The potential for lost benefits of Up-Cs in a Sec. 280E environment

By Caleb Egli, CPA, Kansas City; Nila Loveall, CPA, Sacramento, Calif.; Marc Claybon, J.D., LL.M., Denver; and Nick Hollinden, CPA, Sacramento, Calif.

Editor: Howard Wagner, CPA

For entities operating within the cannabis industry, the current regulatory environment presents numerous complexities and challenges, including one of the utmost importance to all business enterprises — obtaining capital for new investment or continuing operations.

At the federal level, cannabis remains a Schedule 1 controlled substance under the Controlled Substances Act; thus its cultivation and sale fall under the category of illegal trafficking. As of this writing, approximately 36 states have legalized some form of medical cannabis programs, and 16 states and the District of Columbia have legalized adult recreational use of cannabis, with more states coming on line each year (Berke, Gal, and Lee, "Marijuana Legalization Is Sweeping the US," Insider (updated April 14, 2021)). This has created a strange dichotomy for business owners to operate in, with the ever-looming threat of federal enforcement action, along with the burden of Sec. 280E, which creates much higher effective tax rates for their operations than for non-cannabis entities.

Cannabis businesses are not only unable to develop and maintain traditional banking relationships and financing arrangements but may also be considered too risky to be viable candidates for traditional investors. Additionally, these businesses have not historically been able to list on major U.S. stock exchanges such as the NYSE or NASDAQ and thus are unable to obtain either equity or debt funding from the public markets.

This one-two punch of prohibitively high effective tax rates and restricted capital availability has led many cannabis companies to look across the border to Canada. Most Canadian exchanges permit the entrance and trading of public companies operating in cannabis because Canada legalized the drug at the national level in late 2018. This has created a surge of interest in initial public offerings (IPOs), direct public offerings (DPOs), and reverse takeovers (RTOs).

The umbrella partnership-C corporation structure (Up-C) is a method for an operating partnership to conduct an IPO. This arrangement typically also contains a tax receivable agreement (TRA) to ensure that the original owners of the operating entity are allocated a substantial portion of the tax benefits of this arrangement. Unfortunately for cannabis businesses, Sec. 280E effectively negates these benefits. This item first summarizes the traditional Up-C/TRA arrangement and then addresses the impact of Sec. 280E on the Up-C/TRA structure by examining Sec. 743(b) basis adjustments, adjusted basis calculations pursuant to Sec. 1016, Sec. 751 "hot asset" reporting, tiered-partnership structure considerations, and additional tax and nontax planning items.

Traditional UP-C/TRA arrangement

Despite the inherent complexity surrounding Up-C structures and corresponding TRA obligations, successful businesses across many industries continue to use the structures, including such household names as Shake Shack and Planet Fitness. In its simplest form, the Up-C structure is as follows: A new or existing C corporation public company (Pubco) raises capital through a public offering. This capital is then infused into an existing operating partnership (Opco) in exchange for newly issued units (for simplicity, assume Opco is an LLC) and management control. The existing members of Opco typically retain voting control over Pubco through a special class of shares also issued in the public offering.

This transaction on its own is not particularly enticing to the existing members, but two additional strategies drive considerable benefit. After the offering (and an initial lockup period, if required), the existing members may exercise the right to exchange their partnership interests, in whole or in part, for Pubco stock (or a cash equivalent). This exchange is treated for tax purposes as a sale or exchange to Pubco, and Opco makes a Sec. 754 election to capture any related step-up in basis at the time of sale under Sec. 743(b). Although it is completely voluntary to do so, Pubco and the existing members normally enter into a TRA, which ensures that a portion of the tax savings derived from this step-up are paid back to the exchanging member (the benchmark rate is 85%). This structure preserves flowthrough treatment to the existing members until such time as they exchange, avoiding the potential for double taxation at a time of future sale if Opco were simply converted to a C corporation in a tax-free Sec. 351 exchange and avoiding immediate gain recognition on a taxable conversion. The TRA provides a stream of income (assuming Pubco profitability) for as long as the Sec. 743(b) step-up is amortized and/or depreciated and, as discussed below, many years after.

Existing members and Pubco management need to be aware of the significant administrative burdens associated with even a simple Up-C/TRA transaction like the one described above. Management can be easily overwhelmed by the sheer number of exchanges, especially when considering that a cut-off method for allocating partnership income is generally required. Opco needs to assess previously taxed capital (pursuant to Sec. 743(b)) and fair market value (FMV) of assets (pursuant to Sec. 755) at each exchange date, which may require additional valuations, periodic tax basis balance sheets, and refined Sec. 704(c) schedules. Those efforts all take place just to satisfy Opco's reporting obligations, and then TRA calculations must be separately addressed.

The TRA typically stipulates that the tax savings derived from the Sec. 743(b) step-up are determined in a "with-or-without" calculation — in other words, the hypothetical corporate tax liability if deductions attributable to Sec. 743(b) were removed from the return (net operating loss carryforward/carryback rules are outside the scope of this item). The tax savings are determined after the Pubco tax returns have been filed for the tax year in question, and the applicable percentage of those savings is paid to the exchanging member within a specified window of time; accompanying schedules supporting the step-up and benefit are usually required to be provided simultaneously. The benefit payments constitute additional consideration for the original sale transaction and thus result in additional Sec. 743(b) step-up, with the exception of any stated or imputed interest component (Sec. 483). The additional step-up is sometimes referred to as a "baby TRA." As a result of the baby TRA, the TRA computations are partially iterative and, if they are attributable to Sec. 197 intangibles, will be amortized over the remaining life of those intangibles pursuant to the original transaction (Regs. Sec. 1.197-2(f)(2)(i)). For instance, a payment in year 4 is amortized over 12 years (15 years less three years of useful life already amortized). Many companies are surprised to learn that an exchange in year 1 of Pubco's existence may therefore result in an obligation for the next 20 or more years, until either the iterative component is negligible or Pubco chooses to terminate the TRA (discussed below).

Existing members may grow weary of this delay and choose to monetize their payment stream by assigning their rights to a third party in exchange for an immediate, albeit discounted, cash payment. Lastly, the tax treatment to the exchanging member is a matter of some debate and uncertainty (i.e., whether "open transaction" rules or contingent-payment-sale rules apply), the substance of which is outside the scope of this item. Managers will undoubtedly be peppered with these and other questions, many of which they would be wise to refer to the exchanging member's own tax preparer.

Sec. 280E's effect on Secs. 743, 754, and 755

The tax benefits allocated under a TRA inherently depend upon the Sec. 743(b) step-up created at the time of exchange of Opco units for Pubco stock (the "sale"), with a Sec. 754 election. Sec. 755(a)(1) provides that any increase in the adjusted basis of partnership property be allocated "in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties." Any excess of step-up over this allocation (i.e., once all assets have been stepped up to fair value for tax basis) will be characterized as goodwill or other intangibles.

This step-up allocation methodology presents two problems to cannabis businesses due to the application of Sec. 280E. Under this Code section:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

The practical effect of this Code section is a limitation on deducting any selling, general, and administrative expenses that are not related to activities of cultivation or production. The deduction of cost of goods sold (COGS) from gross receipts to determine gross income is defined under Regs. Sec. 1.61-3(a).

If any portion of a Sec. 743(b) step-up is allocated to fixed assets not used in the cultivation or production of cannabis, perhaps to office equipment instead, the depreciation attributable to this step-up would be nondeductible under Sec. 280E. Further, any amortization of goodwill (a Sec. 197 intangible) created would be inherently nondeductible, as it also would not be considered includible in COGS.

Often, one of the major asset classes for cannabis businesses, as a measure of fair value, is the state and local licenses held for cultivation, manufacturing, distribution, and retail sales of cannabis. Many large multistate operators hold several of these various types of licenses in different localities. As these licenses are the pillar upon which business can be conducted within a particular jurisdiction, they can carry large fair values, dependent upon market conditions. In most cases, any step-up created under Sec. 743(b) would be largely attributable to these licenses.

Depending on the type of license to which the step-up is allocated, amortization may not be considered includible in COGS and thus would be nondeductible. In the blink of an eye, Sec. 280E negates much of the step-up benefit and therefore the TRA benefit as well. While it is industry practice to include amortization of cultivation and manufacturing licenses in COGS, to the extent that a taxpayer can include retail license amortization in COGS for GAAP, there may be opportunity for additional tax benefit.

Adjusted basis calculations under Sec. 1016 and Sec. 751

Opco must also address Sec. 280E in two related, but perhaps unanticipated, partnership contexts — Sec. 1016 adjusted basis and Sec. 751 "hot asset" reporting. Sec. 1016 and related regulations address adjustments to cost basis in determining gain on the sale or disposition of property. Tax advisers will be familiar with guidance under Sec. 1016(a)(2), which provides that basis is adjusted for depreciation and amortization (depletion, etc.) deductions "allowed as deductions in computing taxable income" and "resulting ... in a reduction for any taxable year of the taxpayer's taxes," but "not less than the amount allowable," often referred to as the "allowed or allowable" test. However, it is uncertain whether deductions disallowed under Sec. 280E are considered to be either "allowed or allowable," since they are prohibited by statute.

There is, unsurprisingly, no direct guidance in the Sec. 1016 regulations that addresses Sec. 280E. In an analogous situation, Chief Counsel Advice 201625011 addresses CBS Corp., 105 Fed. Cl. 74 (2012), wherein the court ruled that due to the allocation of depreciation deductions to the production of tax-exempt income (in this case, exempt foreign trade income), the deductions were disallowed under Sec. 265(a)(1) and therefore were not "allowable" deductions under Sec. 1016(a)(2). As a result, adjusted basis was not reduced for the disallowed deductions. Tax advisers should be aware, then, that establishing the partnership's adjusted basis in assets when determining Sec. 734(b)/743(b) step-up or step-down by asset is not a straightforward exercise, especially when there is a mix of assets, each with depreciation or amortization that is or is not subject to Sec. 280E.

Sec. 751 applies when a partner sells an interest in the partnership. The statute requires the seller to look through to the assets of the partnership in determining whether a portion of the gain or loss on sale is ordinary rather than capital. To make this determination, Prop. Regs. Sec. 1.751-1(a)(2) provides for a hypothetical sale of partnership property for FMV immediately prior to the sale of the partner's interest and asks whether the partnership would have recognized ordinary gain or loss. Tax advisers are accustomed to examining receivables, inventory, and potential depreciation or amortization recapture. Due to the application of Sec. 280E, however, a cannabis partnership might have little or no recapture income subject to Sec. 751(a) because the partnership's adjusted basis in tangible and intangible assets has not been reduced for deductions disallowed, as previously discussed. This again complicates the tax adviser's efforts.

Tiered structure considerations

As previously mentioned, the TRA mandates that Opco make a Sec. 754 election to guarantee that an exchange results in a Sec. 743(b) step-up to Pubco (if applicable). Determining the Sec. 743(b) step-up is an onerous exercise even in simple structures, but it can be enormously complex in the Up-C context. When Pubco contributes cash to the partnership in exchange for new membership, a "reverse" Sec. 704(c) layer is created to attribute built-in gain or loss to the pre-offering members, and that layer must be taken into account (along with any "forward" Sec. 704(c) layers or other existing Sec. 704(c) layers).

To make matters worse, it is not uncommon for Opco to sit atop a tiered-partnership structure. In that case, careful attention must be paid to whether lower-tier entities (LTEs) have existing Sec. 754 elections or would like to make one in the current year. Prop. Regs. Sec. 1.743-1(a)(2) requires that a Sec. 743(b) adjustment is pushed down to the assets of LTEs that have a Sec. 754 election. (Note: A mandatory step-down for a substantial built-in loss is pushed down to an LTE regardless of whether a Sec. 754 election is in place.)

In a normal TRA context, despite the administrative burden, management has an incentive to make Sec. 754 elections at LTEs to free up as much depreciation or amortization as possible, which accelerates both Pubco's tax savings and TRA benefit payments. However, in a Sec. 280E context, there may be little or no benefit to pushing down the adjustment, for the reasons expressed earlier in this item. At the very least, it is prudent to examine whether the benefit of making the election at the LTE level exceeds the administrative cost. If no Sec. 754 election is made, a step-up attributable to the LTE will be kept in Opco's basis in the LTE and may result in a benefit to Pubco when Opco disposes of the partnership interest. This may significantly delay the benefit but avoids the current Sec. 280E limitations.

The question of whether to make a Sec. 754 election for an LTE therefore balances on the potential timing for a sale of the LTE and the likelihood of a repeal of Sec. 280E. If one expects an imminent repeal of Sec. 280E, it may be advisable to make a Sec. 754 election now to preserve Sec. 743(b) depreciation or amortization in years after the repeal.

Other implications: Sec. 731(a) distributions in excess of basis

Sec. 731(a) states that "[i]n the case of distribution by a partnership to a partner — (1) gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution."

Nondeductible, noncapitalized expenditures reduce a partner's outside basis in the partnership, and cannabis companies have large nondeductible expenses passing through year after year. It's not surprising that many partners will find themselves with a low outside basis in spite of significant taxable income. As annual tax distributions are often made based on taxable income — gross profit, due to the application of Sec. 280E — there will likely be a need to recognize gain under Sec. 731(a)(1) for the excess monies received over outside basis.

With a Sec. 754 election in place, this gain would require a Sec. 734(b) step-up adjustment at the entity level anytime that gain is recognized by a partner. Gain recognition may also need to be pushed down to LTEs with Sec. 754 elections in place. From a practical standpoint, the operating entity may not have visibility to the tax reporting situation of each individual partner, and obtaining this information might be difficult. Additionally, the process of calculating and tracking successive rounds of step-ups contributes to the ever-increasing administrative burden already identified above.

Other implications: State tax considerations

While state tax implications are beyond the scope of this item, it should be mentioned that while most states generally conform to Sec. 280E, there are a few notable exceptions, including California, Colorado, Michigan, and Oregon. In addition to allowing the legal sale and consumption of cannabis, they also provide for the full deduction of all business expenses for state income tax purposes. In light of this, while many benefits of the Up-C/TRA structure are negatively affected under the current federal regime, there are opportunities within specific state jurisdictions that should be carefully considered during planning.

Other implications: C corp. trapped cash

It is easy to get lost in the tax considerations addressed in the previous sections; however, it is just as important to assess nontax considerations. One such topic is cash planning for Pubco. Opco's operating agreement will commonly provide for tax distributions, and, typically, those tax distributions are both pro rata (importantly, without regard for Sec. 743(b) deductions) and paid based on an individual's marginal tax rate.

Prior to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, there was no substantial difference between the highest marginal rate for an individual and a C corporation, but in current circumstances, Pubco will almost certainly receive tax distributions significantly greater than its tax liability. While Pubco can use excess cash to pay TRA benefit payments, its obligation under the TRA is also decreased due to the corporate rate reduction. Ideally, the operating agreement would allow for reduced distributions to Pubco so that Opco could preserve working capital. Unfortunately, the Up-C/TRA structure is predicated on economic parity among the partnership membership, for reasons that are outside the scope of this item. It may be possible to address this issue with legal counsel during the drafting of the agreement (perhaps by reducing the marginal tax rate used, for instance).

Alternatively, Pubco may use the excess cash to pay dividends, or it may lend the operating cash back to the partnership if existing debt covenants allow. However, due to the parity concerns, the operating agreement may require that a corporate dividend is matched by a corresponding tax distribution from Opco, thereby negating the desired outcome. Also, Pubco may be prohibited from contributing the cash to Opco without taking back additional equity. Stock dividends are a worthwhile alternative because they are typically matched by a corresponding issuance of units at Opco. This allows cash to be contributed back into Opco to the extent desired, although it does also result in a Sec. 704(b) book-up event for Opco.

It may be possible for Pubco to use the cash to make acquisitions or otherwise carry on a trade or business, but this will complicate computations related to the TRA and impose significant administrative burdens (e.g., drafting new contractual agreements and complying with state registrations and state combined filings). Opco should be prepared for the potential for bleeding of working capital to Pubco and address the issue proactively through discussion with legal counsel and tax advisers.

Alternatives and planning considerations

Faced with the veritable mountain of tax and nontax burdens associated with an Up-C/TRA structure, coupled with the limited benefit available while Sec. 280E is in effect, it is a natural response for pre-offering members to ask whether any alternative route may be taken. This determination is heavily fact-specific, but this item touches on a few ideas that may be worth further investigation.

First, TRAs almost invariably allow for Pubco to unilaterally terminate the TRA and pay out any remaining benefit on exchanges that have occurred using specified valuation assumptions, as well as the assumed benefit for any units not yet exchanged. Any exchanges occurring after the termination are therefore not covered by the TRA, and no future payments are required. There are obvious benefits to this approach, but since management making the decision likely has a stake in the TRA, they may not be eager to take this approach, especially given that the current corporate tax rate is the lowest in modern history and Sec. 280E limits the assumed benefit that would be paid out upon termination.

If they are patient, perhaps Sec. 280E will be repealed or the corporate tax rate will return to its pre-TCJA level. If Sec. 280E is repealed, Sec. 754 elections can be made at the LTEs at that time (if they have not been made previously), and maximum benefit would be derived on exchanges occurring subsequent to the repeal. On the other hand, given the uncertainty surrounding Sec. 280E, terminating the TRA may make Pubco more enticing for sale to potential buyers and allow for a higher stock price upon exchange.

If neither terminating nor waiting is palatable, it may be time for the parties to the TRA to go back to the drawing board. Depending on the circumstances, the parties could consider a new transaction whereby the pre-offering members exchange their partnership units for Pubco stock in a Sec. 351 exchange (requires voting control). As previously mentioned, the TRA rights could also be sold to a third party for discounted cash, either in part or en masse. The best path forward may be uncertain, but your clients will be certain to appreciate your insight into these matters so the benefits they were originally sold on do not go up in smoke.


Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or

Contributors are members of or associated with Crowe LLP.

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