For business organizations formed and operated as partnerships for federal and state income tax purposes it has long been assumed that when the partnership and its owners wish to take the business “to market” in terms of a public offering, it has been the general consensus that the partners needs to convert into a corporation before the IPO is effectuated. But that is not, however, the only available model for a partnership’s venturing into an IPO. In this regard, another model involves the use of the “Up-C partnership” structure which is not as widely known.
After the incorporation of the partnership, the existing partners, now shareholders, will be in receipt of their shares. This ownership could include investors in funds that were previously operated as partnerships. The IPO will involve the issuance of a new series or class of shares to the public investors whereby cash is infused into the corporation in exchange for the newly minted shares.
The C corporation structure of course presents a double-tax regime to the corporation and its shareholders. Compare the umbrella partnership real estate investment trust structure (UPREIT). Another possible structure involves a publicly traded partnership (PTP) combined with a tax receivables agreement (TRA). More specifically, the going-public transaction may involve the establishment of a tax receivables agreement. Under this agreement, goodwill or other intangible assets of the asset management business that are amortizable for tax purposes are transferred to a lower-tier partnership or sold to a lower-tier corporation, often using proceeds of the public offering of partnership units to make the purchases of partnership interests of the historical partners and making a section 754 election. As the goodwill or other intangibles are amortized, generating tax deductions, typically 85% of the tax savings attributable to the deductions is paid to the contributors of the management business.
Conventional Structure for Partnership’s Becoming Involved in an IPO
The central authority for the incorporation of an entity taxable as a partnership is Rev. Rul. 84-111, 1984-30 I.R.B. 6, revoking and suspending Rev. Rul. 70-239, 1970 C.B. 74.
There are three alternative methods for incorporating a partnership.
- X, a partnership, transferred all of its assets to newly-formed corporation R in exchange for all the outstanding stock of R and the assumption by R of X's liabilities. X then terminated by distributing all the stock of R to X's partners in proportion to their partnership interests. This is referred to as an “assets-over” method of incorporation.
- Y, also a partnership, distributed all of its assets and liabilities to its partners in proportion to their partnership interests in a transaction that constituted a termination of Y under section 708(b)(1)(A) of the Code. The partners then transferred all the assets received from Y to newly-formed corporation S in exchange for all the outstanding stock of S and the assumption by S of Y's liabilities that had been assumed by the partners. This is referred to an “assets-down” method of incorporation.
- The partners of the Z partnership transferred their partnership interests in Z to newly-formed corporation T in exchange for all the outstanding stock of T. This exchange terminated Z and all of its assets and liabilities became assets and liabilities of T. This is referred to as the “interests over” method of incorporation.
Under each of the alternative models, the IPO process will follow after the conversion of the partnership to a C corporation occurs and the partners exchange their ownership interests in the partnership for shares of stock in the newly formed corporation. See §§ 361, 362, 358(a), 752, 73, 1221, etc.
Assets Over Method of Incorporation
Under the “assets-over” method no gain or loss is recognized by the X partnership on the transfer of all of its assets to the R corporation in exchange for R’s stock and the assumption by R of X’s liabilities. The corporation’s (R) basis in the assets received from the X partnership, equals their basis in X immediately prior to the transfer to R corporation. §362(a). Under §358(a), the basis to X partnership for the stock received from R corporation is the same of the basis to X of the assets it transferred to R less the liabilities assumed by R which assumption is treated as a payment of money to X partnership per §358(d). Furthermore, the assumption by R of X’s liabilities decreases each partner’s share of the partnership’s liabilities reducing the basis of each partner’s partnership interest. §§752, 733. On the distribution of the R stock to the X partners, X will liquidated and terminate. §708(b)(1)(A). The basis of the stock distributed to the partners in liquidation of the partnership is equal to each partner’s adjusted basis in his or her partnership’s interest in X. There is tacking of holding period under §1223(1) as to X’s holding period for the R stock received in the exchange but only as to the proportion of value attributable to its capital assets and §1231 assets . If non-capital assets or section 1231 assets were also contributed, X’s holding period for such stock begins on the day after the date of the exchange. As to R corporation, its holding period in the assets acquired includes the X partnership’s holding period. When X distributes the R stock to its partners, the partners’ holding periods include X’s holding period of the stock. §§735(b) and 1223.
Where the conversion results in a carryover basis to the partner in the stock received in the exchange, regardless of the model used, the built-in gain inherent in the stock will be preserved. Thus if any former partners sell shares of the corporation’s stock in the public market taxable gain will arise.
Note that there generally will be no basis step-up to the corporation. This further results in no additional depreciation or amortization for the corporation. See, in contrast, §§336(e), 338(h)(10), 338(g). This stands in contrast to the use of a TRA as part of an UP-C partnership and capital raise.
Assets Up Method of Incorporation
Under the “assets-up” method, the process starts with the transfer of all of Y partnership’s assets to its partners in a liquidating distribution. See §708(b)(1)(A). Under section 732(b) the basis of the assets (other than cash) distributed to the partners in Y will be equal to the adjusted basis of each partner’s interest less cash distributed. Under section 752, the decrease in Y’s liabilities by the asset transfer and liability assumptions in liquidation is offset by the pick up in liabilities by the partner-distributees resulting in no aggregate adjustment. On the contribution of all of the partnership’s assets by the partners to the corporation (S), no gain or loss is recognized by Y’s former partners in exchange for the S stock under section 351. The basis to the former Y partners in the S stock is the same as their outside basis under section 732, reduced by the liabilities assumed by S which assumption is treated as payment of money under section 358(d). Under section 362(a), the corporation’s basis in the assets received in the exchange equals their basis to the former partners as determined in accordance with section 732(c) immediately before the section 351 transfer to S corporation. There is tacking of holding period under section 735(b).
In an assets up method, a partner(s) may recognize gain under section 357(c) where liabilities contributed to the corporation exceed the tax basis in the contributed assets. Moreover, an assets up conversion may require a partner recognize gain under section 731(a) where the money deemed distributed to a partner in liquidation exceeds the partner’s basis. Generally, section 731(a) will not come into play in general under the other methods.
Interests Over Method of Incorporation
Under the “interests-over” method, gain or loss is not recognized by the partners of the Z partnership on the transfer of all of their ownership interests in Z to T corporation in exchange for T’s stock. §351. The partnership will, by having only one partner, i.e., T corporation, be deemed to have terminated in accordance with section 708(b)(1)(A). Under section 358(a), the stock basis in T stock to the partners in Z will equal the basis of their partnership interests transferred to T less liabilities assumed by T. See §§752(d) and 358(d). T’s asset basis will be derived from the basis of the Z partners in their partnership interests. See §732(c). Tacking of holding period rules will apply. See §1223(1).
It should be noted that the results obtained under these three alternatives are not identical. Generally what drives the form of the transaction is the avoidance of gain on formation or obtaining a higher stock basis in the stock received.
State Law Requirements and Access to Formless Conversion Statute; Check the Box Incorporations
In recent years, various have adopted statutes permitting entities to be converted from one form to another, including conversion of a limited partnership or an LLC to a state law corporation. See e.g., Del. Gen. Corp. Law §265 (conversion of a Delaware ‘other entity‘ to a Delaware corporation; 6 Del. Code Ann. § 17-219 (conversion of Delaware limited partnership to a corporation, statutory trust, business trust or association, REIT, or any other unincorporated business; 6 Del. Code Ann. §18-216 (conversion of a Delaware LLC to a corporation, et al.). These statutes are convenient since they usually provide that the converted entity commenced on the date of its original formation and effectively allow housing of the assets and liabilities in another form of entity without the actual movement or transfer of the assets.
In Rev. Rul. 2004-59, 2004-24 IRB 1050, the Service addressed questions arising with respect to the federal income tax consequences of the conversion of an entity taxed as a partnership under federal tax law to a state law corporation through the use of a state law formless conversion statute. The ruling states that a partnership to corporation conversion will be treated in the same manner as a partnership to corporation check-the-box formless conversion under Treas. Reg.§ 301.7701-3(c)(1)(i). In that type of formless tax conversion, Treas. Reg. §301.7701-3(g)(1) (i) provides that if a tax partnership elects under Treas. Reg. §301.7701-3(c)(1)(i) to be treated as a tax corporation, the following is deemed to occur as part of an “assets-over” formation: (i) the partnership contributes all of its assets and liabilities to the association in return for stock in the association; and (ii) immediately thereafter liquidates, distributing the stock of the association to its partners. Rev. Rul. 2004-59 further clarifies that the other alternatives described in Rev. Rul. 84-111, 1984-2 CB 88 for converting a partnership to a corporation are not available in a conversion under a state law formless conversion statute such as the “assets-up” or “interests-up” methods.
Alternative of Using the Up-C Structure
An IPO which uses an UP-C offering is used by both companies, including private equity firms, to raise capital from IPOs and future public offerings. The application of the funds raised can be applied for one or more purposes, including debt repayments, redemptions and growth activities. As with other possible structures, the Up-C approach permits the shareholders (former partners perhaps) to generate a raise of funds while maintaining control of the business. The owners can also recapitalize their retained interests by receiving put rights with respect to some or all of their shares. All those goals are accomplished while retaining the benefits of holding equity interests in a flow-through entity and potentially increasing the proceeds received by historical owners through the use of a tax receivable agreement (TRA). The UP-C borrows conceptually from the UPREIT structure. It uses an “umbrella” like partnership to hold business assets related to the public offering. Its use is reportedly increasing. In effect the UP-C is a partner in the partnership itself and its shares are sold to the public. With the increasing use of partnerships for organizing business operations it is expected that the UP-C structure will continue to grow.
There are potential income tax savings from maintaining the use of the partnership structure, especially among the non-corporate partners who retain their investments in the partnership. There is only a single level of tax as well as the other operational flexibility offered under Subchapter K.
Another benefit of the UP-C structure is that it provides a path to liquidity via the put right (often called a redemption right) provision of the amended partnership operating agreement. This right will be of substantial benefit to the partners organizing the capital raise. In other words it is there to benefit the long-term owners of the partnership. The redemption right provides historical partners with the ability to periodically put their interests to the partnership in exchange for cash or the public company shares. Those rights are subject to various lock-up provisions and other exchange limitations.
Consideration of the Tax Receivables Agreement will be important again to the historical owners. First, it facilitates the receipt of cash generated from the sale of goodwill and other amortizable intangibles. More particularly, the TRA involves the historical owners entering into a legal agreement with the public company. The TRA obligates the public company to pay a portion of cash tax savings it realizes from tax attributes delivered to the public company by the historical owner. The typical market rate for the payout ratio on a TRA is 85%, and accordingly, the public company promises to pay 85 cents of every dollar of certain cash tax savings. See §§754, 743.
While there is room for disagreement on this point, partnerships seeking a large infusion of equity funds from the public or other sources may opt for the UP-C structure instead of the more traditional C corporation model. The comparison involves a review of many factors, i.e., legal, financial and financial reporting, and tax.
Kostelanetz & Fink, LLP (and this reporter) acknowledge that this post was intended solely to provide information to the reader and is neither intended to be and may not be relied upon as legal advice. Anyone interested in exploring this issue should consult with their tax counsel.
1 Rev. Rul. 84-111, supra
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