speaking, they originate with the seller. For example, due diligence turns up some disturbing information about the target company’s legal status, the target’s financials aren’t as rosy as the buyer was led to believe, the target’s owners keep trying to renegotiate the deal, or a rift develops among the target’s owners – these and other surprises are not unusual. Some result in a change in purchase price or a change in payment terms (including escrows and other holdbacks), while others just kill the deal.
Of course, there are also times when the buyer is the source of the setback or hold-up; for example, the buyer’s financing for the transaction may be in question, or the buyer is distracted by another deal.
It is rarely the case, however, that the buyer’s ownership structure, or the composition of its ownership, presents a stumbling block, especially in what appears to be the well-choreographed process of a private equity deal.
Unfortunately, no one is immune from surprises.
Acquisitions by Private Equity
For the owners of many closely held businesses, the final step of a successful career may be the sale of their business.[i] At that point, the investment into which they have dedicated so much time, effort and money is monetized, leaving them with what is hopefully a significant pool of after-tax proceeds with which to enjoy their retirement, diversify their assets, or pursue other goals.
It used to be that the prospective buyer would almost always come from within the same industry[ii] as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic – they were looking for synergistic acquisitions, ones that would enable them to grow their own business and otherwise provide long-term benefits. Occasionally, the buyer would be a company from a different industry, one that was looking to diversify or add another line of business so as to hedge against a downturn in its primary business.
However, for many years now, the private equity fund (“PEF”) has been a dominant player in the competition for the acquisition of closely held businesses. In general, PEFs are not engaged in any “conventional” business; rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (or “portfolio companies”).
Almost by definition, a PEF is not necessarily looking to the acquisition as a means of developing or establishing a long-term presence in a particular industry (a “buy and hold” investment strategy). Instead, it is looking for “value”[iii] to add to its portfolio of companies, perhaps even consolidating similar companies in the process in order to grow market share and reduce overall costs. In turn, the PEF hopes to sell its “inventory” of portfolio companies to other buyers not-too-far down the road, and hopefully at a sizable gain[iv] that it may share with its investors.
The PEF is formed as a partnership, which is not a taxable entity,[v] and which also facilitates the admission of new investors.[vi] The PEF will often create a holding company (the “HC”) to which it will transfer the funds contributed to the PEF by its investors. The HC, in turn, may establish and fund its own subsidiary companies through which it will aquire target businesses.
Rollover: PEF’s Perspective
One aspect of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “rollover” (or reinvest) some portion of their equity in the target business into the PEF’s “corporate structure” in exchange for an equity interest therein, usually at the level of the HC.
From the perspective of the PEF, such a rollover yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is subject to the risks of the business, as is that of the PEF’s investors. Thus, the former owners are incentivized – or so the theory goes – to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success.[vii]
Rollover: Seller’s Perspective
From the perspective of the target’s owners, however, the rollover may present a troublesome issue.
In many cases, an owner will want to take all of their cash off the table. They may not want to continue risking their capital, especially where the investment is to be controlled by another.
Of course, some owners will be attracted to the potential upside that a rollover investment in a PEF-controlled business may generate. After all, the owner may have the opportunity to benefit not only from the future growth of their former business, but also that of the PEF’s other portfolio companies. In fact, a business owner will generally insist upon being given the opportunity to participate in the growth of these other companies, which is consistent with most PEF’s desire that the target owners invest at the same level of the corporate structure as the PEF itself has – i.e., the HC.
However, the target owners will also insist that their rollover be effected without any adverse tax consequences. The ability of the PEF to satisfy this prerequisite will depend, in no small part, upon the form of the acquisition of the target business.
Like most other buyers, the PEF will generally prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners.[viii] A taxable sale of assets will provide the PEF (specifically, the subsidiary through which the HC indirectly acquires the target’s business) with a cost basis in the acquired assets that may be expensed, depreciated or amortized by the PEF.[ix] The tax deductions so generated will offset the HC’s and, through it, the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.
The target’s owners, on the other hand, will generally not choose an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners,[x] as well as an entity-level tax,[xi] thus reducing the net economic benefit to the owners. Rather, they would prefer to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain.[xii] However, such a sale will not generate basis in the target’s assets for the PEF.
As indicated above, a PEF will often create a subsidiary – the HC – through which it will acquire a target company. Where the target’s assets are being purchased, the acquisition may be effected through an acquisition vehicle (a corporation or LLC) that will be wholly-owned by the HC.[xiii]
The form of rollover by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the rollover will come directly from the former owners.[xiv] Where the HC (more likely, its subsidiary) is acquiring the target’s assets, the rollover may come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.[xv]
The chosen forms of acquisition and rollover will generate very different tax results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity rollover can be effectuated, and whether this transfer may be done tax-efficiently.
The owners of the target business have to recognize that if the rollover cannot be accomplished on a tax-deferred basis, they may be left with less cash and less liquidity than they would have preferred.[xvi]
In order to facilitate the rollover of the target’s equity, the HC may be formed as a partnership for tax purposes.[xvii] A tax-deferred contribution of property to a partnership in exchange for a partnership interest is generally easier to accomplish than a tax-deferred contribution of property to a corporation in exchange for shares of stock in the corporation. That’s because a tax-deferred contribution to a corporation requires that the contributor be in “control” of the corporation immediately after the exchange;[xviii] there is no such requirement for a contribution to a partnership.[xix]
The partnership structure, however, may present an issue for a non-U.S. investor of the PEF.
Assume for our purposes that the target to be acquired by the HC is treated as a partnership for tax purposes, and that it is engaged in a U.S. trade or business. Also assume that the HC is treated as a partnership.
All Cash Deal – Fully Taxable
The gain from a sale of assets by the target partnership to a subsidiary corporation of the HC, in exchange for cash only, will flow through the partnership, and will be taxable, to the target’s owners.[xx] The nature of the gain taxed to the owners[xxi] will depend upon the nature of the assets sold.[xxii]
Alternatively, the owners of a target partnership may sell all of their partnership interests to the HC, or to its acquisition subsidiary, for cash.[xxiii] A sale of all of the partnership interests will be treated, for tax purposes from the buyer’s perspective, as a purchase of the target’s assets,[xxiv] thus providing the HC (and, ultimately, its owners) with a recoverable cost basis in such assets.[xxv]
In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the HC, they will have to do so with after-tax dollars.[xxvi]
Rollover of Some Equity
In order for the target partnership to rollover a portion of its equity into the HC on a tax-advantaged basis, the target will have to contribute some of its assets to the HC in exchange for a partnership interest in the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by the target.[xxvii] The HC will acquire a depreciable or amortizable basis for the assets acquired for cash,[xxviii] and a carryover basis for those received in exchanged for an interest in the HC.[xxix]
The same result may be achieved where some interests in the target partnership are contributed by its partners to the HC as capital, while the remaining interests are sold to the HC (or its subsidiary) for cash.[xxx] In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid, whereas it will take the target’s basis in the assets deemed to have been contributed.[xxxi]
Hiccup: PEF with Foreign Owner?
Assume the target’s owners contribute a portion of their partnership interests to the HC (the rollover) in exchange for an interest therein. Also assume that they sell the balance of their interests to a corporate subsidiary of the HC. Finally, assume that the HC immediately drops the rolled-over target partnership interests to this subsidiary.
Does the PEF, which is itself a partnership, have an issue if one of its members is a foreign investor (“FI”)?[xxxii]
It very well may.
The HC will be the owner of a partnership interest in the target, albeit for a very short period. This will cause HC to be treated as engaging in the target partnership’s business during such period, as would PEF.[xxxiii] In turn, this will cause FI to be treated as engaging in such business.[xxxiv] As a result, FI will have U.S.-source effectively connected income to the extent of its allocable share thereof. PEF will be required to pay a withholding tax with respect to FI’s allocable share of PEF’s effectively connected income.[xxxv] As importantly, FI will be required to file a U.S. federal income tax return.[xxxvi]
Can these adverse consequences be avoided where the PEF only realizes the issue during the process of acquiring the U.S. target partnership?
One possibility is for the target’s owners to contribute to a newly-formed C corporation (“Corp”), in exchange for all of Corp’s stock, that portion of their target partnership interests that are to be rolled-over to the HC.
Corp’s shareholders would then contribute its stock to the HC in exchange for partnership interests in the HC. Corp’s stock would then be dropped down to the HC’s corporate subsidiary (that purchased the remaining target partnership interests), and liquidated,[xxxvii] causing the target to become a disregarded entity.
The insertion of Corp between the target partnership and the rollover partnership interests of target’s erstwhile owners, and subsequently between the HC and the rolled-over interests in the target, would seem to prevent the HC, PEF and the FI from being engaged in the target’s trade or business.
But what is the impact of this arrangement upon the target’s owners? Will they still obtain tax-deferred treatment for the now indirect exchange of their partnership interests for equity in the HC?
The contribution of the Corp stock to the HC will qualify for tax-deferral as a capital contribution to a partnership.[xxxviii] But what about the contribution of the rollover target partnership interests to Corp?
The contribution of property to a corporation in exchange for stock in the corporation is accorded tax-deferred treatment if the contributor is in control of the corporation immediately after the contribution.[xxxix] Under the principles of the step transaction doctrine, however, where the contributor is obligated before the exchange to dispose of their stock in such a way that they lose control of the corporation, the IRS will ignore the momentary control and treat the exchange as a taxable event to the contributor.
Some have pointed to Rev. Rul. 2003-51 and to PLR 201506008 in support of the proposition that the tax-deferred contribution of property to a corporation in exchange for its stock will not be jeopardized by the pre-ordained transfer of such stock to a partnership as part of another tax-deferred exchange. Unfortunately, this revenue ruling and the PLR are easily distinguished from the scenario described above.
The revenue ruling describes a taxpayer that contributed property to a corporation in exchange for 100-percent of its stock. The taxpayer then contributed this stock to another corporation, to which another person also contributed property, and they both received stock in such second corporation,[xl] with the taxpayer receiving only 40-percent thereof. The IRS recognized that the second contribution in the ruling would normally break control with respect to the first contribution. The IRS disregarded this consequence, however, because the contributing taxpayer could have by-passed the first contribution and gone directly to the second, with the second qualifying as tax-deferred exchange. That this alternative route was available to the contributing taxpayer was key to the IRS’s ruling – the first contribution was not necessary to effect a tax-deferred exchange.[xli] The ruling distinguished earlier IRS rulings – which on similar facts had found a taxable exchange – based on the fact that there was no such alternative exchange available to the contributor in those rulings.
The above PLR is also easily distinguished. It doesn’t even rely on or cite the revenue ruling. Three taxpayers contributed assets to a new corporation in exchange for all of its stock. The same three taxpayers then contributed their stock in the new corporation to a new partnership in exchange for all of its partnership interests. The taxpayers represented that the new corporation would remain in existence and be engaged in a trade or business – it had economic substance. Thus, the new partnership, which was wholly-owned by the three taxpayers, owned all of the new corporation, which was previously owned by the three taxpayers. In other words, the three taxpayers continued to own 100-percent of the corporation, albeit indirectly.[xlii]
Neither the revenue ruling nor the PLR bear any similarity to the issue presented by the situation described above.
What’s more, there is no bona fide, non-tax business reason for the use of Corp. It is being formed for the sole purpose of shielding the FI from tax liability and from having to file tax returns. What’s more, Corp will be liquidated by the HC’s corporate subsidiary shortly after its drop-down to such subsidiary; i.e., its existence is transitory.
In light of the foregoing, the target’s owners may realize nothing but a Pyrrhic victory – a tax-deferred contribution to a partnership (the rollover) that causes the recognition of gain for their preceding contribution to a corporation – if they follow the strategy suggested to accommodate the FIs.
What Is To Be Done?
Answer: The owners of the target partnership should ask that the PEF agree to indemnify them for the amount of the lost tax deferral benefit.
The PEF itself should take measures to ensure that it does not find itself in the same position for future acquisitions. For example, if it cannot ask the FIs to contribute their interest in PEF to a corporate blocker, perhaps it should consider providing an alternative or parallel investment vehicle through which the FIs may acquire an interest in the PEF’s portfolio companies.
What is clear, is that the burden of resolving the issue should not rest with the target company’s owners, with whom the PEF has already agreed to engage in a tax-deferred rollover of a portion of their target equity.
[i] The “end” of a business does not always take the form of a sale to a new owner; indeed, many businesses simply peter out.
[ii] Or at least one related to it.
[iii] Or the potential for value that may be realized with the proper management that the PEF’s team can provide.
[iv] Return on investment.
[v] IRC Sec. 701.
[vi] IRC Sec. 721.
[vii] The rollover also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF has to borrow, or that it already has and would prefer to use for operations or further investment.
[viii] An exception would be the acquisition of all of the membership interests of an LLC that is treated as a partnership for tax purposes. In that case, the buyer is still treated as having purchased the assets of the target LLC, and as taking a cost basis in such assets. Rev. Rul. 99-6, Situation 2.
[ix] IRC Sec. 168(k), Sec. 167, and Sec. 197.
[x] For example, in the case of a target partnership or S corporation, from the sale of assets subject to depreciation recapture under IRC Sec. 1245.
[xi] In the case of a C corporation, under IRC Sec. 11; in the case of an S corporation subject to built-in gains tax, under IRC Sec. 1374. There is no entity level tax in the case of a partnership. IRC Sec. 701.
[xii] IRC Sec. 1221. But see IRC Sec. 741 in the case of the sale of a partnership interest, and its reference to Sec. 751 (regarding “hot assets”).
Also note the application of the tax on net investment income under IRC Sec. 1411 which, in the case of a target S corporation or partnership, may apply to some of the target’s owners and not others, depending upon their level of participation in the business.
[xiii] In this way, the HC’s other subsidiaries and assets may be protected from the liabilities of the business being acquired.
[xiv] If the target is an S corporation, and the parties make an election under IRC Sec. 338(h)(10) to treat the stock sale as a sale of assets instead, the rollover will not yield any tax deferral benefit. In other words, the election is incompatible with a tax-deferred rollover.
[xv] In the case of a corporate target, this will require a distribution of assets by the corporation to its shareholders. Such a distribution would be treated as a sale of the distributed assets by the corporation. IRC Sec. 311(b) or IRC Sec. 336. The distribution may also be taxable to the shareholders. IRC Sec. 301, Sec. 302, or Sec. 331.
[xvi] That’s because they will have to use some of the cash received to satisfy the tax liability arising from the exchange for equity in the HC.
[xvii] IRC Sec. 761, Reg. Sec. 301.7701-3.
[xviii] IRC Sec. 351 and Sec. 368(c). “Control” is defined as 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 of the corporation.
[xix] IRC Sec. 721.
[xx] IRC Sec. 702(a).
[xxi] As ordinary income or as capital gain.
[xxii] IRC Sec. 702(b).
[xxiii] IRC Sec. 741 and Sec. 751.
[xxiv] Rev. Rul. 99-6, Situation 2, explains that, from the buyer’s perspective, the target LLC will be treated as having distributed its assets to its members, from whom the buyer then acquired the assets.
[xxv] IRC Sec. 1012.
[xxvi] In other words, they will pay tax on the gain recognized from the sale, then use some of the after-tax proceeds to invest in the HC.
[xxvii] Reg. Sec. 1.707-3, and IRC Sec. 721.
Assume S transfers property X to partnership HC in exchange for an interest in the partnership. At the time of the transfer, property X has a fair market value of $4,000,000 and an adjusted tax basis of $1,200,000. Immediately after the transfer, HC transfers $3 million in cash to S. The partnership’s transfer of cash to S is treated as part of a sale of property X to the partnership. Because the amount of cash S receives does not equal the fair market value of the property, S is considered to have sold a portion of property X with a value of $3,000,000 to the partnership in exchange for the cash. Accordingly, S must recognize $2,100,000 of gain ($3 million amount realized less $900,000 adjusted tax basis ($1.2 million multiplied by $3,000,000/$4,000,000)). Assuming S receives no other transfers that are treated as consideration for the sale of the property, S is considered to have contributed to the partnership, in S’s capacity as a partner, and on a tax-deferred basis, $1 million of the fair market value of the property with an adjusted tax basis of $300,000. Reg. Sec. 1.707-3(f), Ex. 1.
[xxviii] IRC Sec. 1012.
[xxix] IRC Sec. 723.
[xxx] The HC would then drop down the contributed interest to its subsidiary, following which the subsidiary will own all of the equity in the target partnership, and the target will become a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.
[xxxi] Where the rollover contribution is to the HC in exchange for equity in the HC, and the sale is to a subsidiary of the HC, an election under IRC Sec. 752 should be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the acquiring subsidiary. IRC Sec. 743; Reg. Sec. 1.743-1(g).
[xxxii] A non-U.S. person. IRC Sec. 7701(a).
[xxxiii] Reg. Sec. 1.702-1(b).
[xxxiv] IRC Sec. 875. However, query in the case of an FI from a treaty country whether the permanent establishment requirement would be satisfied.
Previously, PEF’s FI did not have this issue because PEF’s activities, and those of the HC, consisted only of trading in stocks or securities for their own account, which is not treated as a trade or business. IRC Sec. 864(b)(2)(A)(ii). The HC’s only activity consisted of holding the stock of its corporate subsidiary (a C corporation), which effectively acted as a blocker with respect to any actual trade or business activities being conducted by the portfolio companies; only when the corporation paid dividends to the HC did the foreign members have U.S. income; moreover, these dividends may have qualified for a reduced U.S. tax rate depending on the jurisdiction of the FI and whether there was a tax treaty with the U.S.; in the absence of a treaty, the dividends would be subject to 30% U.S. tax on the gross amount thereof. Finally, assuming the sale of the FI’s interest in PEF generated only capital gain, it would not be subject to U.S. income at all.
See IRC Sec. 864(c)(8) – enacted as part of the Tax Cuts and Jobs Act – with respect the taxation of the gain from the sale of an interest in a partnership engaged in a U.S. trade or business.
[xxxv] IRC 1446.
[xxxvi] Reg. Sec. 1.6012-1(b), Reg. Sec. 1.6012-2(g).
[xxxvii] Under IRC Sec. 332, on a tax-deferred basis.
[xxxviii] IRC Sec. 721.
[xxxix] IRC Sec. 351.
[xl] As the “control group.”
[xli] Query why the taxpayer acted as they did – was the first contribution made in error?
[xlii] Compare this to the target partnership’s former owners who are receiving only a small interest in the HC.
See also Reg. Sec. 1.368-1(d), which addresses the continuity of business enterprise requirement for a tax-free reorganization (not a Sec. 351 transaction) where the assets acquired by the acquiring corporation are contributed to a partnership. Although not directly on point, it conveys the IRS’s thinking in a situation that, like a Sec. 351 exchange, considers whether the transferor-taxpayer’s relationship to, or form of ownership of, the assets it has transferred has changed to a degree that warrants taxation. Each partner of the partnership is treated as owning (in accordance with their partnership interest) the partnership assets used in a business. The issuing corporation is treated as conducting the business of the partnership if the corporation owns an interest in the partnership that represents a significant interest in the partnership business, or if the corporation has active and substantial management functions as a partner with respect to the partnership business; between 20-percent and 33.3-percent of the partnership is enough if the corporation performs substantial management functions.
More than one-third suffices if the corporation has no management functions in the partnership. See examples 14 and 15 of Reg. Sec. 1.368-1(d) for illustrations of situations that involve the transfer of acquired stock to a partnership.