A private equity sponsor is offering a deal structure with twenty percent rollover equity into their acquisition holding company, but we need to know whether that rollover triggers an immediate tax liability. How do we structure the rollover equity under Section 721 or Section 351 to ensure it is completely tax-deferred?

Question

Tyler Smith · Accepted Answer

If structured improperly, rolling equity into a buyer's holding vehicle can trigger an immediate capital gains liability on the value of that rollover without you receiving any cash to pay the tax. To ensure that your rollover is completely tax-deferred, the transaction must be executed through specific non-recognition provisions of the Internal Revenue Code.

If the buyer uses a partnership or a limited liability company treated as a partnership for federal tax purposes, the rollover should be structured under Section 721. You contribute your company stock, membership units, or assets to the partnership holding company in exchange for partnership equity. Under Section 721, neither the contributing partner nor the partnership recognizes gain or loss on the contribution of property in exchange for a partnership interest.

If the buyer uses a corporate holding vehicle, the rollover must qualify under Section 351. To achieve non-recognition treatment under Section 351, the transferors, which includes you rolling equity alongside the private equity sponsor contributing cash, must collectively own at least 80 percent of the voting power and total shares of the new holding corporation immediately after the transaction.

Key structural checkpoints to verify with transaction counsel:

- Ensure you receive the exact same class of common equity or pari passu preferred units as the sponsor to avoid disguised compensation characterization.
- Do not allow the buyer to run the rollover through a taxable redemption or purchase-and-sale agreement prior to the holding company contribution.
- Audit the operating agreement for liquidation preferences that could wipe out your rollover value before you ever reach a secondary liquidity event.