Private equity transactions frequently involve a rollover — the selling business owner contributes a portion of the sale proceeds (or a portion of the business itself) to the acquiring partnership in exchange for a partnership interest. The rollover allows the seller to maintain an equity stake in the business going forward and to defer tax on the rolled portion.

But the tax treatment of a rollover is not automatic. The disguised sale rules under IRC §707(a)(2)(B) can recharacterize what looks like a tax-free contribution as a taxable sale. And the carried interest rules under IRC §1061 can convert long-term capital gain on the partnership interest into short-term gain.

Under IRC §721, no gain or loss is recognized when a partner contributes property to a partnership in exchange for a partnership interest. This is the foundational rule that makes rollover equity transactions tax-efficient.

When a business owner rolls over equity into the acquiring partnership, the contribution is treated as a tax-free exchange under §721. The seller's basis in the partnership interest equals the adjusted basis of the contributed property. The holding period of the contributed property carries over to the partnership interest.

Example: A business owner sells 80% of the business for $8 million cash and rolls over the remaining 20% (worth $2 million) into the acquiring partnership. The cash proceeds are taxable; the rollover is tax-free under §721. The seller's basis in the partnership interest equals the basis of the contributed 20% interest.

The disguised sale rules are the primary trap in rollover equity transactions. Under IRC §707(a)(2)(B) and Treas. Reg. §1.707-3, a contribution of property to a partnership followed by a distribution from the partnership to the contributing partner is treated as a sale — not a tax-free contribution — if the facts and circumstances indicate that the contribution and distribution are part of a single integrated transaction.

Under the regulations, if a partner contributes property to a partnership and receives a distribution within two years, the transaction is presumed to be a disguised sale. The partner must rebut this presumption by demonstrating that the distribution was not part of a prearranged plan to transfer the property.

If a partner contributes property and receives a distribution more than two years after the contribution, the transaction is presumed not to be a disguised sale.

In a typical PE rollover, the seller contributes equity to the acquiring partnership and receives a partnership interest. If the partnership subsequently distributes cash to the seller — for example, as part of a recapitalization or a return of capital — within two years of the contribution, the IRS may recharacterize the contribution as a disguised sale.

The recharacterization converts what was intended to be a tax-free rollover into a taxable sale, with gain recognized at the time of the original contribution.

The regulations provide several exceptions to the disguised sale rules:

• Debt-financed distributions: A distribution funded by partnership debt is generally not a disguised sale if the debt is allocable to the contributing partner under the partnership allocation rules;
• Guaranteed payments: Payments that are guaranteed regardless of partnership income are not disguised sale proceeds;
• Operating cash flow distributions: Distributions of operating cash flow (not exceeding the partner's share of net cash flow from operations) are generally not disguised sales; and
• Reimbursement of preformation expenditures: Distributions that reimburse the contributing partner for capital expenditures incurred within two years before the contribution are generally not disguised sales.

A related provision, IRC §707(a)(2)(A), addresses disguised payments for services. If a partner performs services for a partnership and receives a "profits interest" that is disproportionate to the partner's capital contribution, the IRS may recharacterize the profits interest as a payment for services — taxable as ordinary income.

This rule is particularly relevant for management team members who receive profits interests in connection with a PE transaction.

IRC §1061, enacted as part of the Tax Cuts and Jobs Act of 2017, imposes a three-year holding period requirement for certain partnership interests held by service providers (commonly called "carried interests").

Under §1061, a partner who holds an applicable partnership interest (API) — a partnership interest received in connection with the performance of services in an investment activity — must hold the interest for more than three years to receive long-term capital gain treatment. Gain on an API held for three years or less is recharacterized as short-term capital gain, taxed at ordinary income rates.

Section 1061 primarily affects:

• Private equity fund managers who receive carried interests;
• Hedge fund managers with performance allocations;
• Real estate fund managers; and
• Business owners who receive partnership interests in connection with services (rather than capital contributions).

A business owner who contributes capital (not services) to the acquiring partnership in a rollover transaction generally does not hold an API and is not subject to §1061. However, if the rollover includes a profits interest component in exchange for the seller's agreement to continue managing the business, that component may be an API subject to the three-year holding period.

When a business owner rolls over equity into a partnership under §721, the basis and holding period of the partnership interest are determined as follows:

• Basis: The partner's basis in the partnership interest (the "outside basis") equals the adjusted basis of the contributed property, plus any gain recognized on the contribution;
• Holding period: The holding period of the contributed property carries over to the partnership interest for capital gain purposes, provided the contributed property was a capital asset or §1231 asset in the hands of the contributing partner.

The partnership's basis in the contributed property (the "inside basis") equals the contributing partner's adjusted basis in the property at the time of contribution. This creates a potential §704(c) allocation issue — if the contributed property has a built-in gain or loss at the time of contribution, that gain or loss must be allocated to the contributing partner when the partnership eventually sells the property.

Structure the rollover carefully. The disguised sale rules require careful attention to the timing and nature of any distributions following the rollover. Distributions within two years of the contribution are presumed to be disguised sales. The transaction documents should clearly identify which distributions fall within the exceptions.

Identify any API components. If the rollover includes a profits interest in exchange for services, that component is subject to the §1061 three-year holding period. The transaction should clearly distinguish between the capital contribution (not an API) and any service-based profits interest (potentially an API).

Address §704(c) allocations in the partnership agreement. The partnership agreement should specify how built-in gains and losses on contributed property will be allocated among the partners. The traditional method, the traditional method with curative allocations, and the remedial method each have different tax consequences.

Get a valuation. The allocation of value between the cash proceeds and the rollover equity affects the seller's basis in the partnership interest and the partnership's inside basis in the contributed property. A credible third-party valuation supports the allocation.

Partnership rollover equity is a powerful tool for deferring tax in PE transactions — but the disguised sale rules, the §1061 carried interest rules, and the §704(c) allocation rules create traps for the unwary. Proper structuring requires careful attention to the transaction documents, the timing of distributions, and the character of the partnership interest received.

If you are involved in a PE transaction or a business sale with a rollover component, contact us well before the transaction closes.

Governing authority: IRC §§707(a)(2), 721, 722, 723, 1061; Treas. Reg. §§1.707-3, 1.704-3; Rev. Proc. 93-27; Rev. Proc. 2001-43.

Related: Selling an S Corporation: Asset Sale vs. Stock Sale · Goodwill in a Business Sale · Installment Sales