Business owners who receive “rollover equity” in sales of their businesses may have to specifically structure their transactions to avoid taxable distributions. Consider the following situation:

John Doe, an individual, owns 100% of Blackstone. Blackstone is a corporation that Doe uses to operate one of his businesses. Buyer offers to purchase the business and desires to keep Doe on as an owner and manager and, thus, proposes the following:

1. Buyer and Doe form Whitestone, an LLC taxed as a partnership.
2. Buyer gets a membership interest in Whitestone in exchange for contributing cash to Whitestone.
3. Doe gets a membership interest in Whitestone in exchange for contributing 10% of all the Blackstone stock to Whitestone.
4. Doe sells the remaining 90% of the Blackstone stock to Whitestone for the cash that Whitestone received from Buyer.

This four step transaction results in Buyer and Doe being co-owners of Whitestone and Whitestone owning 100% of Blackstone.

In steps 2 and 3, Buyer and Doe do not recognize gain or loss when they contribute property to Whitestone in exchange for membership interests in Whitestone (under IRC Section 721). In step 4, assuming the value of the Blackstone stock was higher than Doe’s basis in the stock, Doe must recognize gain equal to the amount of cash Doe received minus Doe’s basis in the Blackstone stock (under IRC Section 1001).

LLCs are generally taxed as partnerships. Internal Revenue Code generally permits members to contribute property to, and receive distributions from, an LLC without recognizing gain. See IRC Sections 721 & 731. This is consistent with the nonrecognition principles governing partnerships under the Internal Revenue Code.

In transactions involving the sale of a business, the parties often use the nonrecognition provided by Section 721 to give selling parties “rollover equity.” The selling parties receive an equity interest in the acquiring company in exchange for a portion of the equity interests that the selling parties had in the target company. If the acquiring company is an LLC, IRC Section 721 says this exchange is not a taxable event.

There are at least two reasons to use rollover equity: (1) it reduces the overall tax owed by the selling parties, and (2) by having the selling parties continue their ownership interest in the enterprise incentivizes them to keep working to make the business successful after the transaction.

After the transaction discussed above, when Doe receives distributions from Whitestone, the nonrecognition treatment of IRC Section 721 will not apply. When Whitestone earns income through its operations, and then distributes some of that to Doe, Doe is generally taxed according to the rules governing “Operating Distributions” as discussed infra. If Whitestone makes a payment to Doe of cash not generated through operations several provisions of the Internal Revenue Code trigger gain recognition by recharacterizing what might otherwise appear to be a “distribution.”

Under IRC Section 731, a member of an LLC recognizes gain only if the member receives cash in excess of the member’s basis in the member’s interest in the LLC. Under IRC 705 a member increases the member’s basis in the member’s membership interest to reflect income that was allocated to the member by the LLC. Under IRC Section 722, a contributing member to an LLC takes as the member’s basis in the LLC interest received an amount equal to the sum of the adjusted basis the member had in any contributed property, plus any cash contributed.

Therefore, because Doe had a $0 basis in the Blackstone stock that Doe contributed to Whitestone, Doe took a $0 basis in the Whitestone membership interest that Doe received (Section 722). Assume the transaction involving Whitestone was consummated in 2019. If Whitestone earns $200 in 2020, and $20 of that income is allocated to Doe, Doe will owe tax on that $20 of income. It also increases Doe’s basis in Doe’s membership interest from $0 to $20 (Section 705). In 2021, if Whitestone distributes $20 to Doe, Doe will not owe tax on that distribution because Doe had a $20 basis (Section 731). Upon the distribution of the $20 to Doe, Doe’s $20 basis drops to $0 (Section 733).

If Buyer and Doe cause Whitestone to take out a $10 million recourse loan, the loan increases Buyer’s and Doe’s aggregate basis in their membership interests by $10 million (Section 752(a)). Doe’s own basis in Doe’s membership interest goes from $0 to $1 million.

Since an LLC member recognizes gain on a distribution only if the member receives cash in excess of the member’s basis in the member’s interest in the LLC, now that Doe’s basis in Doe’s membership interest is $1 million, and Whitestone has $10 million in cash (loan proceeds), Whitestone can distribute $1 million to Doe, and Doe arguably does not need to recognize income (Section 731). This was the result in Otey v. Commissioner, 634 F.2d 1046 (6 th Cir. 1980).

After the Otey case Congress enacted IRC Section 707(a)(2)(B), addressed this type of transaction, a contribution of property to a partnership, together with a related distribution to the same partner and decided it should be characterized as a sale or exchange of the contributed property. This would treat Doe’s contribution of the 10% of the Blackstone stock to Whitestone, followed by a distribution of $1 million to Doe, as a taxable sale of the Blackstone stock.

Doe may be able to avoid the application of Section 707(a)(2)(B) by waiting 2 years after the sale of Blackstone before receiving the $1 million distribution from Whitestone. Treasury Regulation Section 1.707-3(d) creates a presumption that transfers separated by more than 2 years are not sales. Note, however, that the IRS can nevertheless try to rebut the presumption offered by Treasury Regulation Section 1.707-3(d) (see a list, in Treasury Regulation Section 1.707-3(b)(2), of 10 facts and circumstances that tend to show that a sale occurred).

Doe must still navigate the “mixing bowl” rules of IRC Sections 704(c)(1)(B) and 737, which can trigger gain to the contributing partner. Section 704(c)(1)(B) triggers gain recognition where property (other than cash) is distributed to a partner other than the contributing partner within 7 years of the original contribution. Section 737 triggers gain recognition if, within 7 years of a contribution, the contributing partner receives a distribution of property (other than cash) that is not the property that the contributing partner originally contributed.

It is safe to say that the structure of a business sale, especially one that will include roll-over equity, requires careful planning with your business attorney and tax advisor.

The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.