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March 1, 2010 | BUYOUTS

GUEST ARTICLE

Be Wary When Rolling Over

Management Equity
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By Thomas Kesoglou and Kenneth K. Yoon, McCarter & English, LLP
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fter searching high and low, you finalFOSection 351
ly found that deal youve been lookT
Generally, under the U.S. Internal Revenue
ing for.
O Code,
transferring property to a corporation in
The target company has an excellent
N
.
exchange for shares in such corporation is typically
management team and you have the particular
viewed as a mere change in form of an
industry expertise to bring the company to the
LY
N
investment as opposed to a disposition or cashing
next level. You are interested in acquiring the
O
out of an investment. For the most part, such a
business, but would like the existing shareholdG
transfer is generally regarded as an inopportune
ers and management team to stay on board and
N
I
time to recognize any gains and impose any taxes.
own a piece of the business. You want the
D
A
As a result, Section 351 and related Internal
management team to have skin in the game,
E
Revenue Code sections permit taxpayers to transfer
but you dont want to take a pound of flesh as
R
the basis in the property exchanged to the shares
collateral damage by not structuring it correctly.
L
A
received in a transaction, deferring the imposition
So, you offer up a proposal that allows the
N
of taxes until and at such time the stock received
existing shareholders and management team to
O
S
is sold or disposed of.
reinvest in the business by accomplishing a
R
There are three principal requirements that
tax-free rollover of a portion of their existing
E
P
must be met in order for a taxpayer to receive the
stock under Section 351 of the Internal Revenue
tax deferment benefits under Section 351 of the
Code. The existing shareholders and man- R
O
code:
agement team, however, maintain that theyF
(1)...The transferor must transfer property (as
Y
want to own the same type of security as your
P
opposed to services);
fund (i.e. a strip of preferred stockOwith
(2)...The shares issued in the tax-free exchange
redemption features baked in a stockholders
C
must be common stock and certain preferred
agreement). You are reluctantDsince the
stock (other than non-qualified preferred stock)
management team would already
have been
Thomas Kesoglou
TEmuch
and not other property such as cash or debt
made liquid with respect to
as
as 80
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instruments (or in tax terms, boot); and
percent of their holdings inR
the target company
P the deal would be IRRs and the management teams ongoing (3).gImmediately after the exchange, the group
upon closing the deal. But,

priced right if the management team received

the same security. So you agree. The deal finally
closes and everyone is off to the races.
Twelve months later, the company is
performing fantastically and beyond everyones
expectations. But then, the IRS comes knocking
at the management teams door and declares
that the rollover was, in fact, not a tax-free
exchange under Section 351 of the Internal
Revenue Code, resulting in significant tax
liabilities to the management team. The
management team is furious, to say the least,
and has asked that you fix the problem since
the deal was priced assuming a tax-free
exchange. This fix could certainly affect your

performance, if not resolved appropriately.

You call the lawyer who did the deal and ask,
How did this happen? How can this be avoided in
the future? Does this mean all of my deals were
structured incorrectly?
Unfortunately, the preferred stock issued in the
transaction described above was deemed to be
nonqualified preferred stock resulting in the
loss of the tax-free status of the rollover. Although
the terms of the preferred stock in the charter of
the issuing corporation did not include a
redemption feature, the fact that the preferred stock
was redeemable (albeit by contract in the stockholders agreement) resulted in the tax-free status of the
rollover to be compromised.

transfering the property (e.g. the buyer and the

management team) must own stock possessing at
least 80 percent of the total combined voting
power of all classes of voting stock and at least 80
percent of the total number of shares of each
class of stock immediately after the exchange.
Each of the three requirements set forth above
are necessary in order to achieve the nonrecognition of gain (or loss) in connection with a
tax-free exchange. Although each requirement
must be met independent of the others, the most
thorny requirement to meet is that the shares
issued in the tax-free exchange cannot be nonqualified preferred stock. Under Section 351(g) of
the Internal Revenue Code, non-qualified

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BUYOUTS | March 1, 2010

GUEST ARTICLE
preferred stock is preferred stock that: (i) the
holder has the right to require the issuer or a related
party to redeem or purchase; (ii) the issuer or
related party is required to redeem or purchase;
(iii) the issuer or a related party has the right to
redeem or purchase, and, as of the issue date, it is
more likely than not that such right will be
exercised; or (iv) the dividend rate varies in whole
or in part with reference to interest rates,
commodity prices, or other similar indices.
Section 351(g) includes a few exceptions to the
definition of non-qualified preferred stock (as well
as exceptions to the exceptions), such as the
put/call right cannot be exercised for twenty years
or that the right may only be exercised upon the
death, disability or mental incompetence of the
holder. Preferred stock, however, that enables a
shareholder to participate in corporate growth to
a significant extent avoids being classified as
preferred stock under Section 351, and therefore
qualifies as stock for non-recognition purposes.
Under Section 351 such preferred stock would not
be treated as participating in corporate growth
unless there is a real and meaningful likelihood of
the shareholder participating in the earnings and
growth of the corporation.

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Kenneth K. Yoon

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up a new type of preferred stock that includes
.N a
Same Security Dilemma
redemption feature but does not runYafoul of
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Many existing shareholders and management Section 351. In evaluating whether to abandon
the
Nequity fund
teams are willing to entertain the idea of a tax-free redemption features, a private
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exchange but only if they do not recognize gain (or manager would need to determine
G how frequently
loss) with respect to the stock they receive in the they have utilized the redemption
IN rights in their
D conditions should
exchange, and they receive the identical securities prior deals. Current market
as are received by the buyer (i.e. they are pari also weigh in on the analysis
EA to exclude redemption
R liquidity events (e.g. sale
passu with the buyer in the transaction). Therein rights since more attractive
Lor public offering) would be
lies the dilemma. Should the existing shareholders of the business
A
and management team have identical rights as the unavailable, which
N increases the importance and
O
private equity fund, especially with respect to value of the
S redemption rights. Also, a quick
redemption rights? Private equity fund managers reviewRof the fund organizational documents
almost always receive preferred stock that features should
PE be conducted to determine if such rights
a mandatory redemption right in order to create must be included in the deal.
R
another liquidity option. Since the existing share- O At the end of the day, the most relevant
F
holders and management teams have already been question is: Are these redemption rights worth
made liquid with respect to as much as 80 percent
PY giving up in order to establish equivalency with
of their holdings in the target company, O
private the existing shareholders and management
Cprovide team in order to preserve the tax- free nature of
equity fund managers are not anxious to
D
this redemption right to the existing shareholders
the exchange to induce the existing shareholdand management teams until the fund
TE has become ers and management team to sell? Or is there a
liquid with respect to its investment,
IN and it has better way to structure the transaction so that
R
achieved the IRR it is seeking.
everyone can have their cake and eat it too?
P
Accordingly, if the existing shareholders and
management team insist on both non-recognition
of gain (or loss) under Section 351 (other than on
the cash received for 80 percent of target company
shares) and having the same security with the same
rights as the private equity fund with respect to
shares issued in the transaction, the private equity
fund manager should determine whether to
abandon the mandatory redemption feature in the
transaction (by evaluating and determining the
importance, relevancy and value of the mandatory
redemption and put and call rights) or to conjure

the common stock upon a liquidity event) would

not be considered preferred stock and consequently, any redemption rights that the existing
shareholders and the management team receive
would not jeopardize the tax-free exchange. As a
result, any preferred stock to be issued in a
transaction should include a participation feature
to permit the inclusion of the redemption rights.
A typical method of structuring a Section 351 taxfree exchange where the management team
obtains the same security as the private equity fund
is to have the private equity fund capitalize a
newly-formed corporation with cash in exchange
for shares of Series A Participating Preferred
Stock (which includes redemption rights) of the
newly-formed corporation. The newly-formed
corporation would then pay cash (typically for at
least 80 percent) for the shares in the target
company, providing significant liquidity to the
existing shareholders and management team. At
the same time, the existing shareholders and the
management team would contribute up to 20
percent of the target company stock to the newlyformed corporation in exchange for the same
shares of Series A Participating Preferred Stock of
the newly-formed corporation purchased by the
private equity fund.
While we wont attempt to address, here, all the
issues and details concerning Section 351 and
rollover transactions, and this brief discussion is
not meant to be tax advice, we hope this small
example illustrates how important it is to consult
with your corporate and tax lawyers early on,
before fixing, and baking in, the terms of your deal.
Often, choosing a good structure means
considering trade-offs, and deciding on priorities,
based on your particular circumstances and
objectives. Sometimes, seemingly small differences
can make all the difference in changing the
outcome. Also, the laws are subject to change, as
are typical market terms, so working with your
advisors early on, and considering the full picture,
is key to a successful outcome.

What It Looks Like

If abandoning the redemption feature is not an
option for your fund, then a new type of preferred
stock that includes a redemption feature but does
not run afoul of the tax-free exchange rules of
Section 351 should be considered. As described
above, Section 351(g) only applies to preferred
stock (i.e. stock that, by its terms, has no
meaningful participation in corporate growth). For
purposes of Section 351(g), a participating preferred
stock (i.e. stock that shares in proceeds along with

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Thomas Kesoglou and Kenneth K. Yoon are

partners in McCarter & English, LLPs NewYork
office. Kesoglou is a member of the firms
corporate department and focuses his practice
on advising clients in connection with leveraged
recapitalizations, management buyouts, mergers and acquisitions, mezzanine financings,
early and late stage private equity and venture
capital investments and secondary transactions. Yoon is a member of the firms tax department and focuses on tax law (including tax
aspects of mergers and acquisitions, securities
offerings, investment funds, and executive
compensation) as well as general representation
of technology and emerging companies.
Reach Kesoglou at 212-609-6821 or
tkesoglou@mccarter.com, Yoon at 212-6096827 or kyoon@mccarter.com.

(#20484) Reprinted with permission from the March 1, 2010 issue of Reuters Buyouts. Copyright 2010 Thomson Reuters.
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