Down to the Wire?
“I have wondered at times what the Ten Commandments would have looked like if Moses had run them through the U.S. Congress.” – Pres. Ronald Regan
That line probably describes the exasperation with which many Americans are observing the behavior of their representatives in Congress these last few weeks.
At this point, a number of folks are wondering whether the eviscerated version of the legislation proposed by the Administration in April of this year, and passed by the House last month[i], will be enacted into law before the end of this year, early next year, or not at all.
Regardless of what happens with the President’s Build Back Better plan, those business owners who had already decided to complete the sale of their businesses before the year-end are proceeding as planned – they’re not taking any chances with the Democrats still seeking to enact significant tax increases[ii]; then there are those few owners who have reluctantly agreed to defer their sales into January because of factors related to their buyers[iii], and out of the owners’ control, though in some instances these owners have succeeded in extracting concessions from buyers (for example, a promise to pay a gross-up) as compensation for the increased income tax risk to which the owners are being exposed on account of the delay.[iv]
Skin in the Game
As we have discussed in earlier posts, many of the buyers to which closely held businesses have been, or are being, sold this year-end are well-funded private equity firms that are looking for portfolio companies with potential for growth.
A key component in the package of consideration offered by most such firms is in the form of equity in the acquiring entity itself or in the acquiring entity’s parent company, where its investors reside.
From the perspective of the private equity buyer, it is less expensive to issue equity than to pay cash to the owners of a target business – the buyer does not have to raise more capital from its investors, and it does not need to incur more indebtedness.
The issuance of equity also seeks to align the interests of the former owners – who are usually hired to run the target business during some post-acquisition transition period – with those of the buyer and its investors; it ensures that the former owners of the target have “skin in the game”[v]; if the business does well – in part, presumably, because of their efforts – so will the former owners; if it doesn’t, well, that’s how it goes.
Tax Deferral
From the perspective of the former owners of the target business, the receipt of equity in the acquiring company provides an opportunity to participate in the continued growth of the business.
Perhaps just as importantly, the receipt of equity in the buyer or in its parent may allow the former owners to defer recognition and, thus, taxation of some of the gain realized in the disposition of their business.[vi]
“Tax deferral” – a term that is often used interchangeably by business owners with “tax-free” – are two words that often delight the owner of a business who is considering its disposition.[vii]
Yes, “tax free” can be a great result for a transfer (rollover) of property from one business into another. However, such a transfer is not really free of tax in the sense of never being taxed; rather, it defers the recognition, and the resulting taxation, of the gain inherent in the asset being transferred.
It is important that the business owner recognize the distinction.
Gain Recognition
When a taxpayer disposes of property, the amount of gain they realize is measured by the difference between the amount realized – generally, the amount of cash plus the fair market value (“FMV”) of the property received by the taxpayer – over their adjusted basis for the property transferred.
Where the property received by the taxpayer is not of a kind that the Code views as a “continuation” of the taxpayer’s investment in the disposed-of property, the taxpayer must recognize and pay tax on the gain realized. This is what occurs, for example, when a taxpayer exchanges one property for another property that is not of like kind to the first (for example, cash).
Continuing the Investment
So, what kind of property must a taxpayer receive in exchange for the property they are giving up in order to make the exchange “tax free”?
Most business owners are familiar with the “like kind exchange” transaction by which a taxpayer exchanges of one real property for another, assuming both are, and will be, held by the taxpayer for use in a trade or business or for investment.[viii]
Many business owners are also familiar with the tax treatment of a contribution of property by a taxpayer to a corporation in exchange for shares of stock in the corporation.[ix] In general, if the taxpayer does not receive any cash or other property in the exchange and is “in control” of the corporation[x] immediately after the exchange, the taxpayer’s exchange of the property will not be treated as a taxable event.
A similar rule applies in the case of a contribution of property to a partnership in exchange for a partnership interest.[xi] Generally speaking, such a property transfer will not be treated as a taxable event, even if the taxpayer receives a less-than controlling interest in the partnership.[xii]
Preserving the Gain
In recognition of the fact that the taxpayer in each of the above examples of “tax free” exchanges is continuing their investment in the business, albeit in a different form, the taxpayer’s adjusted basis for the equity interest they receive will be the same basis that the taxpayer had in the property transferred.[xiii]
Similarly, the business entity to which a contribution of property is made, in exchange for an equity interest therein, will take the contributed property with a basis equal to the basis that the contributing taxpayer had in the property at the time of the contribution.[xiv]
Thus, the gain inherent in the property exchanged by the taxpayer for equity in a business entity is preserved in the equity received by the taxpayer in the exchange; it is also preserved in the hands of the business entity.
Receipt of Cash
The foregoing discussion contemplates a situation in which a taxpayer does not also receive cash (or other property not of “like kind”) in connection with the transfer of their property to a business in exchange for equity in the business.
However, a taxpayer will often want to monetize some portion of their investment in the transferred property – to take some money (and risk) off the table – rather than limit themselves to receiving only an illiquid minority equity interest in another business.
In that case, because the taxpayer is partially “discontinuing” their investment in the transferred property (by receiving cash), the taxpayer is required to recognize some gain. As stated by the IRS, “the gain . . . realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income . . . sustained.”[xv]
Contribution to a Corporation
In the case of a contribution of property to a corporation in exchange for stock therein, as part of what is otherwise a tax-deferred exchange, the taxpayer must recognize an amount equal to the lesser of the amount of cash received from the corporation or the amount of gain realized by the taxpayer in the exchange.[xvi]
Thus, if the amount of cash received by the taxpayer is less than the gain realized on the transfer of the property to the corporation, the taxpayer will recognize a portion of the gain realized, up to the amount of cash received; the rest of the gain realized will continue to be deferred.
Where the amount of cash received is equal to or greater than the gain realized on the transfer of the property, then the entire gain realized must be recognized by the taxpayer.
The import of this result should not be underestimated. For example, what if the taxpayer were to divide their transfer into two parts: the first, a capital contribution to a parent company in exchange for equity, followed by a sale to the parent’s subsidiary in exchange for cash?[xvii]
Contribution to a Partnership
The analysis is somewhat different in the case of a partnership.
In that context, the IRS is concerned that a taxpayer will try to treat the contribution of property and the payment of cash as two separate events: a tax deferred contribution (not a sale) of property to a partnership that is followed by a current distribution of cash by the partnership.[xviii] Congress foresaw this possibility.
However, unlike the legislative “fix” for contributions to a corporation, described above, the Code’s partnership tax provisions do not have a rule equivalent to the “recognition of gain to the extent of cash received.”
Instead, the contribution of property to a partnership in exchange for a partnership interest plus cash is treated as two transactions: a sale in which property with a FMV equal to the amount of cash paid by the partnership is treated as having been sold to the partnership (under the so-called “disguised sale” rules[xix]), and a contribution of the remaining FMV of the property to the partnership in exchange for a partnership interest.[xx]
The gain to be recognized by the taxpayer is determined by allocating the taxpayer’s basis in the property transferred to the partnership between the sale portion and the contribution portion of the transaction, based upon their relative share of the total consideration.[xxi]
Some Examples
Assume that Property has a FMV of $100, and an adjusted basis in the hands of Taxpayer of $40.
If Property were sold in exchange for $100 of cash, Taxpayer would realize and recognize $60 of gain ($100 minus $40).
Same facts, except Taxpayer contributes Property to a corporation in exchange for $100 worth of stock therein in a transaction that satisfies the criteria for “tax free” treatment. Taxpayer realizes $60 of gain ($100 of stock over $40 basis), but because Taxpayer receives only stock of the transferee controlled corporation, none of the gain is recognized. Taxpayer takes the stock with a basis of $40 (preserving the $60 of unrecognized gain).
Same facts, except Taxpayer receives $70 of stock and $30 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($30) or the gain realized ($60). Thus, Taxpayer must recognize $30 of gain. Taxpayer takes the stock with a basis equal to their basis in Property ($40), less the amount of cash received ($30) plus the amount of gain recognized ($30), or $40. Thus, $30 of the unrecognized gain inherent in Property is deferred ($70 FMV stock over $40 basis.)
Same facts, except Taxpayer receives $20 of stock and $80 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($80) or the gain realized ($60). Thus, Taxpayer must recognize the entire $60 of gain realized notwithstanding they also received equity in the corporation. Taxpayer takes the stock with a basis equal to their basis in Property ($40), less the amount of cash received ($80) plus the amount of gain recognized ($60), or $20 (the same value as the stock received; there is no gain to defer).
Same facts, except Taxpayer contributes Property to Partnership in exchange solely for a partnership interest. Taxpayer takes their partnership interest with a basis of $40 (their basis in Property), and Partnership takes Property with a basis of $40.
Same facts, except Taxpayer receives a $70 equity interest in Partnership, plus $30 of cash. Taxpayer is treated as having sold a $30 portion of Property, and as having contributed a $70 portion. The gain to be recognized on the sale and the gain to be deferred on the contribution are determined by allocating Taxpayer’s basis in Property between the sale and contribution portions of the transaction. Because the cash represents 30% of the total consideration received, 30% of Taxpayer’s basis is allocated to the sale, or $12 ($40 x 0.30). Thus, Taxpayer recognizes gain of $30 minus $12 = $18. The remaining 70% of the basis, or $28, is allocated to the contribution transaction; thus, Taxpayer takes their $70 partnership interest with a basis of $28 (preserving the $42 of gain not recognized on the transfer of Property).
Is the “Deferral” Worthwhile?
A taxpayer in one of the foregoing situations has transferred an asset over which they have full control – their business – in exchange for cash and a minority equity interest in the buyer.
The taxpayer may give up this control in order to attain other benefits, including, for example, the opportunity to use the after-tax cash consideration to diversify their investments; the access to funding, technical, and other assistance necessary to further grow the business and to share in that growth as an equity owner, albeit one with a minority stake, provided there is ample time to realize such appreciation before the buyer (in the case of a private equity firm) flips the business; and the deferral of some of the gain the taxpayer may realize on the transfer.
The loss of control may also present difficulties for the taxpayer. Some are obvious – others are less so; for example, if the taxpayer contributes appreciated property to a partnership in exchange for a partnership interest, the partnership is required to allocate its income, deductions, gains, and losses in such a way so as to cause the gain inherent in the property at the time of its contribution to be allocated entirely to the taxpayer.[xxii] The taxpayer will be taxed on such gain, but they may not receive a distribution of cash from the partnership to enable them to satisfy this tax liability.[xxiii]
Moreover, the equity interest that the taxpayer receives in exchange for their property may be just as illiquid, at least initially, as the exchanged property. There may not be a market for the entity’s equity, and its shareholders’ agreement or operating agreement will likely restrict the transfer of the taxpayer’s interest.[xxiv]
But at least the taxpayer deferred a portion of the tax on the transfer of their property.
Query, then, what happens if a taxpayer plans to give up control of a property in exchange for an illiquid minority interest in the buyer’s business entity to which the taxpayer contributed such property, yet will not enjoy any tax deferral?
Assuming the deferral was an important consideration, the taxpayer may want to rethink or restructure the deal.
Perhaps the taxpayer can ask to be grossed up for the “lost” deferral, though this may be too expensive a proposition for the acquiring entity. Alternatively, the taxpayer may ask the buyer to change the composition of the consideration to be paid so as to reduce the tax exposure.
The matter will ultimately be determined by how badly one party wants to dispose of their property, and how badly the other party wants to acquire it.
[i] The Build Back Better Plan. H.R. 5376, as passed by the House on November 19.
[ii] Senate Finance Chair Wyden is still trying to convince his colleagues that they should add an annual mark-to-market tax to the bill. Go figure.
[iii] For example, delays in obtaining the necessary regulatory approvals.
[iv] Another is the funding of an escrow this year (“proof of funds”) to ensure the buyer’s funds will be available to complete the deal in January.
[v] The phrase is attributed to Warren Buffett.
Where possible, key employees of the acquired target company may be granted profits interests in the buyer. Rev. Proc. 93-27, Rev. Proc. 2001-43, and Notice 2005-43.
[vi] Conceivably, the gain recognition may be deferred to a time when tax rates have once again been reduced (assuming they are ever increased). It may also be that the equity will be held until the death of its owner, thus receiving a step-up in basis (IRC Sec. 1014, under current law) in the hands of the owner’s estate, and thereby eliminating the income tax on the appreciation in the value of the equity.
[vii] I imagine it is similar to the feeling I have when I pull into the drive-through of the local McDonald’s and notice the two-for-one offers for certain breakfast sandwiches.
[viii] IRC Sec. 1031. You may recall it was just earlier this year that the Administration proposed limiting the use of this provision. Thankfully, the House Ways and Means Committee did not include it in its version of the President’s tax plan.
[ix] IRC Sec. 351. The corporation itself is not taxed on the issuance of its own stock. IRC Sec. 1032.
[x] Or is part of a “control group” of shareholders who, usually pursuant to a plan, are in control after having made capital contributions to the corporation.
[xi] IRC Sec. 721.
[xii] Unlike the requirements for a contribution to a corporation. The control requirement will present a challenge in the case of a rollover to a private equity firm organized as a corporation. That said, I have seen corporate parents of buyers accommodate a rollover by the owners of a target by organizing a new holding company to which the parent’s shareholders and the target’s owners transfer their respective equity, pursuant to a plan, in exchange for all the stock of the new holding company. A control group.
[xiii] IRC Sec. 358 in the case of stock in a corporation. IRC Sec. 722 in the case of a partnership interest.
[xiv] IRC Sec. 362 in the case of a corporation. IRC Sec. 723 in the case of a partnership.
[xv] Reg. Sec. 1.1001-1(a).
[xvi] IRC Sec. 351(b). A similar rule applies to like kind exchanges in which boot is also received. IRC Sec. 1031(b).
[xvii] See the examples that follow in the text, above.
Taxpayer contributes property to Corp in exchange for cash plus equity; the amount of cash received is equal to the amount of gain realized; thus, the entire gain is recognized.
Instead, taxpayer splits the transfer into two: one a contribution to the buyer’s parent corporation, the other a sale to the buyer corporation; the basis is split between the two transfers, such that the gain on the sale is less than the amount of cash received; not all the gain is recognized.
[xviii] IRC Sec. 731. In the case of such a distribution, the taxpayer/partner will be able to use their entire outside basis (i.e., the basis in their partnership interest) to offset the cash and reduce the gain realized.
[xix] The regulations under IRC Sec. 707 provide factors to consider in determining whether a transfer of property to a partnership is properly treated as a sale.
[xx] IRC Sec. 707. Reg. Sec. 1.707-3.
[xxi] Reg. Sec. 1.707-3(f), Ex. 1.
[xxii] IRC Sec. 704(c). The goal is to prevent the taxpayer from shifting this “built-in” gain to other members of the partnership.
[xxiii] See also the “mixing bowl” rules of IRC Sec. 704(c)(1)(B) and Sec. 737.
[xxiv] In any case, who would want a minority interest in a closely held entity?
