Equity Rollovers in M&A Transactions

Equity Rollovers in M&A TransactionsNegotiating and Structuring Rollovers; Tax Considerations for Buyers and Sellers

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.

WEDNESDAY, OCTOBER 27, 2021

Presenting a live 90-minute webinar with interactive Q&A

Michael P. Spiro, Partner, Finn Dixon & Herling LLP, Stamford, CT

Theodore W. (Ted) Wern, Partner, Perkins Coie LLP, Chicago, IL

Tips for Optimal Quality

Sound QualityIf you are listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection.

If the sound quality is not satisfactory, you may listen via the phone: dial 1-877-447-0294 and enter your Conference ID and PIN when prompted. Otherwise, please send us a chat or e-mail [email protected] immediately so we can address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing QualityTo maximize your screen, press the ‘Full Screen’ symbol located on the bottom right of the slides. To exit full screen, press the Esc button.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your participation in this webinar by completing and submitting the Attendance Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926 ext. 2.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please complete the following steps:

• Click on the link to the PDF of the slides for today’s program, which is located to the right of the slides, just above the Q&A box.

• The PDF will open a separate tab/window. Print the slides by clicking on the printer icon.

Recording our programs is not permitted. However, today's participants can order a recorded version of this event at a special attendee price. Please call Customer Service at 800-926-7926 ext.1 or visit Strafford’s website at www.straffordpub.com.

FOR LIVE EVENT ONLY

http://www.straffordpub.com/

Perkins Coie LLP

Equity Rollovers in M&A Transactions

October 27, 2021

Ted WernPartner

Perkins Coie LLP | PerkinsCoie.com6

Closely Held Private Company “Main Street” not “Wall Street” Continuity of Business and Management

after Closing Platform investment, not add-on

investment to existing operating company Rollover equity, not management

“incentive” equity

Profile and Assumptions

Perkins Coie LLP | PerkinsCoie.com7

Alignment of incentives Continuity of management Competitive advantage for buyer (vs

strategic acquirer) “Second kick at the can” for Seller

Purpose of Rollover Equity

Perkins Coie LLP | PerkinsCoie.com

Mechanics and Economic Terms

8

How does the rollover occur? Impact on other M&A terms/agreements Intended tax treatment Economic terms “pari passu” Impact of buyer leverage Dividends/distributions

Treatment of PE fund management fees


Minority Rights

9

Basics: Pari passu treatment Preemptive rights Affiliate transactions (arm’s length) Amendment to transaction documents

More Controversial: Acquisitions/divestitures Strategic matters Debt/equity issuance Other operational items


Liquidity Rights

10

Sanctity of the exit to buyer/PE fund Put/Call Rights Transfer restrictions Drag/tag along rights


Other Key Terms

11

Repurchase rights upon termination/other events

Non-compete/confidentiality restrictions Board/observer rights Tax distributions


Questions and Contact Info

12

Questions?

Contact info: Ted [email protected] Dial: 312-324-8606

mailto:[email protected]

FINN DIXON & HERLING LLP

TAX CONSIDERATIONS FOR EQUITY ROLLOVERS IN M&A TRANSACTIONS

13

Outline

Basic Deal Objectives To Defer or Not to Defer? Common Transaction Types Structuring the Rollover

14

Basic Deal Objectives

Buyer Objectives: Maximize tax attributes

Basis step-up where available Continued engagement by management team

Rollover of equity Potential incentive equity awards

Tax-deferred rollover generally reduces aggregate basis step-up.

Seller/Management Objectives: Maximize after-tax proceeds Continued up-side participation Tax deferral?

15

Management Rollovers in 2021: To Defer or Not to Defer? Benefit of deferral is timing Economic benefit is NPV of after-tax return on

deferred tax amount Deferral in an environment of rising tax rates:

Assumptions: 2021 long-term capital gains tax rate= 20% 2022-2026 long-term capital gains tax rate=28% (per House

Ways and Means Committee proposal including 3% sur-tax on income over $5 million)

Management reinvestment = $100. Pre-deal tax basis=0. Investment is held for 5 years.

16

Benefit (Detriment) of Deferral at Different Valuations

After-Tax Investment Tax-Deferred Rollover

Initial Investment Amount $100 $100

Initial Tax Amount ($20) 0

Net Investment $80 $100

Exit Proceeds $244 $305

IRR on Investment 25% 25%

Tax on Exit Proceeds ($45.92) ($85.40)

Total After-Tax $198.08 $219.60

Economic Benefit (Detriment) of Deferral: NPV of Difference (@Investment IRR)

$7.05

17

After-Tax Investment Tax-Deferred Rollover

Initial Investment Amount $100 $100

Initial Tax Amount ($20) 0

Net Investment $80 $100

Exit Proceeds $126 $157

IRR on Investment 9.5% 9.5%

Tax on Exit Proceeds ($12.88) ($43.96)

Total After-Tax $113.12 $113.04

Economic Benefit (Detriment) of Deferral: NPV of Difference (@Investment IRR)

($0.08)

Common Middle Market Transactions

Target is an S corporation Target is an LLC taxed as a partnership Target is a C corporation_____________________________________ Buyer is an LLC taxed as a partnership Buyer is a newly formed C corporation Buyer is an existing C corporation Buyer is an existing or newly formed C

corporation wholly owned by an LLC taxed as a partnership

18

Target is an S corporation

Stock Sale No basis step-up, possible tax-deferred rollover

§338(h)(10) or §336(e) Election Basis step-up, no tax-deferred rollover, possible

after-tax reinvestment “Drop and Check” F Reorganization Basis step-up, possible tax-deferred rollover

Asset Sale/Asset “Drop Kick” Basis step-up, possible tax-deferred rollover

19

S corporation stock sale

Purchaser acquires 100% of the stock of the S corporation.

Unless purchaser is also an S corporation (or an eligible S corporation shareholder (e.g. US individual or certain trusts or estates), target ceases to be an S corporation.

If purchaser and/or transaction structure allows for tax-deferred rollover, shareholders can exchange shares for buyer equity on a tax-deferred basis.

20

§338(h)(10)/§336(e) Election Target is deemed to have sold 100% of its

assets and liquidated §338(h)(10)

Requires corporate purchaser “Qualified Stock Purchase”

Acquisition by purchase of at least 80% of equity No post-closing related parties (318) Non-purchased stock is treated as purchased in a taxable

transaction for its FMV.

§336(e) No corporate purchaser required Qualified Stock Disposition

Similar to qualified stock purchase

21

The § 338(h)(10)/ § 336(e) Partnership Reinvestment Trap No Qualified Stock Purchase or Qualified Stock

Disposition from “a person the ownership of whose stock would, under section 318(a) (other than paragraph (4) thereof), be attributed to the person acquiring such stock.”

§318(a)(3)(A): To Partnerships And Estates —Stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate shall be considered as owned by the partnership or estate.

§336(e) Regulations limit 318(a)(3)(A) to attribution from partners owning at least 5% by value for purposes of “Qualified Stock Disposition.”

22

Example Buyer, Inc. is owned 100% by

Parent LLC (taxed as a partnership)

Buyer acquires 100% of Target S Corporation for cash from Management Shareholders (who collectively own 100%).

Management Shareholders reinvest 10% of the overall proceeds in Parent LLC on an after-tax basis.

No 338(h)(10) Election can be made. Buyer is a related party to Target S Corporation because Parent LLC is deemed to own all of the stock owned by Management Shareholders; and Buyer Inc. is deemed to own stock deemed owed by Parent LLC (due to downward attribution to more than 50% owned corporation (§318(a)(3)(C)).

A 336(e) Election may be possible if at least 80% of Target S Corporation is purchased from Management Shareholders who own less than 5% each of Parent LLC after the transaction.

336(e) Regulations eliminate Partnership attribution from partners who own less than 5% of partnership value.

23

Parent, LLC

Buyer, Inc.

Target S Corp.

Management Shareholders

100% $$

Qualified Stock Purchase

Steps/Actions1. The Owners of Target S

Corporation (“Target”) contribute all of the outstanding stock of Target to a newly formed Delaware S corporation, Seller Newco, Inc. (“Seller Newco”) in exchange for all of the stock of Seller Newco.

2. Seller Newco elects for Target to be treated as a qualified Subchapter S subsidiary (“Qsub”) on the date of the contribution.

3. Target will then [convert]/[merge] into a limited liability company, (“Target LLC”).

4. Treated as an F Reorganization; Target LLC retains its EIN (Rev. Rul. 2008-18)

5. Purchaser acquires Target LLC. Treated as a purchase of substantially all of the assets of Seller Newco/Target LLC.

S Corporation “Drop and Check” F Reorganization

Owners

[TARGET], Inc.(DE S Corp.)

Seller Newco, Inc.(DE S Corp.)

[Conversion]/ [Merger]

24

[TARGET], LLC

(DE LLC)

Asset Sale/Asset Drop-Kick

25

Target S Corporation

Operating Assets

Target S Corporation

Target LLC

Acquired Assets/Assumed Liabilities

100% of Target LLC

• Either Target S corporation sells assets (subject to assumed liabilities) to buyer; or• Target S corporation contributes assets (subject to assumed liabilities) to a newly formed LLC; and sells LLC

interests to buyer (a “Drop-Kick”)• Can avoid sales and use tax in states that do not have an exemption for casual or isolated sales. • Like in an actual asset sale, liabilities can be retained by Target S Corporation as a matter of state law.

Tax Treatment of S Corporation Sale Structures Sale of stock without §338(h)(10) election or §336(e)

election is treated as a sale of stock by the shareholders. Management shareholders can roll over disproportionately.

Sale of stock with §338(h)(10) election or §336(e) election is treated as a purchase and sale of 100% of S corporation assets in a fully taxable transaction.

Drop and Check F Reorg, Asset Sale and Drop Kick are all treated as a sale of assets by the S corporation target, but Target S corporation can roll over. Rollover is only tax-deferred to the extent shared pro-rata

by S corporation shareholders.

26

LLC/Partnership Target

If Buyer is an LLC/Partnership, acquisition will generally be treated as a partnership merger or continuation.

Parties may elect to treat seller cash proceeds as proceeds of the sale of a partnership interest prior to the merger (rather than as a cash payment to the partnership followed by disproportionate distribution).

If Buyer is a C corporation, acquisition will usually be treated as a partnership termination under Rev. Rul. 99-6. Buyer is treated as acquiring assets; sellers are treated as having sold partnership interests.

Rollover is generally possible depending on Buyer structure.

27

Target is a C corporation

Similar to S corporation stock sale. If Buyer is a C corporation, tax year of Target

will generally end on the Closing Date and it will enter a new consolidated group.

Generally no §338(h)(10)/ §336(e) opportunity unless Target is a subsidiary member of a consolidated group. In that case, tax-free rollover will not be possible.

28

Tax-Deferred Rollover Most common statutory bases for tax-deferred

rollover: §721 §351

Less common (limited to C corporation transactions with significant equity component): §368(a)

Newly Popular: Up-C structure for acquisition of Target LLC by public

company Buyer (especially SPACs)

29

Rollovers under §721 §721(a): No gain or loss shall be recognized to a partnership or

to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

Where Buyer’s structure is either a flow-through LLC, or is a C corporation owned by an LLC taxed as a partnership (which is the issuer of the rollover equity), rollover can generally qualify as tax-deferred under §721.

In some cases in which a newly formed LLC Buyer (taxed as a partnership) acquires an LLC Target taxed as a partnership, the transaction will be treated as a “partnership continuation.” As a technical matter, in that case, the rollover equity is treated as a

retained interest rather than a tax-free transaction under §721(a) (though the overall effect is the same).

Where Buyer is a partnership, basis step-up can often be specially allocated to Buyer sponsor (either by §743(b) adjustment or under §704(c)) so that reduction in step-up caused by tax-deferred rollover is borne by rollover equityholders.

30

Rollovers under §351—Corporate Purchaser §351(a): “No gain or loss shall be recognized if property is

transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.”

§351(b): Receipt Of Property — “If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock permitted to be received under subsection (a), other property or money, then gain (if any) to such recipient shall be recognized, but not in excess of the amount of money received, plus the fair market value of such other property received; and no loss to such recipient shall be recognized.”

31

Issue #1 Control

Transferors in exchange for stock must own 80% or more of the stock after the exchange.

For newly formed corporation, control will generally be met, as Buyer sponsor/shareholders and rollover sellers together constitute a “control” group.

For add-on or strategic acquisitions, control is only met if existing shareholders make meaningful follow-on investments in exchange for stock (or if Target is meaningfully more valuable than Purchaser).

32

Avoiding Problems with Control

§721 does not require control, while §351 does.

Using an LLC taxed as a partnership as the ultimate parent (and 100% owner) of a lower tier C corporation allows for corporate transactions that meet control.

Rollover into LLC is tax-deferred under §721. Contribution by LLC to its wholly owned corporate subsidiary meets the control requirements of §351.

Is the Parent LLC really a “partnership” under §761?

33

Parent LLC

Buyer C Corporation

Issue #2 §351(b) “Boot” Example

Management Seller owns target equity with tax basis of $20 and value of $100.

Buyer to purchase 100% of target equity for $80 in cash plus $20 of Rollover Equity (20% of Buyer).

Buyer Sponsor acquires 80% of Buyer stock for $80.

Contribution of target equity for Rollover Equity qualifies as tax-deferred under §351.

However, gain is recognized to the extent of the cash received by Management Seller in the transaction.

Accordingly, all $80 of cash is recognized as taxable. Rollover Equity retains $20 of tax basis.

No tax deferral. If target is an S corporation,

the purchase will not be eligible for a §338(h)(10) election or §336(e) election, as acquisition via §351 transaction is not considered a “purchase.”

34

Buyer, Inc.

Buyer Sponsor

Management Seller

Eliminating Boot Through Subsidiary Bifurcation

Buyer Parent issues Rollover Equity in exchange for 20% of Target Equity.

Buyer Parent issues 80% equity to Buyer Sponsor in exchange for cash purchase price.

Buyer Parent contributes cash purchase price to Buyer, Inc.

Buyer Inc. acquires 80% non-Rollover Equity from Management Seller.

Rollover exchange is fully tax-free. 20% of basis ($4) is allocated to Rollover Equity.

Purchase of 80% of Target equity by Buyer, Inc. is treated as a separate transaction. $16 of basis is allocated to sale, resulting in gain recognition of $64.

$16 of gain is tax-deferred. If rollover equity is immediately contributed

to Buyer, Inc. there may be risk of IRS challenge/recharacterization.

Purchase by Buyer, Inc. can potentially qualify as a “qualified stock purchase” or “qualified stock disposition” for purposes of §338(h)(10)/ §336(e). Related party bar ought not apply here, as

downstream attribution of ownership to corporations requires more than 50% ownership.

35

Buyer, Inc.

Buyer Parent, Inc.

Buyer Sponsor

$Purchase Price100%

Management Seller

S Corporation Target and Rollovers under §721(a) and §351 Other than in a stock sale with no 338(h)(10) or 336(e)

election, rollover equity is issued to selling S corporation to be shared pro-rata by S corporation shareholders.

If rollover equity is distributed by the S corporation seller, tax deferral will end under §311(b) or, in the case of a liquidation, §331

If rollover is disproportionate to pre-transaction stock ownership, the rollover will only be tax-deferred to the extent of the rolling members’ pre-transaction stock ownership percentage. This can be cured in some transactions by paying a bonus equal

to the NPV of the lost earnings on the deferred tax amount.

36

Tax-Free Reorg

Applies to acquisitions by corporations of corporations.

Minimum equity consideration of 40% for “A” Reorganization.

Less frequently used in middle market transactions, but can be considered for tax-free rollover in certain situations.

37

Up-C Public corporation buyer (often a SPAC). LLC taxed as a partnership is target. Stock issued in the acquisition will not meet “control” under §351. Stock issued in the acquisition will be illiquid for a “lock-up”

period and then can be sold in public market. Instead of immediate acquisition, rollover equity is retained by

rollover sellers. Rollover sellers have a “put” right to exchange retained equity for

a fixed amount of public company stock after lock-up term has passed.

In some cases, public buyer will also have a call right to compel exchange.

Allows for deferral of tax event until stock is marketable. In some cases, “tax receivables agreement” will provide

additional consideration for public company basis step-up acquired on purchase of retained equity.

38

Contact Information

Michael P. Spiro

[email protected]

Theodore W. (Ted) Wern

[email protected]

Equity Rollovers in M&A Transactions

Documents

Transcript of Equity Rollovers in M&A Transactions