An alternate route to an IPO: up-C partnership tax considerations.

• Author: Bilsky, Jeffrey N.
• Position: Part 2 - Initial public offering

Partnerships considering converting to a C corporation and raising capital in an initial public offering (IPO) can often realize-considerable advantages by employing an Up-C partnership structure. The structure is implemented by forming a C corporation while continuing to operate the underlying business through a partnership structure. The corporation raises capital in the public market via an IPO, contributes the capital to the operating partnership in exchange for a partnership interest, and typically becomes the managing member of the operating partnership. The partnership's legacy partners typically have rights to exchange their partnership interests for stock of the public company on a one-for-one basis. Last month, Part 1 of this two-part article (1) described the Up-C structure, common issues in its implementation, and its enhancement via a tax receivable agreement (TRA). This Part 2 explores common tax considerations preceding and following an IPO employing an Up-C structure.

Interest in using the Up-C structure is driven by the potential to create additional value to both the public company and the legacy partners. To ensure that these benefits are realized, it is critical that taxpayers and their advisers traverse a maze of possible pitfalls and traps for the unwary. While each transaction presents its own nuances and specific issues, a number of considerations apply in setting up nearly every Up-C structure.

The following provides an overview of typical issues and considerations that need to be addressed when implementing an Up-C structure. However, it should not be considered an exhaustive discussion of the various considerations and issues that one may encounter when embarking on the journey to an Up-C structure.

Evaluating Impact of Pre-IPO Partnership Restructuring

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. Consequently, it is critical for the tax adviser to take into account the potential impact of these transactions. Any company that is considering an Up-C structure should seek the advice of qualified 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.

Sec. 708(b)(1)(B) Terminations

One universal consideration in the pre-IPO restructuring is identifying the potential Sec. 708(b)(1)(B) technical terminations at the operating partnership or other levels within the existing organizational structure. A technical termination under Sec. 708(b)(1)(B) occurs upon a sale or exchange within any 12-month period of 50% or more of the interests in the capital and profits of a partnership. It is therefore critical to determine whether there has been a sale or exchange of partnership capital and profits interests. Further, it is necessary to quantify the percentage of capital and profits interests sold or exchanged. These two requirements create numerous planning opportunities as well as pitfalls. While determining whether a sale or exchange has occurred can be straightforward, care must be taken in many situations. Consider, for example, the "all or nothing" rule in tiered partnership structures under Regs. Sec. 1.708-1(b)(2):

[I]f the sale or exchange of an interest in a partnership (upper-tier partnership) that holds an interest in another partnership (lower-tier partnership) results in a termination of the upper-tier partnership, the upper-tier partnership is treated as exchanging its entire interest in the capital and profits of the lower-tier partnership. If the sale or exchange of an interest in an upper-tier partnership does not terminate the upper-tier partnership, the sale or exchange of an interest in the upper-tier partnership is not treated as a sale or exchange of a proportionate share of the upper-tier partnership's interest in the capital and profits of the lower-tier partnership. Once all of the potential sale and exchange transactions have been identified, it will be necessary to determine the actual percentage of capital and profits exchanged. Although conceptually straightforward, determining these percentages can become extremely complicated very quickly. Fortunately, because the overall Up-C transaction will require a detailed analysis of each partner's Sec. 704(b) capital account and ownership in the pre-IPO and post-IPO entities, the requisite information to determine the percentage interests in both capital and profits should be available. Although a technical termination generally does not result in immediate taxable income recognition, failure to properly identify each technical termination can have significant consequences for the overall Up-C plan. (2)

A related consideration is whether the pre-IPO restructuring will involve any partnership merger transactions with a combination of cash-out and rollover partners. In this situation, careful planning is required to ensure that any gain resulting from the partnership merger is recognized only to those partners receiving cash. For example, structuring a pre-IPO partnership merger transaction to take advantage of Regs. Sec. 1.708-1(c)(4) (3) may avoid potential gain recognition to the rollover partners.

Disguised Sales Under Sec. 707(a)(2)(B)

In connection with the likely restructuring transactions, certain legacy partners may receive cash distributions. Although these distributions may be provided for a variety of valid and reasonable business purposes, care must be taken to avoid the rules for a disguised sale of a partnership interest of Sec. 707(a)(2)(B). Due to the absence of Treasury regulations providing guidance on disguised sale treatment, tax advisers need to wade through the Sec. 707(a) (2) (B) legislative history as well as voluminous and often conflicting case law and IRS pronouncements to determine whether this treatment is appropriate.

Sec. 707(a)(2)(B) provides that if (1) there is a direct or indirect transfer of money or other property by a partner to a partnership; (2) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner); and (3) the transfers, when viewed together, are properly characterized as a sale or exchange of property, then the transfers shall be treated either as a transaction between the partnership and one who is not a partner or as a transaction between two or more partners acting other than in their capacity as members of the partnership. In the absence of regulations, Treasury has indicated, pursuant to Notice 2001-64, that determination of whether a transaction is a disguised sale of a partnership interest under Sec. 707(a)(2)(B) is to be made on the basis of the statute and its legislative history. (4)

Calculating Sec. 704(b) Capital Accounts

It will be necessary to revalue the operating partnership Sec. 704(b) capital accounts upon contribution of IPO proceeds by the public company. When the operating partnership revalues its Sec. 704(b) capital, it must consider the allocation of the expected revaluation gain or loss among the particular...