tax notes desalvo - staying power of the up c

The Staying Power of the UP-C:It’s Not Just a Flash in the Pan

By Phillip W. DeSalvo

Reprinted from Tax Notes, August 8, 2016, p. 865

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The Staying Power of the UP-C:It’s Not Just a Flash in the Panby Phillip W. DeSalvo

During the latest economic downturn and cor-relative reduction in initial public offerings (IPOs)on U.S. public equity markets, the phrase ‘‘UP-Csare dead’’ (or similar) was uttered by a few boldpredictors of the equity markets. The author pro-poses that this assertion is not only erroneous, butto the contrary, there will continue to be an upsurgein UP-C offerings in the coming years. This articlewill familiarize the reader with the UP-C structureand discuss why UP-Cs could continue to be thepreferred offering structure for operating partner-ships. To accomplish that goal in bite-size segments,this article is presented as follows: (1) an overviewof the transaction structure; (2) the primary benefitsof the UP-C structure; (3) the typical UP-C companyprofile; (4) pitfalls to be aware of during the offeringprocess; and (5) when considering tax and businesscharacteristics, a summary conclusion of the stayingpower of the UP-C.

A. UP-C Offering Structure Prominence

An UP-C offering is a transaction structure usedby both strategic companies and private equity

firms to raise capital from IPOs and future publicofferings. The cash raised from the offerings can beused for various company purposes, including buy-ing out investors, paying down existing debt, fund-ing acquisitions, and covering other generalbusiness operations and organic growth. This trans-action approach provides the historical owners ofthe business a means to raise cash while retainingcontrol of the business operations and providing anexit mechanism via the redemption right. All thosegoals are accomplished while retaining the benefitsof holding equity interests in a flow-through entityand potentially increasing the proceeds received byhistorical owners through the use of a tax receivableagreement (TRA), which is discussed below.

While using an umbrella partnership to holdbusiness assets related to a public offering is notnovel,1 the proliferation of UP-C offerings in thepast few years has dramatically increased2 becauseof two significant factors.

First, the use of entities classified as partnershipsin the United States has significantly outpaced theuse of corporate entities over the past 15 years.Based on the most recent publicly available IRSfiling data, in 2001 U.S. taxpayers filed about thesame number of partnership returns as corporatereturns — about 2.1 million for each entity type. In2012 however, the number of partnership tax re-turns (about 3.4 million) more than doubled thefigure for corporate tax returns (about 1.6 million)(see figure on the next page).3 This data suggeststhat as more companies operate in entities treatedas a partnership, there may be more companieseyeing public offerings that hold business opera-tions in partnership form and are thus ripe for UP-Cstructures.

Second, the availability of the UP-C structure andawareness of its potential benefits are now morewidely known and customary among the business,investment banking, legal, and tax communities. Infact, many private equity sponsors intentionally

1See reg. section 1.701-2(d), Example 4 (discussing the part-nership antiabuse rule and the IRS’s inability to apply that typeof rule and recast an umbrella partnership real estate investmenttrust public offering structure).

2Based on publicly available information filed with the SECon IPOs using an UP-C structure.

3IRS, ‘‘Tax Statistics,’’ available at https://www.irs.gov/uac/tax-stats.

Phillip W. DeSalvo

Phillip W. DeSalvo is amanaging director in KPMGLLP’s mergers and acquisi-tions tax practice in the Chi-cago office. He thanks DanBasca, Jim Tod, Jarod Wall,and Scott Worsdell ofKPMG’s partnership prac-tice group for their contribu-tions to this article.

In this article, DeSalvo discusses the stayingpower of the umbrella partnership corporationstructure and explains its benefits as well as itspotential pitfalls.

The information contained in this article is of ageneral nature and based on authorities that aresubject to change. Its applicability to specific situa-tions should be determined through consultationwith your tax adviser. This article represents theviews of the author only.

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invest in operating companies through partnershipstructures to lay the foundation for an UP-C IPO tobe considered as a potential exit strategy.

B. Potential Benefits of the StructureAssuming an operating company has the appro-

priate profile, the benefits of structuring an IPO asan UP-C — as opposed to a traditional C corpora-tion — can be significant and multifaceted. Thebenefits include the execution and augmentation ofvarious tax, economic, and business goals, includ-ing those discussed below.

1. Retention of partnership operating company.One of the primary benefits of structuring into anUP-C offering is the historical owners’ retention ofequity in a flow-through entity for U.S. federalincome tax purposes. The benefits of holding equityin partnership interests, as opposed to corporateshares, are numerous, and the associated tax rulescan be complex and go beyond the scope of thisarticle. In summary, however, a partnership equityinterest provides the following benefits to investors:

• only a single level of tax, which is assessed atthe investor level (no entity level income tax);

• tax-deferred cash distributions during theholding period up to a partner’s tax basis in thepartner’s equity interest;4

• potential increase in a partner’s outside taxbasis from allocations of income (a ‘‘basisbuild’’) that can reduce taxable gain on dispo-sition;

• a flexible ownership structure that allows vary-ing types of equity interests and also allows forfuture and ongoing tax-deferred contributionsto the partnership in exchange for equity (tax-free contributions are not subject to controlrequirements found in corporate tax law); and

• increased value delivered to a third party onexit via additional tax basis, which, in conjunc-tion with the benefits listed above, could resultin incremental proceeds when an investormonetizes a partnership interest.5

2. Ability of historical owners to monetize equityinterests. Another significant advantage of theUP-C structure is that it provides equity owners ina private partnership a path to liquidity via the putright (often called a redemption right) provision ofthe amended partnership operating agreement. One

4Tax basis in a partnership interest includes the adjustedbasis of property and cash contributed to the partnership in

addition to the partner’s allocable share of partnership liabilitiesand adjusted for distributions and partnership allocations (seesections 705, 722, and 752). In some situations, those rules mayallow for the use of a leveraged distribution with no taximplications other than a reduction in the partners’ outside taxbasis.

5In the UP-C structure, this incremental value is capturedthrough the TRA payments that are crystallized when the publicentity purchases historical owners’ units, but the same conceptholds true if a third-party trade sale is the ultimate exit strategy.

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of the transaction steps of implementing the struc-ture is to recapitalize the existing partnership andtypically unify the entity into one class of commonpartnership interests (intended to be substantiallysimilar to the economics of the common shares ofthe public corporation). As part of that recapitaliza-tion, and immediately before the offering, the part-nership agreement is amended to include aredemption right for the historical owners of thepartnership. That redemption right provides his-torical partners with the ability to periodically puttheir interests to the partnership in exchange forcash or the public company shares. Those rights aresubject to various lock-up provisions and otherexchange limitations.

3. The TRA: Incremental proceeds to selling his-torical owners. In addition to the tax and liquiditybenefits described above, there can be a consider-able economic advantage to the historical owners inan UP-C offering in the form of significant addi-tional proceeds through TRA payments. As men-tioned above, as part of the transaction, thehistorical owners enter into a legal agreement withthe public company, called the tax receivable agree-ment. The agreement obligates the public companyto pay a portion of cash tax savings it realizes fromtax attributes delivered to the public company bythe historical owner. The typical market rate for thepayout ratio on a TRA is 85 percent, and accord-ingly, the public company promises to pay 85 centsof every dollar of certain cash tax savings to thecounterparty of the TRA.

The parties may negotiate the TRA terms, whichdepend on various factors, including the profile ofthe historical owners; the strategy of the companyand its financial advisers (for example, investmentbank and legal counsel); and the attributes availableto be transferred to the public company (for ex-ample, increased tax basis resulting from the sale ofpartnership units, net operating losses, credits, andexisting carry-over basis adjustments). In mostagreements, the parties agree that the public com-pany will pay the historical owners 85 percent ofany cash tax savings realized from increased depre-ciation or amortization deductions that resultedfrom the purchase of partnership interests and thecorrelative section 743(b) basis adjustment.6 MostTRAs also provide for payment on tax basis and therelated deductions created as a result of the TRA

liability payments because some TRA paymentsmay be considered additional contingent purchaseprice for the acquired partnership units. In otherwords, some TRA payments have an iterative effect,as each time the public company makes a TRApayment it may generate additional tax basis,which in turn creates additional cash tax savingssubject to the TRA and resulting in additionalpayments.

To demonstrate the power of those payments andthe tax treatment as incremental contingent pur-chase price, consider the following example:

In year 0 historical owner A puts units to thepartnership with a value of $150 million and ashare of inside tax basis of partnership assetsof $0. A public company contributes $150million to the partnership, which is then dis-tributed to historical owner A. This exchangeresults in a tax basis step-up of $150 million forthe public company, all of which is amortizedstraight line over a 15-year period (that is, a$10 million additional tax deduction eachyear). In year 1 the public company uses $10million of its annual amortization deduction tooffset income at a combined federal and stateincome tax rate of 40 percent. Accordingly, inyear 1 the company has saved $4 million andunder the terms of the TRA will pay out 85percent of this cash savings, or $3.4 million, tohistorical owner A. This incremental purchaseprice will create an additional basis adjust-ment of $3.4 million that will be amortizedover the remaining life of the existing adjust-ment (that is, 14 years straight line of about$240,000 of deductions each year).7

In year 2 the public company uses the $10million of annual amortization deductions, inaddition to the $240,000 generated from theyear 1 TRA payment, to reduce its tax liabilityby a total of about $4.1 million. At the TRApayout rate of 85 percent, the public companywould owe historical owner A about $3.48million for year 2. The application of thisconcept continues through the life of the asset.At the end of 15 years, the public company

6To the extent the partnership has a section 754 election inplace during the year of a partnership unit purchase, theacquiring partner (in this case, the public company) may receivea special tax basis adjustment under section 743(b) that willresult in additional depreciation and amortization deductionsspecifically allocated to the public company.

7The example is simplified to assume that the entire TRApayment would be considered additional purchase price andcapitalized into the basis of the purchased partnership interest.However, it is likely that the payment would be considered acontingent installment sale obligation and some portion of thepayment would be considered interest when applying theinstallment sale rules of sections 453, 483, and 1274 and Treasuryregulations promulgated thereunder.



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will have used about $228 million of amorti-zation deductions, saved about $91 million incash taxes, and paid historical owner A about$78 million.

4. Incremental cash flow to public entity. Oneaspect of the UP-C that can often be overlooked isthe cash tax savings retained by the public entity.Although the entity may promise to pay out, as inthe example above, 85 cents of each dollar it saveson increased depreciation and amortization deduc-tions, this means that it retains the additional 15cents on every dollar of cash saved. Using the sameexample above, in the first year of realizing cash taxsavings from tax basis adjustments delivered byhistorical owner A, the public entity keeps $600,000.Extrapolating this result out over 15 years andconsidering the iterative effect that those paymentsgenerate additional tax basis in the system, thepublic company would retain about $13 million ofcash tax savings. In the simplest scenarios, compar-ing the UP-C to a traditional conversion to a Ccorporation IPO is easy: In the traditional IPOscenario, the public company would retain an in-cremental $0 of cash due to cash tax savings becausethe sale of shares does not increase the basis of thecompany’s underlying assets. In the UP-C context,the public entity would retain an incremental $13million in cash from cash tax savings.8

C. Maximizing Structure Value

As noted above and as a threshold matter, enti-ties that are primed to effect an offering via an UP-Cstructure should currently be operated in an entityclassified as a partnership for U.S. federal incometax purposes. In addition to that principal charac-teristic, a few other key characteristics would in-crease value to historical owners.

First, the UP-C structure’s value is increased tothe extent most equity owners in the operatingcompany can benefit from holding equity in apartnership structure (for example, individuals andother flow-through entities with individuals as theultimate owners). To the extent there are corporatepartners, the entities may not benefit to the samedegree as other individual owners. That is not tosay that a corporation cannot benefit from an UP-Cstructure, because there are various circumstancesin which corporations can receive TRA paymentsresulting in incremental proceeds (see Section B).

Second, the public company may realize greatercash tax savings resulting in higher TRA paymentsto the extent there is significant built-in gain in theoperating business assets at the time of a sale orexchange of partnership interests. As the publicentity pays out on its TRA obligation based on a taxbasis step-up delivered by the selling historicalowners, those TRA payments will generally beincreased when there is little to no tax basis in thepartnership assets. Also, the leading candidate foran UP-C will have this built-in gain and relatedbasis step-up attach to assets that can be depreci-ated or amortized, such as property, equipment,and goodwill, as opposed to assets that do notgenerate annual deductions (for example, land orstock in corporate subsidiary).

Third, because the TRA payments depend on thepublic company using specific tax depreciation andamortization deductions, the business should begenerating (or projecting to generate) taxable in-come from its operations. As discussed above, pay-ments made under the TRA are computed ‘‘withand without’’ the applicable tax basis adjustmentsmethod. Therefore, if the public company wouldnot have had any tax liability (ignoring that incre-mental tax basis delivered by the historical ownersresulting from an exchange), any TRA paymentsmay be delayed until the public company canactually use the deductions.

Finally, the leading profile of a company contem-plating an UP-C offering is one in an organicgrowth mode. This is because historical owners willnot only deliver a tax basis step-up to the publiccompany on an exchange at the IPO but alsoadditional step-ups resulting from prospective salesor exchanges of partnership units to the publicentity. Accordingly, the higher the fair market valueof the equity delivered to the public entity, thehigher tax basis step-up that will be delivered andthus result in incremental cash tax savings to thepublic company, 85 percent of which are subject topayments under the TRA.

D. Summary of Potential Traps for the UnwaryWhile the UP-C structure’s potential benefits

described above can be substantial, there are com-plexities and potential traps that taxpayers andtheir tax advisers should address. Those should beweighed against the potential benefits to determinewhether the UP-C structure is a viable alternativeand the more beneficial transaction structure giventhe operating company’s facts and circumstance.

The following are some key issues that should beconsidered when structuring into an UP-C:

• tax receivable agreement terms, including thepotential inclusion of corporate NOLs, existingsection 743(b) adjustments, and partnership

8The example and the cash benefit to the public companyassume that the only tax attributes subject to the TRA are thedepreciation and amortization deductions delivered to thepublic company resulting from its purchase of partnershipinterests from the historical owners and the related section743(b) adjustment.


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common tax basis and the potential impact ofpost-offering contributions or non-pro rata dis-tributions;

• additional tax compliance and maintenancecosts from the implementation of the structure,the operation of the exchange right mecha-nism, and the administrative burden associ-ated with TRA payments and disclosureobligations;

• publicly traded partnership considerations anddetermining compliance with one of the safeharbor exceptions in the section 7704 regula-tions;9 and

• potential application of the anti-churning rulesthat could limit the amortization of intangibleasset tax basis.10

E. ConclusionWhen one is considering the myriad benefits

described above, there are strong arguments aboutwhy the UP-C structure should be the preferredroute when considering a public equity raise forpartnership operating companies. The TRA value isa result of a contractual agreement between thepublic entity and the historical owners, and the taxbenefits are derived from the general tenets ofpartnership tax and subchapter K. Also, when com-pared with a traditional C corporation public offer-ing, the value created by the UP-C structure alsobenefits the public company (and therefore, indi-rectly, public investors) via the retained cash taxbenefits realized after payment of the TRA liability.

Given the proliferation of partnerships as thepreferred entity in the United States, the propensityfor strategic and institutional investors to invest inpartnerships and the multitude of potential benefitsprovided by the structure, the UP-C transactionshould continue to flourish in years to come.

9See reg. section 1.7704-1(e) through (j).10See section 197(f)(9) and the regulations promulgated there-

under.

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