Tax considerations for contingent equity in M&A transactions

Executive summary: Navigating tax issues tied to contingent equity arrangements

Contingent equity arrangements, such as earn-outs, milestone payments and other performance-based equity are commonly used in intended tax-free corporate (sections 351) and partnership (section 721) transactions to bridge the gap in value disagreements and align post-closing incentives.

When structured properly, gain deferral is available on contingent equity issued in the months and years after a merger and acquisition transaction, even when based upon post-transaction activities.

Understanding contingent equity in partially tax-deferred transactions

Contingent consideration is a common feature in transactions to address valuation uncertainty, incentivize post-closing performance or balance risk and are frequently essential to reaching agreement between parties.

However, when contingent consideration takes the form of equity, an added layer of tax analysis is required. Maintaining tax-deferred treatment for contingent equity depends on carefully evaluating what is received, when it is received and the underlying reasons for its issuance.

Where equity is issued upon the occurrence of future events after closing, additional scrutiny is necessary to ensure the arrangement qualifies for deferral under the relevant tax rules as opposed to compensation or taxable consideration upon receipt.

We will explore a basic fact pattern involving a private equity fund and an existing ownership group of a target business (Seller) agreeing to a transaction whereby Seller contributes a disregarded entity (estimated fair market value (FMV) $200 million, ignoring contingent consideration) and receives $100 million in cash and equity initially valued at $100 million.

The acquisition agreement allows Seller to receive up to $50 million in additional equity if certain post-closing earnings before interest, taxes, and depreciation and amortization (EBITDA) targets are achieved. After Year 2, Seller meets its EBITDA targets and receives $50 million in additional equity. The focus of this article is on the tax rules related to the subsequent receipt of the equity and not on the calculation of gain recognition upon the transaction.

Note that in this example, the equity is not issued at closing and is only issued after the targets are met. Careful consideration of the term ‘contingent equity’ is necessary as the legal and economic definition can differ in each transaction.

Contingent stock in corporate transactions: Section 351

Contingent stock arrangements in corporate transactions raise important tax questions, especially regarding whether equity issued after a transaction—based on the outcome of future operations—can still benefit from tax deferral as part of a tax-free exchange, rather than being classified as taxable ‘boot.’ This distinction is crucial, as treatment as boot could trigger tax liability upon receipt and undermine the intended benefits under sections 351 for the overall transaction.

If structured properly, the receipt of the contingent equity is tax-deferred to the recipient. If not, it could result in either failure of the entire section 351 transaction or taxable income on the contingent equity.

Rev. Proc. 84-42 provides guidance to taxpayers issuing contingent equity in such situations. While not strictly determinative, aligning with the guidelines set out in the revenue procedure is advisable, as it can help clarify when contingent stock may be treated as stock for tax purposes in an otherwise tax-deferred transaction, rather than as boot. Key factors to consider generally include whether:

• The arrangement addresses genuine business uncertainties, such as those relating to future performance or valuation
• The maximum number of contingent shares is specified
• Rights to contingent stock are transferable
• Future consideration is paid solely in stock and not in cash or other property

Careful attention to these elements can help ensure that contingent equity retains tax deferral, even when issued following a transaction and based on subsequent business results.

A more exhaustive list of factors is found in various IRS authorities and case law. The IRS has reinforced the ability of future stock issuances to be treated as stock, including in Rev. Ruls. 66-112, 67-90 and 72-205, so long as the contingent stock arrangements fall within certain parameters and are not used to disguise compensation or other non-qualifying consideration. Several courts have reached the same conclusion. See Carlberg v. United States, 281 F.2d 507 (8th Cir. 1960); and Hamrick v. Commissioner, 43 T.C. 21 (1964).

If the arrangement does not fall within the factors set forth in Rev. Proc. 84-42 (and other relevant authorities), there is increased risk that the FMV of a contingent stock right is treated as taxable consideration or even that the overall transaction is not tax-free due to failure to meet the section 351 control requirement.

Capital accounts and section 704(c) considerations

Even when nonrecognition treatment is preserved, contingent equity can have meaningful downstream effects on partnership capital accounts and tax allocations. Whether satisfying the contingency results in additional units or assigned capital value to the units already held, when the contingencies are satisfied, partnerships typically address the resulting economics through either income allocations in the year of issuance or through a capital account revaluation under section 704.

Where income is allocated in the year the contingency is met, some or all the benefit of the tax deferral is lost. How much depends upon whether the issuance results in a shift in capital between partners (all in the year of issuance) or in an allocation of income in the year of the issuance and in future years until capital accounts reflect the economics.

Revaluation approaches can introduce complexity, including allocations of income or loss and the creation of additional section 704(c) layers. While these mechanisms may better reflect the economics, they require careful planning and modeling to avoid unintended tax consequences.

Key questions for deal teams to consider

Executives and investors involved in transactions with contingent equity need to consider items such as:

• Does the transaction include an earnout or other performance-based equity component that requires the recipient to perform services?

• Is the agreement between the parties clear as to the intended tax treatment?

• Contingent corporate stock is generally not treated as issued at closing when considering the section 1202 qualified small business stock exclusion holding period rules.

• In partnership transactions, does the partnership agreement address the treatment of income allocations and capital accounting treatment of the contingent equity?

Addressing these questions early can help reduce the risk of unintended tax outcomes.