Prior to taking a portfolio company public, private equity firms should engage in careful tax planning in order to minimize any unanticipated corporate tax and/or investor tax in connection with pre-IPO restructuring.
This article was published in the October 27, 2016 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG).
In many cases, before a private equity fund (PE Fund) can engage in an initial public offering (IPO) of a portfolio company, the portfolio company group likely will proceed with pre-IPO restructuring. These restructuring steps may involve reincorporating in a jurisdiction with more robust or favorable corporate law, adding a new parent company in a jurisdiction deemed more preferential to public investors, distributable reserves planning, or the recapitalization of various classes of stock into a single class, just to name a few.1 Careful tax planning is required to ensure, where possible, that the portfolio company is not inadvertently subject to corporate-level income tax on the actual or deemed transfer of its assets, that U.S. investors in the private equity fund are not subject to tax on shares that are not sold in connection with the IPO, and that any gain recognized is capital gain or qualified dividend income and not ordinary income.2 This article discusses the advantages of the F Reorganization3 in connection with such planning and the potential impact of the final regulations issued in September 2015 (the Regulations) on such planning.
Example 1: Insertion of FloatCo Prior to IPO
Assume that a PE Fund and the managers of a portfolio company collectively own 100 percent of the stock of the portfolio company (PC). For a variety of reasons, it is determined that the PC should become a subsidiary of a new company (FloatCo) that will be the IPO vehicle. The PE Fund also will sell shares of the PC in a secondary offering at the time of the IPO. To accomplish the desired structure, the PE Fund and the managers transfer all of their shares in the PC to FloatCo. FloatCo sells some of its shares directly to the public in the IPO, and the PE Fund sells shares of FloatCo to the public pursuant to the secondary offering.
Please click here to view images.
Certainly, it would be the PE Fund’s intention that its U.S. investors would recognize capital gain only on the shares of the stock that are actually sold by the PE Fund. However, the initial transfer of shares of the PC to FloatCo is not necessarily a tax-free transaction. There is a risk, if done incorrectly, that restructuring in combination with the IPO transaction would be fully taxable, thus triggering taxable gain to the PC shareholders on all of the appreciation in the PC’s shares, even if there is insufficient cash in the transaction or secondary offering to pay the tax on such gain. In general, if all transferors collectively own 80 percent of the voting stock and 80 percent of each class of non-voting stock of FloatCo immediately after the exchange, then the transfer may indeed be tax-free. For this purpose, public shareholders who acquire shares of FloatCo directly from FloatCo would be treated as part of the transferor group (i.e., they transferred cash to FloatCo in exchange for FloatCo stock as part of the formation transaction). However, purchasers who acquire their shares from the PE Fund would not be treated as part of the transferor group. Similarly, service providers, such as managers of the PC and other advisors, who receive stock of FloatCo in return for their services will not be treated as part of the transferor group. If such persons acquire more than 20 percent of the post-IPO shares of FloatCo, the transaction would fail to qualify for tax-free treatment absent further planning. Additionally, under the "step transaction doctrine,"4 any transfers of shares by any member of the transferor group that are made as part of a binding contract existing at the time of the initial transfer of stock of the PC to FloatCo would be considered in determining whether the transferor group truly had control of FloatCo immediately after the transfer.
It may be undesirable to limit the size of the secondary offering based on tax concerns. Moreover, the need to consider, and perhaps limit, transfers by other members of the transferor group (e.g., managers, co-investors or public shareholders who acquired their shares in the IPO) may also be undesirable. Accordingly, additional planning, as described in Example 2, may be beneficial.
Example 2: Enter the F Reorganization – Insertion of FloatCo and Conversion of PC to LLC Prior to IPO
Please click here to view images.
In this example, immediately after the PC is transferred to FloatCo in exchange for FloatCo stock, the PC is converted into a limited liability company. Assuming that the PC is a domestic entity, it would become a disregarded entity of FloatCo (i.e., essentially treated as a division of FloatCo for federal tax purposes). The same result could be achieved if the PC were merged into a domestic limited liability company formed by FloatCo. If the PC were foreign, we could achieve the same result by making a check-the-box election to treat the PC as a disregarded entity of FloatCo solely for U.S. tax purposes.
The resulting structure is nearly identical to the structure in Example 1, but the analysis is quite different. As a result of the conversion of the PC to a disregarded entity for U.S. tax purposes, the transaction no longer can be analyzed as a transfer to a controlled corporation because the transaction is more properly viewed as an acquisition of the PC’s assets, rather than its stock. However, the transfer may be viewed as an F Reorganization of the PC, followed by the sale of FloatCo stock (the PC’s successor in the F Reorganization) to new public shareholders and the secondary offering of FloatCo stock by the PE to public shareholders.
An F Reorganization is a "mere change in identify, form or place of organization of one corporation, however effected" (collectively, a mere change). The reorganization in Example 2 appears to qualify as an F Reorganization because, immediately after the transfer of the PC to FloatCo and the conversion of the PC to a disregarded entity, FloatCo is a reorganized shell of the corporate business previously conducted by the PC. Although the PC exists for legal purposes, it does not exist for U.S. income tax purposes, and FloatCo is deemed to own all of the PC assets and liabilities.
As with all reorganizations, a reorganization must meet certain specific requirements, discussed below, in order to qualify as an F Reorganization. We will turn to these requirements now, as well as describe potential pitfalls that could prevent the transactions described in Example 2 from qualifying as an F Reorganization.
F in a Bubble
Consistent with IRS rulings going back several decades, the Regulations adopt the concept colloquially known as the "F in a bubble." Unlike most other types of tax-free transactions, steps related to, but not part of, the F Reorganization are ignored (i.e., the Regulations essentially "turn off" the step transaction doctrine) in determining whether the transaction qualifies as an F Reorganization. The Regulations also provide helpful guidance in determining when an F Reorganization starts, and when it ends, so that planners can determine what parts of the transaction must be considered part of the F Reorganization.
A series of transactions that can be tested as an F Reorganization begins when the transferring corporation (the PC in our example) begins transferring its assets to the resulting corporation (FloatCo in our example) and when the transferring corporation has distributed to its shareholders the consideration and has completely liquidated. The Regulations specifically incorporate deemed transfers resulting from check-the-box elections.
The Regulations also treat distributions made in connection with a reorganization as separate from the F Reorganization. Thus, in our example, if the PE Fund and the managers received not only FloatCo shares, but also cash of the PC not needed in the business, the cash distribution would not impact the F Reorganization, and the cash distribution generally would be treated as a dividend.
The Regulations identify six requirements in order for a transaction to be treated as an F Reorganization. We turn to these in order.
Stock Issued Solely for PC Stock
Immediately after the reorganization, all stock of FloatCo (including stock of FloatCo issued prior to the reorganization) must be distributed in exchange for PC stock. For example, if FloatCo stock were issued to service providers, purchased for cash or acquired by creditors of the PC in exchange for outstanding debt, this could cause the transaction to fail to qualify as an F Reorganization.
The Regulations permit a de minimis amount of stock to be issued other than in respect of the transfer of the PC to FloatCo in order to facilitate the organization of FloatCo or maintain its legal existence. This is important, because FloatCo would need to be formed in advance of the transactions. Thus, assuming that the PE Fund formed FloatCo with minimum capitalization, the issuance of FloatCo stock to the PE Fund for that cash would be ignored.
The Regulations also deal with the FloatCo stock that was issued to the public in connection with the IPO. Under the F in a bubble concept, if the FloatCo stock is issued to the public after the final step in the F Reorganization (i.e., the conversion of the PC to a limited liability company, merger of the PC into a limited liability company formed by FloatCo, or the deemed liquidation resulting from a check-the-box election of a foreign PC), the issuance is generally viewed as separate and apart from the F Reorganization and should not taint the F Reorganization.
Identity of Stock Ownership
The same person or persons must own all of the stock of the PC (immediately before the reorganization) and FloatCo (immediately after the transaction) in identical proportions. Note that most reorganizations require a "continuity of shareholder interest." This generally requires that shareholders of the target company receive acquiring company stock representing at least 50 percent of the consideration received in a reorganization. Certain reorganizations require the target shareholders to control (generally a 50 percent test) the acquiring corporation. The F Reorganization is the only reorganization that requires complete identity of ownership.
In certain circumstances, the Regulations permit one or more shareholders to receive distributions of cash or property, even in exchange for shares, in connection with the F Reorganization. They also permit a stockholder to exchange their target stock for acquiring stock of equivalent value but having different terms (e.g., common stock of FloatCo may be issued in exchange for preferred stock of the PC in connection with the F Reorganization). Thus, notwithstanding the general requirement of complete identity of ownership, the PC may be able to recapitalize, redeem its stock (even in a nonproportionate manner) or make distributions to its shareholders without causing the reorganization to fail to qualify as an F Reorganization.
Moreover, the F in a bubble concept makes the F Reorganization an attractive pre-IPO reorganization tool. The issuance of shares to the public in connection with the IPO will not taint the F Reorganization if the sale of shares to the public occurs after the last step constituting the F Reorganization. In addition, the Regulations turn off the continuity of shareholder interest requirement in the case of an F Reorganization. Thus, in general, the post-reorganization sales will not taint the F Reorganization, regardless of the amount of stock that the PE Fund sells in the secondary offering, or the percentage of stock issued by FloatCo in the IPO, so long as these subsequent steps occur after the "close" of the F Reorganization.
No Prior Assets or Tax History
FloatCo may not hold any property or have any tax attributes (e.g., net operating losses) immediately before the reorganization. The Regulations, however, permit FloatCo to hold a de minimis amount of assets to facilitate its organization or maintain its legal existence (and have tax attributes related to those assets). Thus, this requirement would not be violated merely because the PE Fund transferred the minimum capital to FloatCo in order to form it. However, an F Reorganization may not be used as a means of combining two operating companies even if, for example, one of the companies ceased doing business but had tax attributes.
Liquidation of Transferor
The PC must completely liquidate for U.S. federal income tax purposes, though it is not required to dissolve under applicable law. Thus, each of the conversion to a limited liability company, the merger into a limited liability company formed by FloatCo and the check-the-box liquidation would effect a liquidation for U.S. federal income tax purposes.
FloatCo Is the Only Acquiring Corporation
The Regulations specifically preclude the use of F Reorganizations as a way of effecting a corporate division. Thus, FloatCo must be the only corporation that holds property that was held by the PC immediately before the reorganization. This requirement does not preclude the taxable distribution of unwanted assets in connection with the F Reorganization. Rather, it prohibits a transfer of assets to another corporation where the other corporation would inherit tax attributes of the PC (i.e., a tax-free transfer).
PC Only Acquired Corporation
Immediately after the reorganization, FloatCo may not hold property acquired from another corporation if FloatCo would take into account the other corporation’s tax attributes. This precludes the use of an F Reorganization to effect the combination of more than one operating business.
Prior to taking a portfolio company public, private equity firms should engage in careful tax planning in order to minimize any unanticipated corporate tax and/or investor tax in connection with pre-IPO restructuring. The general goal is that investors be taxed only on shares sold in connection with the IPO and/or secondary offering, and not on shares that the fund continues to hold. In light of the ability to treat transactions related to and surrounding an F Reorganization as separate and apart from the reorganization (i.e., F in a bubble), the F Reorganization can be a powerful tool with which to effect pre-IPO reorganizations.