Second Bite at the Apple: How to Structure a Tax-efficient Rollover

You’ve spent years building your business from the ground up, nurturing it into a successful enterprise. Now, you’re at a crossroads, contemplating a sale that could set the stage for your next big adventure. This is where the art of structuring a tax-efficient rollover comes into play. In the complex world of mergers and acquisitions, tax-deferred rollovers are more than just financial maneuvers; they’re pivotal decisions that can significantly impact your financial future.

These strategies allow business owners like you to defer tax liabilities and potentially enhance the value received from a sale. In today’s dynamic M&A market, understanding and effectively leveraging tax-deferred rollovers can be the difference between a good deal and a great one. This post will guide you through the nuances of these strategies, ensuring you’re well-equipped to make informed decisions during your business transition.

What’s a Tax-Deferred Rollover and Why Should You Want One

A tax-deferred rollover allows a business owner selling their company to reinvest a portion of their equity into the acquiring entity instead of cashing out entirely. A well-structured rollover defers the tax liabilities that would otherwise be incurred from an outright sale of the entire business. Essentially, it’s a way to continue having a stake in the business or its successor while postponing taxes on the rolled-over portion.

The main benefit of a tax-deferred rollover, other than the obvious reduced tax burden, is to align the seller’s interests with the continued success of the business. This is particularly attractive to buyers who value the seller’s ongoing involvement or expertise. For business owners, this not only means potential future gains but also a continued connection to the business they’ve built. If an earnout is part of the sale, an ongoing role for the seller can put the seller in a position to provide oversight to maximize the likelihood of meeting the earnout’s targets. In today’s M&A market, where maximizing value and minimizing tax impacts are key, understanding and leveraging tax-deferred rollovers can be a game-changer.

One caution, if you’re considering accepting part of the proceeds from the sale of your business as buyer equity, it’s critical that you evaluate the buyer, your future business partner. Review this post on 9 Reasons the Seller Should Conduct Due Diligence on the Buyer for the compelling reasons why due diligence on the buyer is imperative.

Why Does the Buyer Want a Tax-Deferred Rollover?

One reason buyers embrace rollovers is because it allows them to pay less up front for the business they’re buying since part of the consideration is equity in the buyer.

The more important reason buyers favor rollovers is continued alignment with the seller. A seller who is financially invested in the future success of the business is more likely to aid in a smooth transition, offer valuable insights, and foster positive relationships with existing clients and staff. The business continues to capitalize on the seller’s expertise and industry connections for continuity and growth. In essence, a tax-deferred rollover creates a partnership dynamic where both parties share a common goal: the sustained success and growth of the business.

How Is a Tax-Deferred Rollover Structured?

The structure of a tax-deferred rollover depends on the legal entity and tax characterization of the seller and the buyer, and sometimes the mix of the consideration (how much equity and how much cash). It’s wise to consult a tax professional specializing in M&A to get it right, but let’s explore in general terms some of the optimal tax-deferral rollover structures.

Why an F Reorganization is Best When the Selling Business is an S Corporation

F Reorganizations, F Reorgs for short, are all the rage. They offer the best of both worlds to the buyer and seller when the selling business is in an S corporation. An F reorganization is a type of tax-free corporate restructuring blessed by the IRS. It involves a series of steps where an existing S corporation becomes a subsidiary of a newly formed S corporation Holding company, and then the subsidiary S corporation transforms into a single member LLC.

Properly structured, an F Reorg allows S corporation shareholders to defer recognizing taxable gain on the portion of the business exchanged for buyer equity, obtain a tax deduction for transaction costs of the sale, and, most importantly, participate in the future success of the business in a tax efficient manner by receiving buyer equity with no current tax consequences.

Buyers favor F Reorgs because the portion of the assets of the seller’s business the buyer pays cash for receives a step-up in tax basis. The F Reorg structure is optimal and simpler for transferring a business containing legal contracts and requiring regulatory approvals. The F Reorg shields the buyer form relying on the S corporation status of the seller.

If you’re a seller with an S corporation, check out this post for more details: What Is An F Reorganization and Why Are They So Popular?

If the Selling Business is an LLC Taxed as a Partnership There is Maximum Flexibility to Structure a Tax-Deferred Rollover

If the selling business is an LLC taxed as a partnership, the selling partners have multiple options to receive equity in the buyer while achieving tax deferral. The buyer enjoys a step-up in the tax basis of the portion of the business assets the buyer is deemed to acquire with cash.

The selling LLC members can benefit from tax deferral if the buyer equity is stock in a corporation or LLC interests.

Another advantage for both buyer and seller if the selling business is an LLC is the buyer equity issued to the selling LLC members can be structured as a new class of buyer LLC interests or buyer stock, facilitating maximum flexibility in incentivizing the selling members who might continue to stay involved in the business post-sale.

Finally, if the selling business is a partnership, it’s straightforward if some of the selling owners want to be cashed out immediately and others want to rollover all or part of their ownership into buyer equity.

A selling business structured as a partnership for tax purposes provides more flexibility when structuring a sale of the business than any other tax form. However, partnership tax is complex, so it’s critical for the sellers to engage tax advisors with a deep understanding of partnership tax law to protect their interests, avoid surprises such as “phantom income”, and maximize their tax benefits.

What if the Selling Business is a C Corporation?

The most challenging structure to navigate is when the selling entity is a C corporation. This is because there is a dramatic tax cost to the selling shareholders if assets of the corporation are sold, so sellers want to sell stock. But buyers prefer to purchase assets for both legal reasons and to achieve a tax benefit from a step-up in tax basis.

Assuming the buyer is willing to acquire stock, the optimal structure for tax-deferred rollover is the utilization of a holding company. The selling company shareholders contribute their stock in exchange for stock in the buyer’s holding company, and the buyer contributes stock or assets (or a combination of the two) to the holding company in exchange for holding company stock. The cash contributed by buyer is then distributed to the selling shareholders.

This transaction is called a “section 351 with boot”. The section 351 part refers to the Internal Revenue Code section qualifying the formation of a new corporation to be tax-deferred, and “boot” refers to the fact that the contributing selling shareholders will recognize taxable gain to the extent of the cash received (the boot).

If only some of the selling shareholders want to rollover into buyer equity, there is only a slight variation required: buyer purchases the stock directly from the selling shareholders who do not want to rollover, and then buyer contributes that stock to the holding company.

As a C corporation seller, be extremely wary when someone approaches promising to structure the sale of your company as a tax-free reorganization. Yes tax-free reorgs are possible in theory, but the requirements are onerous, and most small and medium-sized businesses don’t have the clout to demand the buyer utilize a tax-free reorg to acquire them.

What if the Seller C Corporation Stock Qualifies as Section 1202 Stock?

If you’re the seller of C corporation stock that meets the requirements of Section 1202, also known as Qualified Small Business Stock or QSBS, then you have unique and valuable tax benefits from rolling over your stock that you will want to retain, if possible.

The tax benefits of QSBS are already incredibly lucrative: if all the requirements are met, including the 5 year holding period, the seller of QSBS can sell the QSBS and permanently exclude up to $10 million of gain on the sale of the stock. In addition, if the seller has invested more than $1 million, the exclusion of gain increases to 10 times the seller’s tax basis.

While a detailed discussion of QSBS is beyond the scope of this post, the key point is that owners of QSBS who cash out can reinvest some or all of the proceeds within 60 days into new stock that qualifies as QSBS and receive a stepped-up tax basis in the new QSBS acquired.

Further, if you’re a seller and you’re close to the 5 year holding period, then you will want to carefully consider the timing of selling your stock to ensure you don’t miss out on the fantastic QSBS tax benefit. If the sale can’t be postponed, there are tax planning strategies that should be considered. Consult a tax advisor knowledgeable in M&A and section 1202 before proceeding.

Conclusion

Navigating the M&A landscape requires a strategic approach to tax planning. Whether your business is an LLC taxed as a partnership, an S corporation, or a C corporation, understanding and utilizing the right tax-deferred rollover structure is key to maximizing after-tax proceeds while aligning with your future business goals. Always consult with a skilled tax advisor to tailor these strategies to your unique situation, ensuring a transition that’s not only financially rewarding but also aligns with your continued business journey and legacy.