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GUEST ARTICLE
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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
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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
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investment as opposed to a disposition or cashing
next level. You are interested in acquiring the
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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
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time to recognize any gains and impose any taxes.
own a piece of the business. You want the
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As a result, Section 351 and related Internal
management team to have skin in the game,
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Revenue Code sections permit taxpayers to transfer
but you dont want to take a pound of flesh as
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the basis in the property exchanged to the shares
collateral damage by not structuring it correctly.
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received in a transaction, deferring the imposition
So, you offer up a proposal that allows the
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of taxes until and at such time the stock received
existing shareholders and management team to
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is sold or disposed of.
reinvest in the business by accomplishing a
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There are three principal requirements that
tax-free rollover of a portion of their existing
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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
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code:
agement team, however, maintain that theyF
(1)...The transferor must transfer property (as
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want to own the same type of security as your
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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
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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,
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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
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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
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and management team have identical rights as the unavailable, which
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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.
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another liquidity option. Since the existing share- O At the end of the day, the most relevant
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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
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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
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achieved the IRR it is seeking.
everyone can have their cake and eat it too?
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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
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(#20484) Reprinted with permission from the March 1, 2010 issue of Reuters Buyouts. Copyright 2010 Thomson Reuters.
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