An alternate route to an IPO: the up-C partnership structure.

• Author: Bilsky, Jeffrey N.
• Position: Part 1 - Initial public offerings

EXECUTIVE SUMMARY

* A conventional conversion of a partnership to a C corporation, followed by an initial public offering (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 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 deferral of gain recognition and an increase in the amount they ultimately receive 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 if the operating partnership in the Up-C structure makes a Sec. 754 election. This basis step-up in many cases will be allocable to depreciable fixed assets or intangible assets, resulting in additional tax deductions.

* Following the IPO, the legacy partners will continue to benefit from the flowthrough nature of a partnership, whereas, had they converted the partnership to a C corporation prior to the IPO, the corporation's future earnings could have been subject to shareholder-level taxation when distributed.

* A TFIA as part of an Up-C partnership structure can add value for the legacy partners, typically entitling them to 85% of the tax savings derived from the basis step-up achieved by using the Up-C structure.

PREVIEW

* Use of an Up-C partnership structure in a public offering of a business structured as a partnership can allow partners to defer recognizing taxable gain and increase the ultimate proceeds they receive from their holdings.

* A tax receivable agreement can enhance the tax-favorable features of an Up-C partnership structure while aligning the goals of the operating partnership and the public corporation.

* As described herein, it is necessary for the operating partnership in an Up-C structure to have a Sec. 754 election in place so the public company being formed receives a Sec. 743(b) basis adjustment in the partnership's assets.

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.

The Up-C partnership structure is often overlooked, but it may be a highly advantageous path to an IPO in the right situation. The existing partners may defer recognizing taxable gain and 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.

This two-part article describes the Up-C structure and its implementation and uses, especially as it relates to a planned IPO. This first part covers the Up-C's basic structure and how it is implemented, contrasting it to a conventional conversion of a partnership to a C corporation and showing how a tax receivable agreement (TRA) coupled with an Up-C can provide even greater value to the original partners (legacy partners). Next month, Part 2 will analyze a wide range of tax considerations that can come into play before, during, and after implementing an Up-C structure with a TRA.

Many advisers and business owners take for granted that a partnership must first convert to a C corporation as part of any pre-IPO planning. A pre-IPO conversion of a partnership into a corporation is typically accomplished via one of the following methods described in Rev. Rul. 84-111:

1. The partnership may contribute its assets to the corporation in exchange for stock of the corporation and then distribute the stock to its partners in liquidation (an "assets over" form);

2. The partnership may liquidate, distributing undivided interests in its assets and liabilities to its partners, who then contribute their undivided interests to the corporation for stock (an "assets up" form);

3. The partners may contribute their partnership interests to the corporation in exchange for stock (an "interests over" form); or

4. The contribution may be "formless" under applicable state statutes. Note that this type of transaction, pursuant to Rev. Rul. 2004-59, is treated the same as the "assets over" form. (2)

The typical view is that the newly converted C corporation will complete the IPO process, and newly issued shares in the operating company will trade on the public market (see Exhibit 1 below).

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. r 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) structure (3) 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...