Rolling Equity Into a DSO? Know When Your Tax Bill Really Comes Due

On closing day, most of your price hits your bank account, and you owe tax on it for the year of the sale.

The rest sits in the buyer's company as units. That tax bill is still coming, and someone else picks the date.

Picture year four. You're still seeing patients, now on the DSO's payroll, holding units you rolled at closing. Then an email: the sponsor is selling. Good news, and a tax bill you didn't schedule.

Here is the short answer. Rolled equity often is not taxed at closing if the deal qualifies under Section 721 or 351. The tax is not gone. Your old basis carries over, so the gain comes due when the DSO sells or recapitalizes, in a year you do not control. Cash at close is taxed now. Your CPA sets the specifics.

Deferred is not tax free

Two code sections do most of the work in a rollover.

• Section 721 says no gain or loss is recognized when you contribute property to a partnership in exchange for an interest in it. Some DSO buyers and joint ventures are LLCs taxed as partnerships.
• Section 351 says no gain or loss is recognized when property is transferred to a corporation solely for its stock, if the people transferring are in control of the corporation right after.

Neither section forgives the gain. It moves it. Under Section 358 for corporations, and Section 722 for partnerships, your basis in the new equity generally starts from your basis in what you gave up. If your basis was low, the gain is still sitting there, inside the units.

Why the buyer's tax form matters

Whether your rollover lands in an LLC or a corporation changes which rule applies.

For a corporation, Section 351 requires control, which Section 368(c) defines as at least 80% of the total combined voting power and at least 80% of the total shares of all other classes of stock. You almost never own 80% of a DSO on your own. Deals usually meet the test by counting the sponsor's investment alongside yours, and the structure has to be built for it.

For a partnership, Section 721 has no control test, but it brings its own traps. That is why "we'll roll it tax free" is a conclusion to verify, not a promise to accept.

The cash next to the rollover

The cash you receive at close is generally taxable now. The harder part is what can get pulled into it. Section 707(a)(2)(B) covers disguised sales: if you contribute property to a partnership and the partnership makes a related transfer of money or property back to you, the two can be treated together as a sale. In plain words, a rollover that looks deferred on paper can become partly taxable if cash moves the wrong way. Your CPA should review the full flow of funds.

When the bill arrives

The deferred gain usually comes due when your units are sold or redeemed: at the DSO's next sale, a recapitalization, or a buyout of your interest. You do not pick that year. The sponsor does.

That has two practical effects:

1. You may owe tax in a year you did not plan for. Keep a cash plan for it.
2. The tax is tied to your original basis, not to what the units are worth later. If the units come back lower than you hoped, ask your CPA how that changes the math.

Incentive units and the 30-day window

Some deals add new incentive or profits units that vest over time. Those can fall under Section 83. If an 83(b) election applies, it must be made no later than 30 days after the date of the transfer (IRC section 83(b)(2)). Miss it and the choice is gone. Ask your CPA whether it applies before you sign.

Five questions before the LOI

Bring these to the DSO's deal counsel and to your CPA. Get the answers in writing.

1. Is the rollover intended to qualify under Section 721 or Section 351?
2. If 351, how is the 80% control test met?
3. Could any cash or later distribution be treated as a disguised sale under Section 707?
4. What will my basis be in the rolled units, and how is it documented?
5. Will I receive incentive units, and does an 83(b) election apply?

Who does what

Your CPA sets the tax specifics. Your attorney negotiates the rollover documents and makes sure the intended tax treatment is stated in them. Your broker or a qualified appraiser sets the value of your practice; I do not value practices. My job is to keep all three working from one plan, so the year your rollover pays out fits your life.

[[CONFIRM: The question I hear most about rollover is "how much will it be worth?" The better first question is "when will I owe tax on it, and who decides?"]]

Plan the second bill now

The first tax bill comes with the year of the sale. The second one arrives whenever your buyer decides to sell. Both deserve a plan before you sign.

Book your 25-minute exploratory call and we will map when each part of your deal is likely to be taxed.

So, do you know which year your rolled equity will send you a tax bill?

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Sources

1. Internal Revenue Code section 721 (nonrecognition on contribution of property to a partnership). https://www.law.cornell.edu/uscode/text/26/721
2. Internal Revenue Code section 351 (nonrecognition on transfer to a controlled corporation). https://www.law.cornell.edu/uscode/text/26/351
3. Internal Revenue Code section 368(c) (control: at least 80% of total combined voting power and at least 80% of total shares of all other classes). https://www.law.cornell.edu/uscode/text/26/368
4. Internal Revenue Code section 358 (basis to distributees in section 351 and related exchanges) and section 722 (basis of a contributing partner's interest). https://www.law.cornell.edu/uscode/text/26/358 and https://www.law.cornell.edu/uscode/text/26/722
5. Internal Revenue Code section 707(a)(2)(B) (disguised sales). https://www.law.cornell.edu/uscode/text/26/707
6. Internal Revenue Code section 83, including 83(b)(2) (election made not later than 30 days after the date of transfer). https://www.law.cornell.edu/uscode/text/26/83

This article is for educational purposes only and is not tax, legal, or investment advice. Consult your own qualified professionals about your situation.