Structuring ideas to achieve redemption or dividend treatment: Zenz

Executive summary: 

Structuring leveraged buyouts to achieve optimal tax treatment for selling shareholders. 

Many merger and acquisition (M&A) transactions, including most private equity (PE) fund transactions, involve the use of debt financing at the target entity to fund a portion of the purchase price (i.e., a leveraged buyout or LBO). Where the target entity is a corporation, the transaction structure will likely dictate the treatment of these debt financed proceeds as either a dividend or redemption (i.e., sale or exchange) to the selling shareholders. While dividend treatment can come with withholding requirements to the company, as well as earnings and profits calculations and additional reporting requirements, it can also provide qualified dividend treatment on shares held less than one year. On the other hand, a redemption may avoid dividend withholding requirements and also provide a better answer for basis recovery if a shareholder is not being completely cashed out in the deal. As a result, understanding how to structure a transaction to achieve redemption or dividend treatment is critical, in order for selling shareholders to achieve the preferred tax result.

Structuring ideas to achieve redemption or dividend treatment: Zenz

Tax techniques of Zenz transactions

A key element of an LBO is that cash borrowed by the target corporation is paid to the selling target shareholders. As a result, the tax rules that apply to distributions from a corporation to a shareholder are key. Distributions with respect to stock represent dividends to the extent of current and accumulated earnings and profits.¹ If instead the corporation redeems shares, the payment is generally treated as a sale or exchange to the shareholder.² As noted above, sale or exchange treatment is often preferred to allow for capital gain to the shareholder. However, when the shareholder has a short-term (less than 12 months) holding period on their stock, sale or exchange treatment would result in a short-term capital gain taxed at ordinary tax rates.³ On the other hand, a dividend is taxed at favorable rates (20% to individuals) as long as it meets the shorter qualified dividend rate holding period.⁴  

In most LBOs, the borrowed cash is transferred at closing via wire along with the buyer’s cash to the selling target shareholders. The example and table below illustrate a simplified LBO transaction by excluding escrows, holdbacks, earnouts and rollover equity that are common in M&A transactions.

Example 1: PE forms ABC Corporation (ABC) to acquire a C corporation target (T) from the T shareholders in a $500 million transaction. ABC acquires T directly from the T shareholders and does not utilize a merger subsidiary. The sources and uses (S&U) shows $500 million total in each of the sources and uses. The selling shareholders receive $300 million in proceeds that is wired directly to them or shareholder representatives. PE funded the $200 million in ABC cash at closing, but it was never actually transferred to ABC. Only $200 million of the $300 million in shareholder proceeds was funded by ABC (through the PE investment). The remaining $100 million represent the LBO proceeds. In this case, T took on a total of $300 million of debt and utilized $150 million to pay off existing debt, $50 million to pay fees and fund working capital, and $100 million to fund the LBO proceeds.

In a situation like this where the cash all changes hands at closing via wire transfer, how should T determine the treatment as a dividend or redemption? Stock purchase agreements are often silent as to the LBO proceeds. If that is the case, the most reasonable conclusion is that the LBO proceeds represent a distribution with respect to the stock as no shares of T were redeemed.⁵  However, if instead the legal agreements call for the redemption of $100 million in T stock using the LBO proceeds and $200 million as the sale proceeds, the parties may reach a sale or exchange position on the LBO proceeds. This is because of the Zenz⁶ decision. In Zenz, the 6th Circuit Court held that a shareholder received sale or exchange treatment on what would otherwise represent a dividend equivalent redemption because it occurred as a part of a larger sale transaction resulting in a complete disposition of a shareholder’s stock. In other words, the integrated transaction of both the sale and redemption resulting in the complete disposition of the shareholder’s interest in the corporation received sale or exchange treatment. 

In example 1, the transaction was a true stock sale. However, these transactions are often structured instead as reverse cash mergers. In a reverse cash merger, ABC forms a transitory merger subsidiary (MS) that merges with and into T with T surviving. For tax purposes, the existence of MS is generally disregarded, and the transaction is treated as a stock acquisition.⁷  Legally, however, the shareholders of T received merger consideration in the transaction, and the IRS has held that LBO proceeds received as merger consideration are received in exchange for the T stock and received sale or exchange treatment.⁸  

Added complications for PE portfolio companies

Example 1 assumes a complete disposition of the target company shares by direct shareholders. However, in many transactions there is less than a complete disposition by certain rollover owners.

Example 2: Assume the same facts as the previous example except that T is wholly owned by a holding company LLC (Holdings), and Holdings is owned by PE, T management, and founders. Further, as a part of the transaction there is a tax-deferred rollover of $50 million by certain owners of Holdings. In this case, if structured as a dividend, Holdings would allocate the dividend under the LLC operating agreement, which could result in dividend income allocation to the rollover investors. But, even if structured as a redemption receiving sale or exchange treatment, rollover owners could receive income allocations making the rollover less tax efficient.

A common transaction step to address this issue involves Holdings distributing T shares to the rollover owners either in exchange for some or all of their Holdings units. The basis consequences to the Holdings owners for the shares they receive in T is beyond the scope of this example. Those rollover owners then transfer their shares of T to ABC in an intended tax-deferred section 351 transaction. The remaining shares of T held by Holdings are then acquired utilizing either a Zenz redemption or reverse cash merger to accomplish sale or exchange treatment to Holdings.

Another complication that often arises is an LBO where T is an LLC taxed as a partnership, and one of the owners of T is a C corporation blocker. The corporate blocker entity receives the LBO proceeds to distribute to its shareholders. The sale of T is often structured as a direct acquisition of T units owned by non-blocker owners and indirectly through the acquisition of the blocker. 

Example 3: Assume the same facts as example 1 except that T is an LLC taxed as a partnership and is owned one-third (33%) by a blocker C corporation (B). As is customary at closing, debt financed wires equal to $100 million of the sale proceeds were paid directly to B shareholders. Assuming the transaction is not specific as to the use of the proceeds, $33.3 million of LBO proceeds would represent a distribution from T to B, followed by a pre-transaction dividend distribution to the extent of B’s earnings and profits.⁹  

To avoid dividend treatment, the parties could structure the acquisition of B as a reverse cash merger with B, or a perhaps more cumbersome alternative, B could effectuate a redemption of $33.3 million of B stock to accomplish a Zenz redemption.

Summary

As the examples above show, with the appropriate planning a selling shareholder is likely able to achieve their preferred tax result between either sale or exchange treatment or dividend distribution treatment in an M&A transaction involving an LBO. However, if not planned accordingly, corporate targets can find themselves subject to unexpected withholding and reporting obligations, and selling shareholders can lose some or all the expected tax deferral on post-transaction rollover ownership. Due to the complexities involved as described above, taxpayers should consult with their tax advisers prior to such a transaction.

  ¹Sections 301(a) and (c)(1). 

  ²Note that certain redemptions, such as ratable redemptions from all shareholders, generally result in dividend treatment. Section 302(d) and section 301; Reg. section 1.302-2(b)(1).

  ³Section 1221(1). 

  ⁴The shorter qualified dividend rate holding period is at least 61 days, during the 120-day period beginning 60 days before the ex-dividend date. Section 1(h)(11)(B)(iii)(l), section 246(c)(1). If the dividend was declared on preferred stock, then the 61-day minimum holding period is extended to at least 91 days during a 181-day period beginning 90 days before the ex-dividend date. Section 246(c)(2).

  ⁵Section 301(a); Rev. Rul. 75-493, 1975-2 C.B. 109.  

  ⁶Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954).

  ⁷Rev. Rul. 90-95, 1990-2 C.B. 67. 

  ⁸Rev. Rul. 79-273, 1979-2 C.B. 125.

  ⁹See section 301.