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
taxnotes
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Volume 152, Number 6 August 8, 2016
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The Staying Power of the UP-C:
It’s Not Just a Flash in the Pan
by 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-Cs
are dead’’ (or similar) was uttered by a few bold
predictors of the equity markets. The author pro-
poses that this assertion is not only erroneous, but
to the contrary, there will continue to be an upsurge
in UP-C offerings in the coming years. This article
will familiarize the reader with the UP-C structure
and discuss why UP-Cs could continue to be the
preferred offering structure for operating partner-
ships. To accomplish that goal in bite-size segments,
this article is presented as follows: (1) an overview
of the transaction structure; (2) the primary benefits
of the UP-C structure; (3) the typical UP-C company
profile; (4) pitfalls to be aware of during the offering
process; and (5) when considering tax and business
characteristics, a summary conclusion of the staying
power of the UP-C.
A. UP-C Offering Structure Prominence
An UP-C offering is a transaction structure used
by both strategic companies and private equity
firms to raise capital from IPOs and future public
offerings. The cash raised from the offerings can be
used for various company purposes, including buy-
ing out investors, paying down existing debt, fund-
ing acquisitions, and covering other general
business operations and organic growth. This trans-
action approach provides the historical owners of
the business a means to raise cash while retaining
control of the business operations and providing an
exit mechanism via the redemption right. 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), which is discussed below.
While using an umbrella partnership to hold
business assets related to a public offering is not
novel,1 the proliferation of UP-C offerings in the
past few years has dramatically increased2 because
of two significant factors.
First, the use of entities classified as partnerships
in the United States has significantly outpaced the
use of corporate entities over the past 15 years.
Based on the most recent publicly available IRS
filing data, in 2001 U.S. taxpayers filed about the
same number of partnership returns as corporate
returns — about 2.1 million for each entity type. In
2012 however, the number of partnership tax re-
turns (about 3.4 million) more than doubled the
figure for corporate tax returns (about 1.6 million)
(see figure on the next page).3 This data suggests
that as more companies operate in entities treated
as a partnership, there may be more companies
eyeing public offerings that hold business opera-
tions in partnership form and are thus ripe for UP-C
structures.
Second, the availability of the UP-C structure and
awareness of its potential benefits are now more
widely known and customary among the business,
investment banking, legal, and tax communities. In
fact, many private equity sponsors intentionally
1
See reg. section 1.701-2(d), Example 4 (discussing the part-
nership antiabuse rule and the IRS’s inability to apply that type
of rule and recast an umbrella partnership real estate investment
trust public offering structure).
2
Based on publicly available information filed with the SEC
on IPOs using an UP-C structure.
3
IRS, ‘‘Tax Statistics,’’ available at https://www.irs.gov/uac/
tax-stats.
Phillip W. DeSalvo
Phillip W. DeSalvo is a
managing director in KPMG
LLP’s mergers and acquisi-
tions tax practice in the Chi-
cago office. He thanks Dan
Basca, Jim Tod, Jarod Wall,
and Scott Worsdell of
KPMG’s partnership prac-
tice group for their contribu-
tions to this article.
In this article, DeSalvo discusses the staying
power of the umbrella partnership corporation
structure and explains its benefits as well as its
potential pitfalls.
The information contained in this article is of a
general nature and based on authorities that are
subject to change. Its applicability to specific situa-
tions should be determined through consultation
with your tax adviser. This article represents the
views of the author only.
tax notes™
TAX PRACTICE
TAX NOTES, August 8, 2016 865
For more Tax Notes content, please visit www.taxnotes.com.

invest in operating companies through partnership
structures to lay the foundation for an UP-C IPO to
be considered as a potential exit strategy.
B. Potential Benefits of the Structure
Assuming an operating company has the appro-
priate profile, the benefits of structuring an IPO as
an UP-C — as opposed to a traditional C corpora-
tion — can be significant and multifaceted. The
benefits include the execution and augmentation of
various tax, economic, and business goals, includ-
ing those discussed below.
1. Retention of partnership operating company.
One of the primary benefits of structuring into an
UP-C offering is the historical owners’ retention of
equity in a flow-through entity for U.S. federal
income tax purposes. The benefits of holding equity
in partnership interests, as opposed to corporate
shares, are numerous, and the associated tax rules
can be complex and go beyond the scope of this
article. In summary, however, a partnership equity
interest provides the following benefits to investors:
• only a single level of tax, which is assessed at
the investor level (no entity level income tax);
• tax-deferred cash distributions during the
holding period up to a partner’s tax basis in the
partner’s equity interest;4
• potential increase in a partner’s outside tax
basis from allocations of income (a ‘‘basis
build’’) that can reduce taxable gain on dispo-
sition;
• a flexible ownership structure that allows vary-
ing types of equity interests and also allows for
future and ongoing tax-deferred contributions
to the partnership in exchange for equity (tax-
free contributions are not subject to control
requirements found in corporate tax law); and
• increased value delivered to a third party on
exit via additional tax basis, which, in conjunc-
tion with the benefits listed above, could result
in incremental proceeds when an investor
monetizes a partnership interest.5
2. Ability of historical owners to monetize equity
interests. Another significant advantage of the
UP-C structure is that it provides equity owners in
a private partnership a path to liquidity via the put
right (often called a redemption right) provision of
the amended partnership operating agreement. One
4
Tax basis in a partnership interest includes the adjusted
basis of property and cash contributed to the partnership in
addition to the partner’s allocable share of partnership liabilities
and adjusted for distributions and partnership allocations (see
sections 705, 722, and 752). In some situations, those rules may
allow for the use of a leveraged distribution with no tax
implications other than a reduction in the partners’ outside tax
basis.
5
In the UP-C structure, this incremental value is captured
through the TRA payments that are crystallized when the public
entity purchases historical owners’ units, but the same concept
holds true if a third-party trade sale is the ultimate exit strategy.
2.1 2.13
2
2.95
1.6
3.39
0.5
0
1
1.5
2
2.5
3
3.5
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Corporations Partnerships
Legal Entity Comparison by Number – 2001 to 2012
Corporations vs. PartnershipsMillions
COMMENTARY / TAX PRACTICE
(Footnote continued in next column.)
866 TAX NOTES, August 8, 2016

of the transaction steps of implementing the struc-
ture is to recapitalize the existing partnership and
typically unify the entity into one class of common
partnership interests (intended to be substantially
similar to the economics of the common shares of
the public corporation). As part of that recapitaliza-
tion, and immediately before the offering, the part-
nership agreement is amended to include a
redemption right for the historical owners of the
partnership. That redemption right provides his-
torical 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.
3. The TRA: Incremental proceeds to selling his-
torical owners. In addition to the tax and liquidity
benefits described above, there can be a consider-
able economic advantage to the historical owners in
an UP-C offering in the form of significant addi-
tional proceeds through TRA payments. As men-
tioned above, as part of the transaction, the
historical owners enter into a legal agreement with
the public company, called the tax receivable agree-
ment. The agreement 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 percent, and accord-
ingly, the public company promises to pay 85 cents
of every dollar of certain cash tax savings to the
counterparty of the TRA.
The parties may negotiate the TRA terms, which
depend on various factors, including the profile of
the historical owners; the strategy of the company
and its financial advisers (for example, investment
bank and legal counsel); and the attributes available
to be transferred to the public company (for ex-
ample, increased tax basis resulting from the sale of
partnership units, net operating losses, credits, and
existing carry-over basis adjustments). In most
agreements, the parties agree that the public com-
pany will pay the historical owners 85 percent of
any cash tax savings realized from increased depre-
ciation or amortization deductions that resulted
from the purchase of partnership interests and the
correlative section 743(b) basis adjustment.6 Most
TRAs also provide for payment on tax basis and the
related deductions created as a result of the TRA
liability payments because some TRA payments
may be considered additional contingent purchase
price for the acquired partnership units. In other
words, some TRA payments have an iterative effect,
as each time the public company makes a TRA
payment it may generate additional tax basis,
which in turn creates additional cash tax savings
subject to the TRA and resulting in additional
payments.
To demonstrate the power of those payments and
the tax treatment as incremental contingent pur-
chase price, consider the following example:
In year 0 historical owner A puts units to the
partnership with a value of $150 million and a
share of inside tax basis of partnership assets
of $0. A public company contributes $150
million to the partnership, which is then dis-
tributed to historical owner A. This exchange
results in a tax basis step-up of $150 million for
the public company, all of which is amortized
straight line over a 15-year period (that is, a
$10 million additional tax deduction each
year). In year 1 the public company uses $10
million of its annual amortization deduction to
offset income at a combined federal and state
income tax rate of 40 percent. Accordingly, in
year 1 the company has saved $4 million and
under the terms of the TRA will pay out 85
percent of this cash savings, or $3.4 million, to
historical owner A. This incremental purchase
price will create an additional basis adjust-
ment of $3.4 million that will be amortized
over 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 $10
million of annual amortization deductions, in
addition to the $240,000 generated from the
year 1 TRA payment, to reduce its tax liability
by a total of about $4.1 million. At the TRA
payout rate of 85 percent, the public company
would owe historical owner A about $3.48
million for year 2. The application of this
concept continues through the life of the asset.
At the end of 15 years, the public company
6
To the extent the partnership has a section 754 election in
place during the year of a partnership unit purchase, the
acquiring partner (in this case, the public company) may receive
a special tax basis adjustment under section 743(b) that will
result in additional depreciation and amortization deductions
specifically allocated to the public company.
7
The example is simplified to assume that the entire TRA
payment would be considered additional purchase price and
capitalized into the basis of the purchased partnership interest.
However, it is likely that the payment would be considered a
contingent installment sale obligation and some portion of the
payment would be considered interest when applying the
installment sale rules of sections 453, 483, and 1274 and Treasury
regulations promulgated thereunder.

will have used about $228 million of amorti-
zation deductions, saved about $91 million in
cash taxes, and paid historical owner A about
$78 million.
4. Incremental cash flow to public entity. One
aspect of the UP-C that can often be overlooked is
the cash tax savings retained by the public entity.
Although the entity may promise to pay out, as in
the example above, 85 cents of each dollar it saves
on increased depreciation and amortization deduc-
tions, this means that it retains the additional 15
cents on every dollar of cash saved. Using the same
example above, in the first year of realizing cash tax
savings from tax basis adjustments delivered by
historical owner A, the public entity keeps $600,000.
Extrapolating this result out over 15 years and
considering the iterative effect that those payments
generate additional tax basis in the system, the
public company would retain about $13 million of
cash tax savings. In the simplest scenarios, compar-
ing the UP-C to a traditional conversion to a C
corporation IPO is easy: In the traditional IPO
scenario, the public company would retain an in-
cremental $0 of cash due to cash tax savings because
the sale of shares does not increase the basis of the
company’s underlying assets. In the UP-C context,
the public entity would retain an incremental $13
million 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-C
structure should currently be operated in an entity
classified as a partnership for U.S. federal income
tax 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 to
the extent most equity owners in the operating
company can benefit from holding equity in a
partnership structure (for example, individuals and
other flow-through entities with individuals as the
ultimate owners). To the extent there are corporate
partners, the entities may not benefit to the same
degree as other individual owners. That is not to
say that a corporation cannot benefit from an UP-C
structure, because there are various circumstances
in which corporations can receive TRA payments
resulting in incremental proceeds (see Section B).
Second, the public company may realize greater
cash tax savings resulting in higher TRA payments
to the extent there is significant built-in gain in the
operating business assets at the time of a sale or
exchange of partnership interests. As the public
entity pays out on its TRA obligation based on a tax
basis step-up delivered by the selling historical
owners, those TRA payments will generally be
increased when there is little to no tax basis in the
partnership assets. Also, the leading candidate for
an UP-C will have this built-in gain and related
basis step-up attach to assets that can be depreci-
ated or amortized, such as property, equipment,
and goodwill, as opposed to assets that do not
generate annual deductions (for example, land or
stock in corporate subsidiary).
Third, because the TRA payments depend on the
public company using specific tax depreciation and
amortization deductions, the business should be
generating (or projecting to generate) taxable in-
come from its operations. As discussed above, pay-
ments made under the TRA are computed ‘‘with
and without’’ the applicable tax basis adjustments
method. Therefore, if the public company would
not have had any tax liability (ignoring that incre-
mental tax basis delivered by the historical owners
resulting from an exchange), any TRA payments
may be delayed until the public company can
actually use the deductions.
Finally, the leading profile of a company contem-
plating an UP-C offering is one in an organic
growth mode. This is because historical owners will
not only deliver a tax basis step-up to the public
company on an exchange at the IPO but also
additional step-ups resulting from prospective sales
or exchanges of partnership units to the public
entity. Accordingly, the higher the fair market value
of the equity delivered to the public entity, the
higher tax basis step-up that will be delivered and
thus result in incremental cash tax savings to the
public company, 85 percent of which are subject to
payments under the TRA.
D. Summary of Potential Traps for the Unwary
While the UP-C structure’s potential benefits
described above can be substantial, there are com-
plexities and potential traps that taxpayers and
their tax advisers should address. Those should be
weighed against the potential benefits to determine
whether the UP-C structure is a viable alternative
and the more beneficial transaction structure given
the operating company’s facts and circumstance.
The following are some key issues that should be
considered when structuring into an UP-C:
• tax receivable agreement terms, including the
potential inclusion of corporate NOLs, existing
section 743(b) adjustments, and partnership
8
The example and the cash benefit to the public company
assume that the only tax attributes subject to the TRA are the
depreciation and amortization deductions delivered to the
public company resulting from its purchase of partnership
interests from the historical owners and the related section
743(b) adjustment.
868 TAX NOTES, August 8, 2016

common tax basis and the potential impact of
post-offering contributions or non-pro rata dis-
tributions;
• additional tax compliance and maintenance
costs from the implementation of the structure,
the operation of the exchange right mecha-
nism, and the administrative burden associ-
ated with TRA payments and disclosure
obligations;
• publicly traded partnership considerations and
determining compliance with one of the safe
harbor exceptions in the section 7704 regula-
tions;9 and
• potential application of the anti-churning rules
that could limit the amortization of intangible
asset tax basis.10
E. Conclusion
When one is considering the myriad benefits
described above, there are strong arguments about
why the UP-C structure should be the preferred
route when considering a public equity raise for
partnership operating companies. The TRA value is
a result of a contractual agreement between the
public entity and the historical owners, and the tax
benefits are derived from the general tenets of
partnership tax and subchapter K. Also, when com-
pared with a traditional C corporation public offer-
ing, the value created by the UP-C structure also
benefits the public company (and therefore, indi-
rectly, public investors) via the retained cash tax
benefits realized after payment of the TRA liability.
Given the proliferation of partnerships as the
preferred entity in the United States, the propensity
for strategic and institutional investors to invest in
partnerships and the multitude of potential benefits
provided by the structure, the UP-C transaction
should continue to flourish in years to come.
9
See reg. section 1.7704-1(e) through (j).
10
See section 197(f)(9) and the regulations promulgated there-
under.
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