An Alternate Route to an IPO: The Up-C Partnership Structure (Part 1)

A company that is considering going public has a long road ahead filled with decisions. When the business is structured as a partnership,¹ historically, it has been assumed that the partnership needs to become a corporate entity before the initial public offering (IPO). However, businesses operating as partnerships can take an alternate route to that destination that may yield significantly more value: the Up-C partnership structure.

While potentially tax-free, a conventional partnership-to-corporation conversion transaction can result in immediate gain recognition. For example, a partner may recognize gain under Sec. 357(c) to the extent that liabilities contributed to the corporation exceed the tax basis in the contributed assets. Additionally, when a conversion is accomplished through an "assets up" transaction, a partner may recognize gain under Sec. 731(a) to the extent that money distributed to a partner in liquidation of the partnership interest exceeds the partner's basis in the partnership. A partner should not recognize gain under Sec. 731(a) under the other alternatives.

Assuming there is no recognition of taxable gain, upon the conversion of the partnership to a C corporation, each partner will receive stock with a carryover basis. Initially, this will preserve any built-in gain associated with the ownership interests. Subsequently, when the former partners sell shares of the C corporation stock on the public market, they will recognize taxable gain. Moreover, the converted corporation will not realize any tax benefit in the form of a basis step-up in the business assets that could have been available for tax purposes under a partnership structure. Under the C corporation conversion structure, the former partners recognize taxable gain on the sale of shares, and eventually, when the business assets are ultimately disposed of, the corporation recognizes gain on the same appreciation already taxed to the shareholders. Further, neither the operating company nor the former partners benefit from any resulting additional depreciation and amortization deductions, because this conversion structure does not provide for a step-up in basis.

In a perfect world, all stakeholders would, of course, want to create a structure allowing a basis step-up and incurring only one level of tax. However, the typical partnership IPO transaction can result in double taxation. Creative tax advisers looked to the umbrella partnership real estate investment trust (UPREIT) structure³ for ­inspiration, and in the late 1990s, the Up-C structure was born. Over time, advisers looked to other structures to further enhance the value of the Up-C structure.

Historically, some IPO transactions have used TRAs as a way to alleviate some of the tax cost to the historical owners associated with the going-public transaction. Investment funds realized that combining a publicly traded partnership (PTP) with a TRA could generate significant benefits to the individual partner owners of the funds. For example, in 2007 Fortress Investment Group completed an IPO in which it formed a PTP that issued units in the public market. As part of this structure, the PTP owned a corporate subsidiary that held various operating entities. The legacy partners held units in both the PTP as well as the operating entities. Included in this structure was a TRA that would pay the legacy partners 85% of tax savings generated from a taxable unit disposition that created an amortizable basis adjustment benefiting the corporate subsidiary. Blackstone Group completed a similarly structured IPO resulting in significant TRA benefits to its legacy partners.

Although these structures seemed to fit well within the existing tax law, they generated negative press⁴ and in 2007 prompted Congress to propose legislation⁵ that, if passed, would have curtailed the use and value of TRAs in the PTP context. Since the proposed legislation has not been enacted, no current restrictions appear to exist limiting the ability to supercharge an Up-C structure with a TRA.

Overview of the Up-C Structure

In the Up-C structure, the business forms a C corporation and raises capital on the public market via an IPO. The C corporation, in turn, contributes the capital generated from the IPO to the capital of the existing partnership (operating partnership) in exchange for interests in the operating partnership. Effectively, the C corporation (public company) serves as the publicly traded vehicle and invests in the operating partnership. The public company is a holding company, as it owns an interest in the operating partnership alongside the pre-IPO legacy partners. As part of the structure, the public company typically becomes the managing member of the operating partnership.

The legacy partners, who will continue to own an interest in a partnership, will benefit from the flowthrough treatment of income and will avoid the burden of double taxation that typically applies to corporations and their shareholders. Further, by maintaining the flowthrough treatment and increasing their outside tax basis in their operating partnership units over time by their share of the operating partnership's taxable income each year, the legacy partners will avoid double taxation on the ultimate disposition of their operating partnership units. The legacy partners will also benefit from the liquidity of a public market via an exchange mechanism by which they can exchange their partnership units for public company stock, as further described below.

As part of the overall structure, the legacy partners will typically have rights to exchange their partnership interests for stock of the public company, which they can sell for cash in the public market. In some cases, the public company may have the right to purchase the legacy partners' interests for cash rather than issuing its stock. When coupled with a TRA, the Up-C structure becomes a powerful tax planning tool that can significantly increase the ultimate proceeds realized by the legacy partners upon exiting their investment in the operating partnership. The basic Up-C formation structure is depicted in ­Exhibit 2 (below).

Once the IPO has been completed and the public company obtains an interest in the operating partnership, the legacy partners can exchange existing operating partnership units for public company stock.⁶ The exchange of operating partnership units for public company stock is treated for tax purposes as a taxable sale or exchange of the operating partnership units by the legacy partners. Such sale or exchange treatment does not depend on whether the legacy partners choose to sell their newly acquired public company shares. Therefore, the legacy partners typically would not exchange their operating partnership units for public company stock until they are ready to cash out of their holdings, as there can be an immediate tax impact.

Since one of the objectives of the Up-C structure is to obtain a tax basis step-up in the operating partnership's historical basis in its assets, it is necessary to ensure that the operating partnership has a valid Sec. 754 election in place at the time of any taxable exchange of operating partnership units for public company shares. Therefore, if the operating partnership does not already have a valid Sec. 754 election in place, one typically is made as part of the pre-IPO restructuring.⁷ By having this election in place, for each taxable exchange by the legacy partners, the public company is entitled to a Sec. 743(b) basis adjustment in its newly acquired unit of the operating partnership's assets. In many cases, a step-up is allocable to depreciable fixed assets or amortizable Sec. 197 intangible assets. To the extent any step-up is allocated to depreciable or amortizable assets, the public company realizes additional tax deductions. See Exhibit 3 (below).

Supercharging the Up-C With a TRA

A TRA is a legal agreement entered into between the public company and the legacy partners prior to the IPO. While the basic Up-C structure provides the benefits of gain deferral to the legacy partners and a possible basis step-up to the public company, by entering into a TRA, the legacy partners may be able to monetize a significant portion of the benefits of this step-up, thereby increasing the total proceeds ultimately realized upon exit. The payments to the legacy partners under the TRA can be substantial and result from newly created tax attributes resulting from the Up-C structure. Had the operating partnership simply converted to a C corporation to effectuate the IPO, there would have been no basis-step up, and none of the associated tax benefits would be available to the public company.

Under the basic mechanics of the TRA arrangement, the public company will "pay" the legacy partners an agreed-upon percentage, typically 85%, of the tax savings⁸ derived from the basis step-up. Thus, for example, as the public company's tax liability is reduced as a result of the additional depreciation and amortization deductions allocable to it, cash payments will be made to the legacy partners under the TRA (TRA payments). See Exhibit 4 (below).

The future TRA payments received are likely to be treated as additional proceeds on the earlier sale of the operating partnership units for tax purposes, similar to an earnout arrangement,⁹ that are subject to the installment sale rules under Sec. 453 and will generate additional taxable gain to the legacy partners. Assuming a Sec. 754 election continues to be in place, these TRA payments will also create additional basis adjustments under Sec. 743(b).¹⁰ This may result in an additional layer of depreciation and amortization allocable to the public company, resulting in additional TRA payments. Effectively, there is an iterative effect by which the future TRA payments give rise to additional TRA payments.

One aspect to consider is that, because of the installment sale nature of the TRA payments, a portion may be imputed interest under Sec. 483 or original issue discount under Secs. 1272 through 1274. The amount of interest expense, whether determined under Sec. 483 or Secs. 1272 through 1274, can give rise to a current tax deduction to the public company rather than a step-up. The TRA also can capture any tax benefit from this imputed interest expense and thus can give rise to payments to the legacy partners in a similar manner as amortization from a basis step-up. Since the TRA payments would be treated as additional proceeds on the earlier sale of the operating partnership interests, the TRA proceeds, exclusive of imputed interest under Sec. 483 or original issue discount under Secs. 1272 through 1274, should generally be considered capital gain, as opposed to ordinary income.

Sec. 741 provides that in the case of a sale or exchange of an interest in a partnership, the transferor partner recognizes gain or loss. Further, such gain or loss is considered to be from the sale or exchange of a capital asset, except as otherwise provided in Sec. 751 (relating to unrealized receivables and inventory items). Sec. 751(a) provides that the amount of any money, or the fair market value (FMV) of any property, received by a transferor partner in exchange for all or a part of an interest in the partnership attributable to the partnership's unrealized receivables or inventory items ("hot assets") is considered an amount realized from the sale or exchange of property other than a capital asset. Thus, Sec. 751(a) requires a partner to recognize ordinary income on the sale of a partnership interest to the extent of the partner's share of gain attributable to hot assets, including unrealized receivables and inventory, and the partner generally cannot defer such gain under the installment method.

These results may be unexpected to the selling legacy partner. Therefore, care should be taken in determining the existence of these hot assets by closely reviewing the definitions of unrealized receivables and inventory in Secs. 751(c) and (d), respectively.¹¹ In addition, consideration should be given to the allocation of purchase price resulting from the exchange transaction. Given the disparate treatment between buyer and seller, the allocation of purchase price may be a point of negotiation.

If the legacy partners held their interests for more than one year, favorable long-term capital gain rates should apply to the TRA payments.

Additionally, the legacy partners will need to evaluate the applicability of the Sec. 1411 net investment income tax. Sec. 1411 imposes a 3.8% tax on a taxpayer's net investment income in excess of a threshold amount. Under Sec. 1411(c)(1)(A)(iii), net investment income includes net gain attributable to the disposition of property other than assets used in a nonpassive trade or business. Whether a trade or business is a nonpassive activity with respect to a taxpayer is determined under the rules of Sec. 469. Consequently, legacy partners will need to evaluate whether they materially participate in the operating partnership trade or business within the meaning of Sec. 469. To the extent a legacy partner satisfies the relevant standards and the activity is considered nonpassive, an added benefit of the Up-C structure is that the Sec. 1411 net investment income tax may not apply with respect to that partner. A similar benefit for such a partner would not apply had the partnership converted to a C corporation.

Public Market Dynamics and Considerations

While many dynamics are at play when it comes to the public market valuation of any security, investment bankers and other market professionals generally do not view a step-up coupled with a TRA obligation as a factor contributing to a reduced market capitalization. One reason for this may be that Wall Street research analysts, and public shareholders in general, typically do not assign full value to the tax attributes of a company, as they can be very difficult to value, given the inherent uncertainty regarding their future use. Further, time-value-of-money considerations are also a factor, since many tax attributes can extend 10, 15, or even 20 years into the future and can have limitations imposed on their ultimate use and may even expire unused. Finally, a common public company valuation metric is a multiple of EBITDA, or earnings before interest, taxes, depreciation, and amortization, which, by definition, does not take taxes into account.

In a private market context, it is a common practice to pay for the use of tax attributes such as step-ups. For example, in the merger-and-acquisition market, where a buyer typically wishes to acquire assets and a seller wishes to sell stock, it is common for the buyer to pay the seller for at least a portion of incremental tax costs, including a gross-up payment, to accommodate making an election under Sec. 338(h)(10) in a stock acquisition.¹²

A Sec. 338(h)(10) election essentially allows a stock sale to be treated as a deemed sale of assets for tax purposes, thereby allowing for the buyer to obtain a valuable step-up for tax purposes. In such cases, the Sec. 338(h)(10) election would be jointly made, and the sellers typically would have agreed to such treatment only because they received additional purchase proceeds as consideration. The buyer would generally agree to the higher purchase price only to the extent that the present value of the estimated incremental future tax benefit exceeds the additional cost at the time of closing.

In the Up-C structure, the public company makes the TRA payments over time as tax benefits are realized, and it is still entitled to keep a percentage, typically 15%, of the tax benefits. The portion of the tax benefits retained by the public company can align the interests of the legacy partners and the public company with the goal of maximizing the value of the tax attributes, as each can benefit from the ultimate tax shield created by the structure. Further, the portion of the tax benefit retained by the public company can potentially increase the value to the public company shareholders.

In addition to working through the complexities of the Up-C structure with tax advisers and counsel, any partnership that is considering such a structure should also work with its investment bankers or other valuation advisers to understand the market dynamics as well as the impact on public market perception and overall valuation.

Example of an Up-C Partnership Structure With TRA Benefits

The following example compares the results of an Up-C structure with that of a typical corporate IPO structure.

Basic Facts

Fund investors and other investors each hold 50% interests in AB LLC, a partnership for tax purposes, each having an outside tax basis and tax capital account in their partnership interests equal to zero. At a time when the FMV of AB LLC is $21,000 (assume all appreciation is attributable to amortizable Sec. 197 intangible assets), the fund investors and other investors decide to take their business public via an IPO, effective Dec. 31, 20X0. The IPO is expected to raise $10,000, before a $1,000 underwriters' commission. Immediately following the IPO, on Jan. 1, 20X1, the fund investors, other investors, and public investors (as a group), will each own a one-third interest in the outstanding value of AB LLC. The effective post-IPO ownership is summarized in Exhibit 5 (below).

Assume that on Jan. 1, 20X2, the fund investors and other investors sell 50% of each of their remaining interests in AB LLC in a fully taxable transaction, whereby the fund investors and other investors separately receive consideration of $5,000, and that on Jan. 1, 20X3, the fund investors sell their remaining interest in AB LLC for consideration of $5,000, while the other investors retain their remaining interests.¹³ Finally, assume that the operating business generates taxable income such that AB Inc. or AB Up-C Inc.¹⁴ recognizes $1,000 of taxable income each year following the IPO.

For simplicity, assume AB LLC or AB Inc., in the case of a typical conversion to a C corporation, will distribute all earnings to its members or shareholders. In the event AB LLC remains a partnership, it will distribute $1,000 (assuming available cash is equal to taxable income) each year to AB Up-C Inc., and in the case of conversion to a corporation, AB Inc. will distribute all of its after-tax income to its shareholders, so that the public investors will receive a total of $600 each year, representing their share of $1,000 of taxable income, after payment of an assumed $400 in corporate income taxes.¹⁵

Consequences Under Typical IPO Structure

In a typical IPO transaction, AB LLC would convert to a corporate entity (AB Inc.) pursuant to one of the alternatives described above in Rev. Rul. 84-111. This would likely be accomplished in a tax-free manner, and the units formerly held by the fund investors and other investors would essentially be converted into shares of stock of AB Inc. Following the IPO, the fund investors, other investors, and public investors would own shares in AB Inc. equal to the values reflected in Exhibit 5 and the structure depicted in Exhibit 1.

When the fund investors and other investors sell their AB Inc. shares in 20X2, they will each recognize capital gain equal to the cash received, or $5,000, since they have a zero tax basis in their AB Inc. stock. In 20X3, the fund investors will recognize an additional $5,000 of capital gain upon sale of their remaining AB Inc. stock, since they would receive $5,000 cash proceeds and would still have a zero outside tax basis in their AB Inc. stock.

Upon the disposition of AB Inc. shares by the fund investors and other investors, there should be no tax impact to AB Inc. Further, the gain recognized on the disposition of AB Inc. stock will not result in any step-up in the basis of AB Inc.'s assets. Consequently, AB Inc. will continue to recognize annual taxable income based on its operations and would pay income taxes at an assumed 40% effective corporate tax rate. To the extent AB Inc. makes any distributions to its stockholders, there could be a second layer of tax at the stockholder level to the extent of available earnings and profits (E&P).

Consequences of the Up-C IPO Structure

In the Up-C alternative, a newly formed corporation (AB Up-C Inc.) will be created and will raise $10,000 from public investors in the IPO. AB Up-C Inc. will then contribute the cash raised in the IPO to AB LLC in exchange for partnership units. The IPO and contribution of capital to AB LLC generally will be tax-free transactions. Following these transactions, the public investors (as a group) will own 100% of the stock of AB Up-C Inc., and the AB LLC equity ownership will be held as shown in Exhibit 6 (below), under the structure depicted in Exhibit 2.

Under terms of the LLC operating agreement or a separate exchange agreement, the fund investors and other investors will have an option, via the exchange mechanism, to cause AB Up-C Inc. to purchase their AB LLC units for either cash or shares of stock in AB Up-C Inc. Regardless of the consideration used, the exchange should be fully taxable to the fund investors and other investors as a sale or exchange of their AB LLC interest. Thus, when the fund investors and other investors exchange their AB LLC units in 20X2, they will each recognize taxable gain of $5,000. Further, when the fund investors dispose of their remaining AB LLC units in 20X3, they will recognize an additional $5,000 taxable gain. Since, in this simplified example, AB LLC is assumed to distribute all of its taxable income each year to its members, there is no outside basis "buildup" in each of the members' AB LLC units. Typically, businesses would not distribute all of their taxable income, and there would be some basis buildup, which can serve to decrease the capital gain ultimately realized upon sale.

Assuming AB LLC has a valid Sec. 754 election in place, AB Up-C Inc.'s purchase of the units held by the fund investors and other investors in 20X2 and 20X3 will create a positive Sec. 743(b) basis adjustment attributable to AB Up-C Inc.'s interest in AB LLC. This Sec. 743(b) basis adjustment would be allocable to AB LLC's assets in accordance with the rules of Sec. 755. For purposes of this example, assume that the entire Sec. 743(b) adjustment is allocable to goodwill. Therefore, following the 20X2 transaction, a Sec. 743(b) basis adjustment (step-up) equal to $10,000 would be created and allocated to amortizable Sec. 197 intangible assets (i.e.,goodwill). Then, following the 20X3 exchange, there would be an additional Sec. 743(b) basis adjustment (step-up) of $5,000 attributable to amortizable Sec. 197 intangible assets, bringing the cumulative gross Sec. 743(b) adjustment to $15,000.

Since the entire Sec. 743(b) adjustment is allocated to amortizable Sec. 197 intangible assets, each recorded adjustment resulting from a new exchange will be amortized ratably over 15 years.¹⁶ Consequently, AB Up-C Inc. will be entitled to deductible amortization in 20X2 and 20X3 equal to $667 and $1,000, respectively. Exhibit 7 (below) illustrates the recording of the original Sec. 743(b) adjustments resulting from each partner's exchange of AB LLC units, as well as the amortization attributable to each Sec. 743(b) basis adjustment. See also Exhibit 8 (below).

In 20X2, AB Up-C Inc. will have $1,000 of taxable income allocable to it from the AB LLC operations, which it will reduce by the $667 20X2 amortization deduction. This will result in net taxable income to AB Up-C Inc. equal to $333, creating a net tax liability of $133 ($333 × 40%). In 20X3, the $1,000 amortization deduction will reduce AB Up-C Inc.'s taxable income to zero. These results are illustrated in Exhibit 9 (below).

Assume that under the terms of the TRA, AB Up-C Inc. will pay the fund investors and other investors 85% of the net tax savings resulting from the Sec. 743(b) adjustment amortization. Based on the tax savings reflected in Exhibit 9, AB Inc. will remit a total of $227 ($267 × 85%) and $340 ($400 × 85%) under the TRA in 20X2 and 20X3, respectively, to the fund investors and other investors. In this example, the TRA payment will be allocated between the fund investors and other investors based on the relative amount of Sec. 743(b) amortization allocated to AB Up-C Inc. Consequently, the fund investors and other investors will receive TRA payments in 20X2 and 20X3 as shown in Exhibit 10 (below).¹⁷

While not presented in this simplified example, the TRA benefits paid in each year to the fund investors and other investors will be considered additional purchase price and will give rise to further Sec. 743(b) basis adjustments (step-up). Each additional step-up created by the TRA payments would give rise to further future amortization deductions, which, assuming AB Up-C Inc. has sufficient taxable income to benefit from the additional amortization deductions in future tax years, can serve to increase future TRA payments to the fund investors and other investors.

Part 1 of this article has introduced a potential alternative to the typical partnership IPO. The Up-C alternative can deliver significant potential value to the existing partners. Next month, Part 2 will continue with a more detailed look at a number of important tax considerations typically encountered when implementing an Up-C structure. It will focus on the critically important pre-IPO restructuring transactions, including identifying technical terminations, potential disguised sale distributions, and setting up and maintaining the partners' capital accounts. It will also explore some of the complexities that can arise in calculating and tracking the Sec. 743(b) basis adjustments and associated TRA payments.  

Footnotes

¹Entities including limited liability companies (LLCs), limited partnerships (LPs), and general partnerships (GPs) may be taxed as partnerships and are here included in the term.

²While a detailed discussion of the tax consequences resulting from a partnership conversion into a corporation is beyond the scope of this article, it is important to note that under certain circumstances any of these alternatives may result in an immediate cash tax cost and should be carefully evaluated as part of the planning process.

³In the UPREIT structure, individual investors contribute appreciated real estate to an LP in exchange for partnership interests that are exchangeable for REIT shares. The receipt of the partnership interests is generally not a taxable event. The tax on the appreciation is not recognized by the investor until the future exchange of the partnership interests for REIT shares.

⁴See Johnston, "Tax Loopholes Sweeten a Deal for Blackstone," The New York Times (July 13, 2007), available at www.nytimes.com.

⁵Proposed language in the Temporary Tax Relief Act of 2007 (H.R. 3996) would have limited the potential TRA benefits by amending Sec. 1239 to effectively create ordinary income to the sellers of partnership units.

⁶The timing of such exchange transactions may be subject to required "lockup" periods in which no exchanges can take place until a specified time after the IPO.

⁷Regs. Sec. 1.754-1 provides that the Sec. 754 election must be filed "with the partnership return for the taxable year during which the distribution or transfer occurs." As a technical matter, therefore, the Sec. 754 election is not valid if it is made as part of the pre-IPO restructuring unless there has been a distribution or transfer to which Sec. 734 or Sec. 743 applies. Part 2 of this article will discuss other requirements of a Sec. 754 election and common considerations in practice.

⁸Typically, tax savings covered under the TRA include federal, state, local, and foreign taxes, and assessments or similar charges that are based on or measured with respect to net income or profits (such as franchise taxes).

⁹In a typical earnout payment structure for the sale of a company, a portion of the sale price is paid over time as certain agreed-upon financial targets are met, rather than all proceeds being paid upfront upon closing of the transaction. This mechanism can align the seller's interests with those of the buyer in terms of company profitability and other metrics after closing.

¹⁰Sec. 743(b) adjustment calculation and tracking will be covered in more detail in Part 2 of this article.

¹¹The term "unrealized receivables" includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for (1)goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2)services rendered or to be rendered. It also includes various types of property enumerated in the flush language of Sec. 751(c).

The term "inventory items" means (1) property of the partnership of the kind described in Sec. 1221(a)(1); (2) any other property of the partnership that, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in Sec. 1231; and (3) any other property held by the partnership that, if held by the selling or distributee partner, would be considered property of the type described in (1) or (2).

¹²The Sec. 338(h)(10) election is available only in connection with three specific types of targets: (1) S corporations, (2) a member of a consolidated group (other than the common parent), or (3) a member of a nonconsolidated but affiliated group (again, other than the common parent).

¹³For simplicity, this hypothetical example assumes no equity appreciation between 20X0 and 20X3.

¹⁴For purposes of the example, the public company analyzed under the typical corporate IPO structure is referred to as "AB Inc.," while the public company analyzed in the Up-C IPO structure is referred to as "AB Up-C Inc."

¹⁵For simplicity, the example does not consider the tax cost to the individual public investors associated with their receipt of the distribution from AB Inc.

¹⁶Under Sec. 197(a), Sec. 197 intangible assets are generally amortized ratably over the 15-year period beginning with the month in which such intangible was acquired.

¹⁷For simplicity, this example does not consider the installment sale rules under Sec. 453, in which a portion of the TRA payments is treated as imputed interest rather than additional purchase price. While a typical TRA would provide for the benefit of any interest deduction to be captured in the calculation of benefits for a given tax year, a Sec. 743(b) basis adjustment (step-up) should not apply to the extent of the imputed interest portion of the TRA payment.