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.
Partnership transactions: Section 721
Contingent equity in partnership transactions introduces further layers of analysis. In addition to understanding if the issuance is connected to the initial section 721 transaction, capital accounting and income allocations to partners must be considered.
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.
A private equity sponsor owns AcquireLLC, a partnership. Seller contributes a disregarded entity (FMV $200 million) and receives $100 million in cash and a partnership interest valued at $100 million. The acquisition agreement allows Seller to receive up to $50 million in additional partnership equity if the contributed business achieves certain post-closing EBITDA targets. After Year 2, the business meets its EBITDA targets, and Seller receives $50 million in additional equity.
1. Tax treatment at closing:
Seller’s contribution of the disregarded entity to AcquireLLC in exchange for a partnership interest and $100 million in cash falls under section 721. Under section 721(a), generally, no gain or loss is recognized on the contribution of property to a partnership in exchange for an interest in the partnership, except to the extent of cash or other nonqualifying consideration received. In this case, the transaction operates as a proportionate asset sale: Seller is treated as exchanging a portion of the property for the $100 million in cash (nonqualifying consideration or ‘boot’) plus any corresponding liability assumption and the remainder for partnership interests (qualifying consideration).
2. Potential treatment of additional equity issued after Year 2:
Whether the additional $50 million of equity is considered part of the original section 721 exchange depends on the facts and circumstances, including whether it is treated as consideration for the contributed property, an allocation of post-transaction profit or as compensation for services.
If it is considered part of the original section 721 transaction and not as compensation, the analysis shifts to whether the issuance of the additional equity would cause a capital shift among the partners—potentially requiring an income allocation—or whether it would result in a capital account book-up.
If a capital account book-up occurs, further consideration must be given to whether the book-up applies only to the contributing partner or to all partners, and at what value the book-up should be made.
Note, however, if the right to contingent equity is tied to Seller’s provision of services, employment or management after closing, there is a risk that the IRS could treat the equity as compensatory, subject to section 83, resulting in ordinary income recognition (e.g., guaranteed payment) instead of nonrecognition treatment under section 721.
1. Potential tax treatment at closing:
The facts are identical to Example 1, except that Seller transfers the disregarded entity to AcquireCo, a newly formed C corporation, and receives $100 million in cash plus AcquireCo stock in return. The requirements of section 351 are satisfied, and the transaction is governed by section 351.
Under section 351(a), no gain or loss is recognized on the transfer of property to a corporation in exchange for stock if the transferors control the corporation immediately after the exchange. However, Seller must recognize gain to the extent of the $100 million cash received (the ‘boot’).
The stock is considered nonrecognition property for this purpose, and it may be appropriate to consider the value of any contingent equity at closing when determining the gain realized. This example does not assume boot was received in excess of realized gain.
2. Potential treatment of additional equity issued after Year 2:
If the additional $50 million of AcquireCo stock is viewed as part of the original section 351 exchange (that is, as consideration for the contributed property, not for services), then in general no additional gain or loss is recognized when the stock is issued. See Rev. Proc. 84-42.
However, if the FMV of the contingent equity ultimately exceeds the estimate at closing and the overall realized gain increases, additional gain recognition may be appropriate if the seller previously received boot in excess of the gain realized at closing.
This determination is generally made on an asset-by-asset basis, as illustrated in Rev. Rul. 68-55. Whether and how installment treatment could or should apply to gain recognition is beyond the scope of this analysis.
Note, however, if Seller’s right to the contingent stock depends on the provision of services, employment or management after closing, the IRS could treat the stock as compensation. In that case, the equity is subject to ordinary income recognition under section 83, rather than qualifying as nonrecognition property under section 351.
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.
Conclusion: Tax implications of contingent equity
Contingent equity is a valuable commercial tool, but in tax-free transactions, it often carries more tax significance than expected. Early identification of key tax issues before transaction terms are finalized can help preserve intended tax outcomes while still achieving business objectives.
Related insights
- /insights/services/business-tax/earn-outs-with-continued-employment-purchase-price-or-compensati