Rollover Structuring
Generally speaking, the goal for any rollover investment should be tax-deferral. However, there are two primary issues to consider: (1) the amount deferred, and (2) whether deferral is actually optimal.
Amount deferred: Let’s say that you’ve agreed to sell your business for $50m. You hold your business through an S corporation and you’ve agree to an asset deal and the buyer is requesting $5m of rollover investment. Assume your S corporation has net tax basis of $10m in its assets. Further assume that the buyer is using 50% leverage ($25m) to fund the acquisition. One would expect to defer 10% of your $40m of gain but it turns out that the actual deferral can vary significantly based upon the tax classification of the buyer and the amount of leverage incurred in the acquisition. If, for instance, the buyer is a C corporation, your gain recognition would be approximately $36m, while if the buyer is a structured as a partnership for tax purposes, your gain recognition would be $32m.
Is deferral optimal? Here’s the thing about deferral – it’s temporary. And while there’s a time value to money (any time you want to pay us in advance for a project, you’re welcome to do so), it rarely makes sense to trade deferral for a permanent cost. Yet that’s what nearly every rollover investment of assets into a corporation does. Why? It’s likely a confluence of factors - everyone likes the idea of not paying taxes today and thus tend to undervalue the cost of future taxes. Additionally, due to the lack of understanding of tax consequences, there’s likely a disconnect between the seller, who gets all of the benefit of the deferral and none of the benefit of the basis step-up, and the buyer, who likely hasn’t priced the tax benefit into its financial model at all.
As previously discussed, a buyer of assets gets a (generally) amortizable tax basis step-up. That leads to deductions that reduce tax liability in the future for the buyer and has significant value. However, when assets are transferred to a buyer in a tax-deferred manner, the buyer foregoes a tax basis step-up – that’s the cost of the seller’s tax deferral. If the buyer is a pass-through entity, that’s not a big deal; any deductions generated by a tax basis step-up are temporary in nature and will be recaptured on exit, meaning that you’re trading tax deferral for tax deferral. However, if the buyer is a C corporation, amortization deductions lead to permanent tax reduction and you’re trading tax deferral for a permanent cost.
Example 1
C corporation Buyer agrees to acquire 100% of the assets of Company A (an S corporation) for $50,000x, but has asked the sole owner of Company A to rollover $10,000x of value. Assume no acquisition indebtedness is incurred in the transaction and that Company A has $5,000x of net tax basis in its assets. Buyer will be treated as purchasing 80% of Company A’s assets for $40,000X, resulting in a tax basis step-up of 80% of the $45,000x of built-in gain ($36,000x). With respect to the remaining $10,000x of assets, Buyer will take a carryover basis of $1,000x. Company A will defer $9,000x of taxable gain in connection with the rollover.
Assuming the gain deferred is all long-term capital gain and ignoring state tax, the benefit obtained by Company A’s shareholder is deferral of $1,800x of tax, which will be recognized when Company A disposes of the shares of the Buyer. If that’s 5 years and you apply a 6% discount rate, the benefit of deferral is about $455x (less if the shareholder of Company A is active in the business and would avoid the net investment income impact on the initial sale).
Conservatively, the cost to a corporate buyer under those facts is the loss of approximately $600x of deductions per year for the next 15 years. If we assume that the buyer can fully utilize those deductions, the value of those deductions, assuming a federal corporate tax rate of 21% and ignoring state tax, is approximately $1,223x.
