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

Equity Rollovers in M&A Transactions

Negotiating and Structuring Rollovers; Tax Considerations for Buyers and Sellers

WEDNESDAY, NOVEMBER 30, 2022

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

Today’s faculty features:

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

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

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 Equity Rollovers in M&A
Transactions

November 30, 2022

Ted Wern
Partner (Chicago)
Perkins Coie LLP
 Profile and Assumptions

▪ 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

6 Perkins Coie LLP | [Link]

 Purpose of Rollover Equity

▪ Alignment of incentives
▪ Continuity of management
▪ Competitive advantage for buyer (vs
strategic acquirer)
▪ “Second kick at the can” for Seller

7 Perkins Coie LLP | [Link]

 Mechanics and Economic Terms

▪ 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

8 Perkins Coie LLP | [Link]

 Minority Approval Rights

▪ Fundamental Rights:
▪ “Pari passu” treatment
▪ Preemptive rights
▪ Affiliate transactions (arm’s length)
▪ Amendment to transaction documents
▪ Wish List:
▪ Acquisitions/divestitures
▪ Strategic matters
▪ Debt/equity issuance
▪ Other operational items
9 Perkins Coie LLP | [Link]
 Liquidity Rights/Restrictions

▪ Sanctity of the exit to buyer/PE fund

▪ Put/Call Rights
▪ Transfer restrictions
▪ Drag/tag along rights

10 Perkins Coie LLP | [Link]

 Other Key Terms

▪ Repurchase rights upon termination/other

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

11 Perkins Coie LLP | [Link]

 Questions and Contact Info

Questions?

Contact info:
Ted Wern
twern@[Link]
Direct Dial: 312-324-8606

12 Perkins Coie LLP | [Link]

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 2022: To Defer
or Not to Defer?
◼ Benefit of deferral is timing
◼ Economic benefit is NPV of after-tax return
on deferred tax amount
◼ Near-term tax rate increases are unlikely
given results of 2022 mid-term elections; BUT
◼ Increasing deficits and political uncertainty
may lead to rate increases in the future.
◼ As rates increase, the benefit of deferral
decreases.
16
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

17
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
18
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.
19
§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

20
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.”
21
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
◼ Management Shareholders
reinvest 10% of the overall Shareholders
proceeds in Parent LLC on an
after-tax basis.
Parent,
◼ No 338(h)(10) Election can be
made. Buyer is a related party
LLC
to Target S Corporation
because Parent LLC is
$$
deemed to own all of the stock 100%
owned by Management
Shareholders; and Buyer Inc.
is deemed to own stock
deemed owed by Parent LLC Buyer, Inc.
(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 Target S Corp.
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. Qualified Stock
Purchase

22
S Corporation “Drop and Check” F Reorganization

Steps/Actions
1. The Owners of Target S
Corporation (“Target”) contribute
all of the outstanding stock of
Target to a newly formed
Owners
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 Seller Newco, Inc.
Subchapter S subsidiary (“Qsub”) (DE S Corp.)
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) [Conversion]/
[Merger] [TARGET],
[TARGET], Inc.
5. Purchaser acquires Target LLC. LLC
Treated as a purchase of (DE S Corp.)
(DE LLC)
substantially all of the assets of
Seller Newco/Target LLC.

23
Asset Sale/Asset Drop-Kick

Target S Corporation Target S Corporation

100% of Acquired
Target LLC Assets/Assumed
Liabilities

Operating Assets

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.

24
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.

25
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.

26
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.

27
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)

28
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.

29
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.”

30
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).
31
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 Parent LLC
corporation allows for
corporate transactions
that meet control.
◼ Rollover into LLC is tax-
deferred under §721.
Contribution by LLC to its Buyer C Corporation
wholly owned corporate
subsidiary meets the
control requirements of
§351.
◼ Is the Parent LLC really a
“partnership” under §761?

32
Issue #2 §351(b) “Boot” Example
Management Seller
◼ Management Seller owns
target equity with tax basis of
$20 and value of $100. Buyer
◼ Buyer to purchase 100% of Sponsor
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. Buyer, Inc.
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.”

33
Eliminating Boot Through Subsidiary Bifurcation
◼ Buyer Parent issues Rollover Equity in
exchange for 20% of Target Equity.
Management Seller
◼ Buyer Parent issues 80% equity to Buyer
Sponsor in exchange for cash purchase
price.
◼ Buyer Parent contributes cash purchase Buyer
price to Buyer, Inc. Sponsor
◼ 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
Buyer Parent, Inc.
to Buyer, Inc. there may be risk of IRS
challenge/recharacterization.
◼ Purchase by Buyer, Inc. can potentially $Purchase Price
qualify as a “qualified stock purchase” or 100%
“qualified stock disposition” for purposes of
§338(h)(10)/ §336(e).
❑ Related party bar ought not apply here, as
downstream attribution of ownership to Buyer, Inc.
corporations requires more than 50%
ownership.

34
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.

35
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.

36
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.

37
Contact Information

Michael P. Spiro
mspiro@[Link]

Theodore W. (Ted) Wern

twern@[Link]