The scenario
Consider a common middle-market structure: an LLC taxed as a partnership (‘Partnership’) owns 100% of the stock of an operating C corporation (‘PortCo’). Partnership has three owners: a private equity sponsor holding 60%, a co-investor holding 25% and a management equity holder holding 15%. The management holder is departing, and PortCo's cash will fund the exit.
The key tax issue is who ends up recognizing the income. In many cases, that turns largely on the order in which the steps occur.
Structure 1: The straightforward approach and the problem it creates
In the most intuitive structure, PortCo distributes cash to Partnership, and Partnership uses that cash to buy out the departing partner's interest.
The problem: When a C corporation distributes cash to its shareholder, the distribution is treated as a dividend to the extent the corporation has earnings and profits (‘E&P’). For a profitable portfolio company, E&P will often exceed the distribution amount, meaning the entire payment is classified as dividend income.
Because Partnership (not the departing partner) is the shareholder of record, that dividend is recognized at the partnership level and allocated among all the partners under the partnership agreement, not just the departing partner. The continuing partners end up bearing a share of the dividend tax even though the departing partner is the only one leaving.
Illustrative example:
Partnership has three partners: A (60%), B (25%) and C (15%). C is being bought out for $10 million, funded by PortCo's cash. If PortCo has sufficient E&P, the entire $10 million is a dividend allocated to all partners proportionately. A and B together could be allocated $8.5 million of dividend income even though C is the only partner exiting. This is the ‘wrong-partner dividend’ problem.
Structure 2: A potentially better approach—distribute stock first
An alternative structure changes the sequence. Instead of moving cash from the corporation to the partnership, Partnership first distributes shares of PortCo stock to the departing partner in redemption of the partnership interest, and PortCo then redeems that stock for cash. This analysis assumes the PortCo stock is not treated as a marketable security for purposes of section 731(c). That sequence can solve the wrong-partner dividend problem, the partnership-level issues require consideration of whether the disguised sale rules under section 707(a)(2)(B) and Reg. section 1.707-3, the seven-year mixing-bowl rules under sections 704(c)(1)(B) and 737 and whether redemption-year allocations will be needed to place the partners in the correct post-transaction capital positions.
This sequencing matters because it changes who is treated as the shareholder in the dividend-versus-sale analysis. If the redemption qualifies as a sale or exchange, the departing partner (now shareholder) recognizes gain or loss (or dividend). Sale-or-exchange treatment might occur, for example, if the redemption completely terminates the departing partner's stock ownership.
If the redeemed partner retains an interest in the partnership, the analysis becomes more nuanced. In that case, the section 302 analysis must take into account whether the retained interest causes the partner to be treated as continuing to own PortCo stock and, as a result, whether the redemption is treated as a sale or exchange or instead as a dividend.
Illustrative example:
Partial redemption where the partner remains in Partnership. Assume Partnership has a single class of PortCo stock, no other owner is redeemed and C owns 15% of Partnership before the transaction. Partnership distributes a portion of the PortCo stock to C, PortCo redeems that stock for cash and C retains a 5% interest in Partnership afterward. Because C continues to own an interest in Partnership, C is still treated as constructively owning a portion of the PortCo stock after the redemption, and that retained ownership must be considered in the section 302 analysis. On these facts, however, the redemption appears to qualify for sale-or-exchange treatment under section 302(b)(2): C’s post-redemption constructive ownership is less than 50%, and C’s 5% post-redemption interest is less than 80% of C’s 15% pre-redemption interest. The point is not that every partial redemption fails but that the retained indirect ownership must be modeled before concluding that the stock-first structure produces the intended section 302 result.
Key planning considerations
While the stock-first approach is a powerful tool, it requires disciplined execution. Several planning points deserve attention:
- Complete exit is the cleanest result. The strongest outcome occurs when the departing partner fully exits the partnership. If the departing partner retains even a small continuing interest (whether equity, a profits interest or governance rights) the tax rules may treat them as still owning stock indirectly through the partnership. This ‘constructive ownership’ can prevent the redemption from qualifying for sale-or-exchange treatment.
- Constructive ownership rules must be modeled in advance. The tax code attributes stock ownership between related parties and between entities and their owners. These attribution rules can cause a partner who appears to be fully cashed out to still be treated as a stock owner for tax purposes. Deal teams should map all direct and constructive ownership before selecting the structure.
- Each step must stand on its own. The IRS could challenge the stock-first structure if the two steps—distributing stock and then redeeming it—appear to be a single prearranged transaction designed solely to avoid a partnership-level dividend. Courts have generally respected multi-step transactions where each step has independent legal and economic significance. To strengthen this position, each step should be separately approved, documented and implemented with its own business rationale.
- Valuation and documentation are critical. The stock distribution and the redemption price should be supported by an independent fair market value analysis. The partnership's books should reflect the economic consequences of each step, and transaction documents should not describe the arrangement as a single integrated plan.
- Identify which shares are being distributed. Deal teams should determine whether the redeemed partner originally contributed the shares being distributed or whether blocks of stock were issued to Partnership in connection with that partner's property contribution. If so, using those same shares in the redemption may produce a more favorable result and better align the tax consequences with the departing partner's economics without the need for special elections and calculations.
