I am selling my business to private equity and retaining 20% in the buyer's LLC. Is that rollover equity taxable at closing?
Not automatically. The cash sale is generally a taxable disposition. A separately identified contribution of qualifying property for an interest in a buyer holding company taxed as a partnership may defer gain under Section 721. Merely receiving buyer units worth 20% of the price, or labeling them “rollover,” does not establish that treatment. If the holding company is a corporation, Section 351 has different requirements; a taxable exchange for buyer equity can also occur. Determine the legal transfers, entity tax classifications, basis and consideration before the letter of intent locks in the deal.
This question belongs to a founder or controlling owner negotiating a substantial partial exit, not to a reader seeking a generic definition of capital gains. AE can compare the signed deal steps to the tax model, quantify sale-year income and deferred basis, and coordinate the seller's return and future K-1s before closing.
Separate the cash sale from the equity contribution
Start with the transfer documents: what property does the owner sell for cash, what property does the owner contribute for units, and which legal entity issues those units? A partnership-taxed holding company can generally receive property for a partnership interest without immediate gain under Section 721, but the IRS partnership guidance identifies exceptions, including disguised sales and investment-company rules. The cash leg must be analyzed as a sale; a cash distribution connected to a purported contribution can also cause some or all of the arrangement to be treated as a sale under Section 707. Debt shifts, preferred rights, guaranteed payments and transaction expenses can change the result.
If a corporate holding company issues stock instead, IRS Publication 542 explains that Section 351 generally requires the property transferors as a group to control at least 80% of the corporation immediately after the exchange. A seller's personal 20% stake neither proves nor disproves the group-control test. Cash or other nonstock consideration, liabilities, stock rights, sequencing and the identity of all transferors need separate review. Do not apply the partnership rule to a corporation, or assume a stock-for-stock exchange is tax-free just because no cash reaches the seller on that leg.
A 20% rollover illustration—and what it does not prove
Suppose a founder owns C-corporation stock worth $10 million with $1 million aggregate adjusted stock basis. The draft deal says the founder will receive $8 million cash and buyer-holdco units valued at $2 million. For a simple separately documented structure, assume 80% of the shares are sold for $8 million and 20% are contributed to a domestic LLC taxed as a partnership solely for its units. If basis is allocated pro rata and no special rule changes it, the sold shares carry $800,000 basis, producing a preliminary $7.2 million gain before selling costs and character analysis; the contributed shares carry $200,000 basis and $1.8 million built-in appreciation. If Section 721 actually applies, that latter appreciation is deferred, not forgiven, and the owner generally begins with carryover outside basis rather than a $2 million tax basis in the units.
The example is not a conclusion that this proposed transaction qualifies. If the documents instead make the entire $10 million exchange taxable, followed by the founder's purchase of buyer units using $2 million of proceeds, gain on the whole stock disposition may be recognized now. If the target is an S corporation, a partnership generally cannot be its shareholder; the deal may need a different target structure and a separately reviewed reorganization, not this C-stock illustration. If buyer consideration includes debt relief, compensation, a noncompete, earnout or preferred equity, the numbers and character change. AE's business-sale structure guide covers the stock-versus-asset and pre-sale reorganization fork; the earnout guide addresses a different deferred-payment issue.
Five questions to settle before signing the rollover term sheet
- What is being retained? A direct unsold interest, property contributed to holdco, buyer units issued as taxable consideration, and cash reinvested after a sale can have different tax results even when each is described as a 20% rollover.
- How is holdco taxed? Confirm its federal classification and the entity issuing equity. Test Section 721 for a genuine partnership contribution or the distinct Section 351 and possible reorganization rules for corporate stock; do not infer classification from “LLC” in the name.
- Which basis and gain attach to each leg? Reconcile historical share or outside basis, prior distributions, debt, purchase-price allocation and closing costs. For partnership sellers, IRS Publication 541 also warns that unrealized receivables and inventory can produce ordinary income on an interest sale.
- Is any value compensation or a disguised sale? Management incentives, consulting payments, noncompetes, guaranteed cash, redemption rights and rapid distributions require their own character and timing analysis. A contribution followed by related cash is not automatically a tax-free rollover.
- What happens on the second exit? Forecast basis, holding period, future partnership allocations, debt shares, distributions and sale treatment. A deferred gain can become taxable later, and a lucrative equity value does not equal current cash available to pay the first closing's tax.
Documents AE needs for a pre-closing return model
- Letter of intent, transaction steps, draft purchase and contribution agreements, holdco operating agreement, capitalization table, management-equity terms and closing funds flow.
- Target and seller entity classifications, ownership history, prior returns, stock or partnership outside-basis workpapers, debt schedules and pending elections.
- Asset values and purchase-price allocation, working-capital and debt adjustments, earnout or escrow terms, transaction-fee invoices, noncompete and employment agreements.
- Tax projection for cash received, rollover property, ordinary-income components, state filings, future distributions and a downside case if the deferred-equity value declines.
Common failure points: treating the headline rollover percentage as the tax-free percentage; allocating all stock basis to the cash leg; calling a post-sale reinvestment a nonrecognition exchange; overlooking Section 351 control or Section 707 disguised-sale rules; having a partnership acquire S-corporation stock; ignoring ordinary-income assets or deal-fee character; and filing a return that cannot be reconciled to the closing statement and new K-1.
Before accepting the buyer's after-tax proceeds schedule, have AE reconcile the legal transfer diagram, cash flow, seller basis and reporting positions. The review can reveal a defensible deferral, an unexpectedly taxable equity leg, or a price and structure term that needs negotiation before the deal becomes hard to change.
Related AE guidance and primary sources
This federal framework illustrates alternatives, not a conclusion that any particular private-equity rollover qualifies for nonrecognition. Entity classification, integrated transaction steps, stock eligibility, liabilities, preferred rights, compensation, basis, state rules and closing documents can change the answer. Transaction counsel and the return preparer should review the same signed facts before execution and filing.