PRIVATE EQUITY

1
PRIVATE EQUITY

• Corporate Tax Committee
• May 6, 2006
• Julie Divola
  Eric Solomon
• Pillsbury Winthrop Shaw Acting
  Deputy Assistant Secretary Pittman LLP
  (Tax Policy)
  
• Department of the
  Treasury
• Andrew W. Needham William D.
  Alexander
• Cravath, Swaine Moore LLP
  Associate Chief Counsel (Corporate)
• Internal Revenue Service

2
Private Equity

• Dividend vs. capital gain in a partial exit
• Section 338(h)(10) transactions involving
  management rollovers
• Minimizing taxes on PIK preferred stock
• Avoiding partial liquidation treatment

3

• Dividend vs. Capital Gain in a Partial Exit

4
Dividend vs. Capital Gain
5
Leveraged Recap in lt One Year(assumes ep gt
total distribution)

• Investor
• Individual
• US Corporate
• Foreign
• Tax-Exempt

• Prefer Dividend or Capital Gain?
• Dividend if (15 x (Distribution)) lt (35 x
  (Distribution - Basis))
• Dividend if (35 x (Distribution x (1 - 70)) lt
  (35 x (Distribution - Basis))
• Capital Gain
• Indifferent

6
Leveraged Recap in gt One Year(assumes ep gt
total distribution)

• Investor
• Individual
• US Corporate
• Foreign
• Tax-Exempt

• Prefer Dividend or Capital Gain?
• Capital Gain
• Dividend if (35 x (Distribution x (1 - 70)) lt
  (35 x (Distribution - Basis))
• Capital Gain
• Indifferent

7

• Section 338(h)(10) Transactions Involving
  Management Rollovers

8
Section 338(h)(10) Election

• Election to Treat a Stock Sale as an Asset Sale
• Can Apply to a Subsidiary in a Consolidated/Affili
  ated Group or to an S Corporation
• Qualified Stock Purchase (QSP) Acquiring must
  purchase amount of stock described in section
  1504(a)(2) in one or more transactions within a
  12-month period. See section 338(d)(3)

9
Section 338(h)(10) Election

• Section 1504(a)(2) Generally 80 voting power
  and 80 value (excluding certain plain vanilla
  preferred)
• Purchase under section 338(h)(3) means
• The stock basis is not determined, in whole or
  part, by reference to its basis in the hands of
  the seller
• The stock is not acquired in an exchange that is
  subject to section 351 or section 354
• The stock is not a acquired from a person whose
  stock would be attributed to the acquiring person
  under section 318(a) (ignoring option
  attribution)

10
Section 338(h)(10) Election Example 1

• X forms Newco to acquire Target
• Targets FMV is 200.
• P corp. owns 80 of Target A (employee) owns 20
  of Target
• A will rollover her 20 interest by
  contributing her Target stock to Newco
• X contributes 150 to Newco
• Newco forms Merger Sub and contributes the 150
  received from X
• Merger Sub borrows 10
• Merger Sub merges into Target with Target
  surviving P receives 160 in the merger

P
A
X
Newco Stock
150
Newco Stock
Target Stock (20)
20
80
Newco
150
Target
Merger Sub
10
Merger
Loan
11
Section 338(h)(10) Election Example 1

• Are the QSP requirements satisfied?
• A portion of Ps shares were acquired by
  redemption.
• A shares (acquired in a section 351 transaction)
  represent 21 of the Target shares
• P shares (acquired by purchase) represent only
  79 of the Target share
• What if the loan is to Newco?

A
P
X
Newco Stock
150
Newco Stock
Target Stock (20)
Newco
160
150
Target
10
Loan
12
Section 338(h)(10) Election Example 2

• X forms Newco to acquire Target
• Targets FMV is 200.
• P receives 190 plus 5 of the Newco stock
• Are the QSP requirements satisfied?
• Ps shares of Target were acquired in a section
  351 transaction with boot
• Any difference if all of Ps gain is recognized?
  See section 338(h)(3)(A)(ii).

P
5 Newco Stock 190
X
190
Newco Stock
Target Stock (100)
Newco
Target
13
Section 338(h)(10) Election Example 3

• X forms Newco to acquire Target
• Target is an S corporation with a FMV of 200.
• P owns 70 of Target A owns 30 of Target
• X contributes 180 to Newco
• A will rollover a third of his shares. A
  receives 10 of the stock of Newco and 40
• Newco forms Merger Sub and contributes 140
• Merger Sub merges into Target with Target
  surviving P receives 140 in the merger

A
P
X
Newco Stock 40
180
Target Stock (30)
30
70
Newco Stock
Newco
140
Target (S Corp.)
Merger Sub
Merger
14
Section 338(h)(10) Election Example 3

• Are the QSP requirements satisfied?
• As shares (equal to 30 of Target) were acquired
  in a section 351 transaction

A
P
X
Newco Stock 40
180
Newco Stock
Target Stock (30)
Newco
140
140
Target (S Corp.)
15
Section 338(h)(10) Election Example 4

• P and A (Target shareholders) contribute Target
  stock to Newco in exchange for Newco shares in a
  section 351 transaction
• At the same time, P sells its Newco shares to X
  pursuant to a binding written agreement
• Transaction fails section 351 control immediately
  after test. See Rev. Rul. 70-140.
• Can Newco and P make the section 338(h)(10)
  election?
• What if A receives a note convertible into Newco
  shares?

(1)
(2)


160
P
X
Newco Stock
A
Target Stock (80)
Newco Stock
Newco Stock
Target Stock (20)
Newco
Target
16
Section 338(h)(10) Election Example 5

• Facts are the same as in Example 1 except
• Pursuant to a binding written agreement, X sells
  Newco shares to friendly bank.
• What if the Newco shares sold by X are a special
  class of nonvoting preferred stock? What if
  there is only one share of the special class of
  preferred?
• See PLR 8817079 (2/4/88), supplemented by PLR
  8822062 (3/7/88) (single share of non-voting
  preferred stock sold to affiliate is sufficient
  to disqualify transaction under section
  368(a)(2)(E)).

(1)
(2)
Newco preferred stock

A
X
FB

Newco Stock
P
Newco Stock (common preferred)
160
Target Stock (20)
Newco
160
160
Target
17
Section 338(h)(10) Election Example 6

• Facts are the same as in Example 1 except
• As interest in Target is recapitalized
  immediately before the incorporation of Newco. A
  receives plain vanilla preferred stock.
• Can A get section 351 treatment this way without
  impacting the section 338(h)(10) election? See
  Rev. Rul. 57-114 (transitory ownership not
  respected).
• Does it help if A gets plain vanilla preferred
  stock of Newco?

A
X
Newco Stock
P
Newco Stock
150
Target Pref. Stk. Com. Stk. (20)
Newco
160
150
Target
10
Loan
18
Section 338(h)(10) Election Example 7

• Same as Example 1 except
• Target merges into Merger Sub in a forward
  subsidiary merger. P receives cash and A
  receives Newco stock.

P
A
X
Newco Stock
150
150
Newco Stock
Newco
150
20
80
Target
Merger Sub
10
Merger
Loan
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Section 338(h)(10) Election Example 8

• Same as Example 1 except
• Target is converted into an LLC immediately
  before the transaction.
• A receives Newco stock in exchange for Target LLC
  interests.
• P receives cash in exchange for Target LLC
  interests.

P
A
X
Newco Stock
150
Target LLC interests
150
Newco Stock
Newco
Target LLC interests
80
150
20
Target LLC
Merger Sub
10
Merger
Loan
20

• Minimizing Dividend Taxes on PIK Preferred Stock

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Significance to Participants

• Foreign Investors
• Avoid U.S. withholding taxes
• Avoid accelerated liability for tax
• Potential tax exemption
• U.S. Investors
• Avoid accelerated liability for tax
• Capital gain conversion

22
Pre-Money Valuation Disputes

• Conversion Price LP / of Common Shares
• Conversion Price usually at-the-money
• PIK Preferred to bridge

23
A Common Valuation Dispute

• The founders of XYZ Corp need to raise 20
  million. They value the business at 30 million.
  VentureCo proposes to invest 20 million in
  exchange for newly-issued convertible preferred
  stock, but values the business at only 20
  million. So the founders propose that the
  preferred be convertible into 40 of the common
  stock (i.e., 20/(20 30)), VentureCo proposes
  that the preferred be convertible into 50 of the
  common stock (i.e., 20/(20 20)).

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The PIK Solution

• XYZ Co issues PIK preferred stock, initially
  convertible into 40 of the underlying common.
  The PIK dividend rate is 8.5.
• After 5 years, the preferred stock is now
  convertible into 50 of the common stock (i.e.,
  (20M x 1.085)5 30M).
• By PIKing the dividends, VentureCo receives its
  desired conversion price after 5 years, even
  though it invested at a pre-money valuation of
  30 million.

25
305 Issues with PIK Preferred

• 305 (b)(4) distributions on preferred stock
• 305 (b)(5) distributions of convertible
  preferred stock
• 305 (b)(2) cash to some, increase in
  proportionate interest to others

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• Avoiding Partial Liquidations

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Partial Liquidations

• Partial Liquidations
• Characterized as a sale or exchange for tax
  purposes
• Can result in short-term capital gain rather than
  dividend income for short-term holders
• Can result in a disallowed capital loss
• Can cause S corp. distributions that would
  otherwise be tax-free as distributions from the
  accumulated adjustments account (AAA) or as a
  return of basis to be taxable capital gains.

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Partial Liquidations

• Partial Liquidations
• One of the four tests for determining whether a
  redemption qualifies for sale or exchange
  treatment.
• Unlike the other redemption tests, no change in
  the shareholders ownership is necessary.
• Partial liquidation treatment applies even though
  no shares are surrendered.
• Meaningless gesture rule applies. See Rev. Rul.
  81-3.
• Partial liquidation treatment is mandatory.

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Partial Liquidations

• Partial liquidation treatment only applies to
  distributions to non-corporate shareholders
• Generally look through to the holders of
  pass-through entities.
• Distribution must be in partial liquidation of
  the distributing company

30
Partial Liquidations

• Distribution are in partial liquidation if
• The distribution is not essentially equivalent to
  a dividend (determined at the corporate level not
  the shareholder level) and
• The distribution is pursuant to a plan and
  occurs within the taxable year of the adoption of
  the plan or the following taxable year.

31
Partial Liquidations

• Subjective test for when a distribution is not
  essentially equivalent to a dividend
• IRS looks for a genuine corporate contraction
• Requires a sale or curtailment of a significant
  part of the business and a distribution of a
  significant portion of the proceeds

32
Partial Liquidations

• Subjective test
• IRS will not rule unless there is at least a 20
  reduction in the following as a result of the
  sale or distribution
• gross revenue
• fair market value of net assets and
• employees.

33
Partial Liquidations

• Safe harbor test for when a distribution is not
  essentially equivalent to a dividend
• Sale or termination of a qualified trade or
  business (significant or not).
• Retention of a qualified trade or business.
• Distribution of all of the net proceeds from the
  sale or termination.

34
Partial Liquidations

• Qualified trade or business is one that
• Was actively conducted for 5 years prior to the
  distribution and
• Was not acquired during the 5-year period in a
  transaction in which gain or loss was recognized.

35
Partial Liquidations

• Methods for avoiding partial liquidation
  treatment
• Fail to make a plan
• Plan can be informal and the necessary corporate
  documents may qualify as a plan
• IRS may view this inappropriate elective
  treatment
• Any difference if a formal plan is made after
  agreement to sell (or after actual sale)?
• Any difference if the distribution is made after
  a formal plan expires (Rev. Rul. 77468)
• Parent sells stock of a subsidiary without a
  section 338(h)(10) election

36
Partial Liquidations

• Methods for avoiding partial liquidation
  treatment
• Parent sells assets of a subsidiary but does not
  liquidate it (and does not allow a de facto
  liquidation to occur)
• Distribution of only a portion of the proceeds of
  the sale
• Must avoid characterization as essentially
  equivalent to a dividend. What percentage works?
• Is there also a common law test?

37
Partial Liquidations

• Methods for avoiding partial liquidation
  treatment
• Parent distributes other assets rather than
  proceeds form the sale or deemed sale of its
  subsidiarys business
• Is cash fungible? See Rev. Rul. 79-275, Rev.
  Rul. 76279 and Rev. Rul. 76-289
• Liquidate subsidiary before the sale
• Court Holding considerations
• Convert subsidiary into an LLC that is treated as
  a disregarded entity.