You founded a company and the time has finally come to sell. For years you’ve dreamt of the day when you can turn your illiquid stock into cold hard cash and buy a house on the beach and retire.
Hang on tight, that day might not be here yet.
It’s very common for a buyer of a start-up to want the founder to stick around a few more years to ensure a successful transition. Various incentives are put in place to motivate the founder to continue to work hard. One of those, is requiring the founder to retain an equity ownership interest in the go-forward business. When a founder is required to swap equity of the start-up for equity of the buyer, this is referred to as “rolling equity.” The good news is that as long as the equity being received is equity in an entity taxed as a partnership, you can defer tax on the rolled equity.[1]
For example, let’s say your start-up is a C corporation, but buyer is an LLC taxed as a partnership. If you originally got your founder’s stock for par (so basically $0), sell for $7.5M in cash and $2.5M in buyer equity, you’ll have $7.5M in capital gain. The tax on the $2.5M is deferred into the future.
Sounds good right? It generally is. But you’ll want to take a good hard look at the LLC agreement governing the buyer equity. When reviewing such agreements, I look in particular for things which can require you to reach into your checkbook.
Capital Calls
Did you know some LP or LLC agreements require that the owners contribute more cash when requested? This is usually a characteristic of funds, and is not usually a requirement in the agreements governing rollover equity, but I always check for this just the same.
Deficit Capital Accounts
LP and LLC agreements occasionally include a requirement that if your “capital account” goes negative that you pony up the cash to bring it positive. You can often search for the word “deficit” to find whether the LLC agreement in question has this requirement or not. When I represent founders rolling-equity, I try to strike this if possible.
Phantom Income
Here’s the big one. The key tax characteristic of a partnership is that the gain is taxed in the year it is earned, regardless of whether you are distributed any cash. The tax but no cash problem is referred to as phantom income. It’s not fun.
To prevent this, you’ll want the operating agreement governing your rollover equity to have a tax distribution provision. This is a provision which requires that the company distribute a certain minimum amount of cash, usually at least annually, intended to help you pay your taxes.
Tax Distribution Provisions
There are many flavors of tax distribution provisions. A founder rolling equity would generally prefer that tax distributions are:
- Mandatory. Such distributions will almost always be subject to available cash; this is acceptable.
- Not cumulative. For example, if you were allocated $100K of loss last year and $100K of gain this year, should those two net together and thus, you get $0 in tax distributions this year? You do not want them to net, because otherwise any time you get allocated a loss, you have to set aside money as a future year tax-reserve.
- Made quarterly prior to your estimated tax payments being due. The Internal Revenue Service wants its money four times per year, so that’s when you’ll need it too.
- Calculated based on the highest federal and applicable state tax rate.
- Made regardless of a unit’s vested or unvested status.
- Made with respect to 704(c) gain.[2]
- Treated the same with respect to each member. Tax distributions are frequently treated as advances with respect to other distributions. This is common and generally viewed as fair. But make sure everyone is treated equally in this regard.
Other Nice to Have’s
From a founder’s perspective, the “traditional method” is best for 704(c) allocations as it usually results in the slowest allocation of gain over time. In practice this only becomes an issue if the rolled equity is sold for less than its value at the time of contribution, or if there are allocations of 704(c) gain being made each year due to depreciation of amortization of the contributed assets.
At least check to see whether any softening of the section governing the tax matters partner (now, usually called the “partnership representative”) might be in order. Know that as of January 1, 2018, a member, even after leaving a partnership can still be on the hook for taxes if the partnership is audited and the partnership representative elects to have any tax due paid by the members who owned the partnership in the year being audited.
Helpful Language
You’ll want to make sure the deal docs have language something like the following:
“Tax Treatment of the Rollover Exchange. For U.S. federal and applicable state and local income Tax purposes, the parties acknowledge that the Rollover Exchange is intended to be treated as a contribution by the Seller of its Contributed Equity to Parent in exchange for the Equity Consideration pursuant to Section 721 of the Code. The parties shall not take a position inconsistent with such treatment in their tax filings, unless otherwise required by a final determination within the meaning of section 1313 of the Code (or similar provision of state, local or non-U.S. Tax law), and in the event of an audit with respect to such treatment, shall consult in good faith with each other concerning its defense.”
I also saw the below language in a rollover LLC operating agreement recently, which I thought was interesting. It’s intended to prevent buyer from playing tax games in the future if it chooses to sell only part, but not all of the start-up equity.
“Transfer of Certain [ABC Inc.] Shares. In connection with the taxable sale of any [ABC Inc.] shares, the Partnership shall use commercially reasonable efforts in connection with any such taxable sale to not disproportionately transfer shares of [ABC Inc.] shares contributed by [the Rollover Members] in such sale. For example, if the Partnership owns one-hundred (100) shares of [ABC Inc.] (inclusive of ten (10) shares of [ABC Inc.] shares contributed by [the Rollover Members]) and the Partnership is transferring fifty (50) [ABC Inc.] shares in such taxable sale, the Partnership shall use commercially reasonable efforts to not transfer more than five (5) [ABC Inc.] shares contributed by [the Rollover Members] in such taxable sale. Similarly, the Partnership shall use commercially reasonable efforts in connection with any taxable sale of any specific class of property that includes [704(c) Substituted Basis Property] to not disproportionately transfer any [704(c) Substituted Basis Property] in any such taxable sale of such specific class of property.”
Mike Baker frequently advises with respect to rollover equity. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] If the requirements of tax code Section 351 or 368 are met, tax deferral is also possible if the to-be-received-equity is corporate stock.
[2] When a founder contributes equity in his or her start-up in exchange for buyer equity, the built-in gain inherent in the contributed start-up equity is ear-marked and later allocated specifically to such founder when the contributed start-up equity is later sold, or sometimes earlier if the underlying assets are depreciable or amortizable. If tax code Section 704(c) gain is excluded from the type of gain that requires a tax-distribution, you’ll have a cash crunch as allocations of 704(c) gain are made to you.