Roll-Over: Tax Issue
Picking up on yesterday’s discussion, how can a PEF reconcile its preference to acquire a depreciable or amortizable basis for its target’s assets while, at the same time, affording the target’s owners the opportunity to roll-over a portion of their equity in the target into the PEF HC on a tax-favored basis? The answer is hardly simple, and it will depend upon a number factors.
The following discussion will consider some of these factors in the context of various scenarios. In each case, it is assumed that the acquisition will be structured to give the PEF a depreciable or amortizable basis for the acquired assets; that the target or its owners, as the case may be, will acquire an equity interest in the PEF’s HC (the roll-over that will allow them to participate in the growth of the PEF’s other portfolio companies); and that such equity interest shall not exceed 50% of the HC’s equity (thus ensuring capital gain treatment where otherwise available).
Target “C” Corporation
Where the target is a “C” corporation, the sale of its assets will be taxable to the corporation, and the corporation’s distribution of the after-tax proceeds to its shareholders will generate a second layer of tax (albeit as capital gain) to the shareholders (a combined tax rate of almost 50% at present). The shareholders may then invest some portion of their after-tax proceeds in the PEF HC in exchange for an equity interest therein.
In this case, the only way for the target’s owners to enjoy a tax-free, but indirect, roll-over of a portion of their equity into the PEF is by having the target contribute some of its assets to the PEF’s HC in exchange for an equity interest therein, while selling the balance of the assets for cash.
In general, provided the PEF’s HC will be treated as a tax partnership, the contribution of assets to the HC in exchange for a partnership interest therein will not be taxable to the target corporation. (An exception to this nonrecognition rule would apply if the HC assumes liabilities of the target’s business, or takes assets subject to such liabilities, and the contributing corporation’s allocable share of the HC’s liabilities after the contribution is less than the amount of the liabilities assumed or taken subject to) another exception to nonrecognition may apply where the liabilities were incurred in anticipation of the transaction.
However, if the PEF’s HC is a corporation, the target corporation’s contribution of assets to the HC’s capital in exchange for shares of stock therein will be treated as a taxable disposition of its assets unless the target corporation is treated as part of a so-called “control group.” This would be a group of persons (including the PEF) that, acting “in concert,” contributed assets to the HC in exchange for stock in the HC, and that was in “control” of the HC immediately afterwards.
Of course, not all of the target shareholders may want to participate in the roll-over to the PEF’s HC. In that case, the target corporation may have to redeem those shareholders, thus limiting the amount of cash that may be reinvested.
Moreover, some PEFs may insist that only individual shareholders, rather than the target corporation, hold equity in the HC. In that case, a contribution by the target corporation may not be permitted, or may have to be followed by a liquidating distribution to its shareholders. Such an in-kind distribution would be treated as taxable sale by the corporation, thus defeating the sought-after tax deferral benefit.
Target “S” Corporation
If the target corporation is an “S” corporation, it may sell its assets to the PEF HC without incurring a corporate-level income tax (provided the target is not subject to the built-in gains tax). Of course, the gain realized on the sale of the target’s assets will flow through and be taxable to its shareholders. Depending upon the nature of the assets sold, the gain may be taxed as ordinary income or as capital gain.
As in the case of a C corporation, the S corporation may distribute the net proceeds from the sale of its assets to its shareholders, who may then invest a portion of their after-tax proceeds in the PEF’s HC.
Alternatively, if the sale of the S corporation’s business is effected through an acquisition of at least 80% of its stock for cash, coupled with an election to treat the stock sale as a sale of assets for tax purposes, the target shareholders may contribute their remaining shares to the PEF’s HC as a capital contribution. Unfortunately, this capital contribution will not generate any tax deferral benefit for the shareholders because they will still have to recognize all of the gain inherent in the target’s assets by virtue of the deemed asset sale election.
If the only way in which the shareholders of the S corporation target may roll over a portion of their investment on a tax-free basis is for the S corporation itself to make a capital contribution to the HC, then regardless of whether the HC is a corporation or a LLC, then they will have to consider the same issues as described above for a C corporation.
A sale of assets by a target partnership to a PEF HC in exchange for cash will be taxable to the target’s owners. As in the case of an S corporation, the nature of the gain taxed to the owners will depend upon the nature of the assets sold.
Alternatively, the owners of a target partnership may sell all of their partnership interests to the PEF, or to its acquisition subsidiary. A sale of 100% of the partnership interests will be treated, for tax purposes, as sale of the target’s assets, thus providing the PEF with a depreciable or amortizable basis in such assets.
In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the PEF or subsidiary, they will have to do so with after-tax dollars.
In order to roll-over a portion of its equity into the HC on a tax-advantaged basis, the target partnership will have to contribute some of its assets to the HC, or the target owners will have to contribute some of their partnership interests to the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by either the target or its owners. The PEF will acquire a depreciable or amortizable basis for the assets acquired for cash. The same result may be achieved where interests in the target partnership are sold to the HC for cash while the remaining interests are contributed to the HC as capital. 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 (though a protective election may also be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the HC).
If the PEF’s HC is a corporation, however, then the target partnership and its owners face the same issues with respect to their capital contributions to the HC as were described earlier in the case of a corporate target – they will need to be treated as part of a “control group.”
Before the LOI
The foregoing discussion should provide potential parties to a PEF acquisition transaction with some insight into their respective structural and tax preferences. It should also give them an understanding of the tax and economic consequences they will have to consider in negotiating such a transaction.
Armed with this information, they may consider how best to structure the target or the acquisition vehicle so as to minimize any negative tax consequences that may arise out of a roll-over (for example, making an “S” corporation election as early as possible for a potential target corporation, or substantiating the existence and value of personal goodwill).
Where a structural solution is not feasible, the parties should consider a “gross-up” to the purchase price for the depreciable or amortizable assets to be acquired, so as to leave the target’s owners in the same after-tax position in which they would have been had their roll-over been completed on a tax-free basis.
As always, it will behoove the parties to be aware of these considerations and to plan for them well before executing a letter of intent, let alone a purchase and sale agreement. Such preparation will facilitate negotiations and completion of the sale and acquisition of the business.