MMG | December 18th, 2015 | http://www.middlemarketgrowth.org
By Jeffrey N. Bilsky and Avi D. Goodman
A company that is considering going public has a long road ahead. When the business is structured as a partnership, it has historically been assumed that the partnership needs to become a corporate entity before the initial public offering. However, businesses operating as partnerships can take an alternate route that may yield significantly more value: the Up-C partnership structure.
The Up-C partnership structure is often overlooked, but may be highly advantageous in the right situation. The existing partners can increase their total consideration received on future disposition of partnership units by creating certain tax attributes, and subsequently monetizing the associated benefits in the form of cash received as the tax attributes are used.
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) is a holding company and serves as the publicly traded vehicle that is invested in the operating partnership alongside the pre-IPO legacy partners.
Tax Advantages of Up-C Partnership Structures
A conventional conversion of a partnership to a C corporation followed by an IPO results in double taxation with respect to the built-in gain inherent in the partnership assets at the time of conversion. Not only are the partners taxed on the ultimate disposition of stock received for their partnership interests, but the corporation is also taxed on a future disposition of acquired partnership assets.
An IPO undertaken using an Up-C partnership structure, on the other hand, features only a single level of taxation on the built-in gain inherent in the partnership assets at the time of conversion. The legacy partners recognize gain on the ultimate disposition of their ownership interests and obtain potential additional benefits, including an increase in the amount ultimately received for their interests if a tax receivable agreement (TRA) is entered into as part of the structure. The public company, in turn, can receive a step-up in the tax basis of its share of partnership assets that, in many cases, can result in additional tax deductions.
“The Up-C partnership structure is often overlooked, but may be highly advantageous in the right situation.”
Following the IPO, the legacy partners will continue to benefit from the flow-through nature of a partnership, maintaining a single layer of taxation. Further, a TRA as part of an Up-C partnership structure can add value for the legacy partners, typically entitling them to 85 percent of the tax savings derived from the basis step-up achieved by using the structure.
To ensure that the most advantageous post-IPO structure is in place, pre-IPO restructuring transactions are likely necessary. It may not be possible to effectuate certain restructuring steps in a tax-free manner, and some upfront tax costs may result. Any company that is considering an Up-C structure should seek the advice of qualified tax advisers, as determining the optimum pre-IPO structure is not always intuitive. In many cases, several alternative paths lead to the optimum structure, and determining which path is most advantageous to the parties may require complicated tax modeling exercises.
Additionally, the legacy partners will need to evaluate the applicability of the net investment income tax, which imposes a 3.8 percent surtax on investment income in excess of a threshold amount. Net investment income includes net gain attributable to the disposition of property other than assets used in a “non-passive” trade or business. To the extent a legacy partner satisfies the relevant standards and the activity is considered non-passive, an added benefit of the Up-C structure is that the net investment income tax may not apply with respect to that partner.
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 which, by definition, does not take taxes into account.
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. //