Understanding a 721 Equity Rollover: How Sellers Defer Taxes and Stay Invested in Their Business

When selling a business, many owners face a tough choice — cash out entirely or stay invested for the next phase of growth. Fortunately, there’s a third option that can be both financially savvy and strategically aligned: the Section 721 equity rollover.

A 721 rollover allows sellers to reinvest part of their ownership into a new entity controlled by the buyer, deferring capital gains taxes on that portion of the sale. This structure not only provides partial liquidity but also keeps the seller tied to the upside of the company’s future success.

What Is a 721 Equity Rollover?

A Section 721 rollover refers to a tax-deferred transaction under Section 721 of the Internal Revenue Code. In this structure, a seller contributes a portion of their ownership interest or business assets into a new partnership (or an LLC taxed as a partnership) in exchange for an equity stake in that new entity.

Rather than selling 100% of the business for cash — and paying capital gains tax on the entire sale — the seller “rolls over” part of their equity into the buyer’s new structure. The IRS treats this as a nonrecognition event, meaning no tax is due on the contributed portion until a future sale occurs.

How a 721 Rollover Works (Step-by-Step)

1. Formation of a New Partnership or LLC
   The buyer creates a new entity, typically a partnership or an LLC taxed as one. Both the buyer and the seller become partners in this entity.
2. Contribution of Property or Ownership
   The seller contributes part of their existing ownership interest (or specific assets of the business) into the new partnership in exchange for equity.
3. Cash Infusion by Buyer
   The buyer contributes cash into the new partnership, which is used to purchase the remaining portion of the seller’s business interest for cash.
4. Tax Deferral Under Section 721
   The seller defers capital gains taxes on the portion of ownership that was rolled into the new entity — only paying tax on the portion sold for cash.
5. Future Exit and Tax Recognition
   When the seller eventually sells their partnership interest — often at a later exit or liquidity event — the deferred gain becomes taxable.

Benefits for the Seller

• Tax Deferral
  The biggest advantage is the ability to defer paying capital gains taxes on the rolled-over portion. That means more capital stays invested and continues to grow.
• Retained Ownership and Upside
  The seller maintains an equity position, allowing them to benefit from future appreciation or a potential “second bite of the apple.”
• Aligned Interests
  Because both parties are now equity holders, the seller’s continued involvement directly supports the buyer’s success.

Benefits for the Buyer

• Reduced Upfront Cash Requirement
  Rolling over equity reduces the immediate cash needed to close, improving deal feasibility and capital efficiency.
• Continuity and Commitment
  The seller’s ongoing stake and participation can ensure smoother post-acquisition operations and maintain relationships with key customers or employees.
• Performance Incentive
  Sellers who remain co-invested are naturally motivated to help the company perform — a major advantage for private equity groups and strategic buyers alike.

Key Considerations and Pitfalls

While 721 rollovers can create a win-win structure, they must be executed precisely to preserve tax deferral:

• Structure Matters: The rollover must meet the technical partnership and contribution requirements outlined in Section 721 to qualify as tax-free.
• Complexity: Improper structuring (e.g., using a corporation instead of a partnership) can trigger immediate tax recognition.
• Legal & Tax Guidance: Work with experienced M&A attorneys and tax advisors to structure, document, and report the transaction correctly.
• Future Liquidity: The rolled-over equity is illiquid until the next sale event — sellers should ensure they’re comfortable with the timing and risk profile.

Why 721 Rollovers Are Popular in Modern M&A

Private equity firms, family offices, and strategic acquirers frequently use 721 rollovers in deals where the seller has valuable expertise or relationships that contribute to future growth. By keeping the seller invested, buyers preserve institutional knowledge while creating mutual upside.

In many ways, this structure transforms the seller from a departing owner into a strategic partner for the next chapter of the business.

Final Thoughts

A 721 equity rollover is one of the most elegant tools in middle-market and lower-middle-market M&A — blending liquidity, tax efficiency, and long-term alignment between buyer and seller.

But this strategy is not a one-size-fits-all solution. It requires intentional structuring, clear valuation, and sound legal guidance to unlock its full benefits.

If you’re selling a business and want to explore how a tax-deferred rollover could work for your exit or reinvestment strategy, Clearly Acquired can help you evaluate and structure the right approach.

Disclosure

This article is for informational purposes only and does not constitute tax or legal advice. Always consult your CPA and qualified tax counsel before structuring or executing a Section 721 rollover.

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