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The future TRA payments received are likely to be treated as additional proceeds on the earlier sale of the operating partnership units for tax purposes, similar to an earnout arrangement,9 that are subject to the installment sale rules under Sec. 453 and will generate additional taxable gain to the legacy partners.
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Assuming a Sec. 754 election continues to be in place, these TRA payments will also create additional basis adjustments under Sec. 743(b).10 This may result in an additional layer of depreciation and amortization allocable to the public company, resulting in additional TRA payments.
Effectively, there is an iterative effect by which the future TRA payments give rise to additional TRA payments.
One aspect to consider is that, because of the installment sale nature of the TRA payments, a portion may be imputed interest under Sec. 483 or original issue discount under Secs.
Ireland’s Malin raises €330m in initial public offering
1272 through 1274. The amount of interest expense, whether determined under Sec. 483 or Secs.
1272 through 1274, can give rise to a current tax deduction to the public company rather than a step-up. The TRA also can capture any tax benefit from this imputed interest expense and thus can give rise to payments to the legacy partners in a similar manner as amortization from a basis step-up. Since the TRA payments would be treated as additional proceeds on the earlier sale of the operating partnership interests, the TRA proceeds, exclusive of imputed interest under Sec.
483 or original issue discount under Secs. 1272 through 1274, should generally be considered capital gain, as opposed to ordinary income.
Sec. 741 provides that in the case of a sale or exchange of an interest in a partnership, the transferor partner recognizes gain or loss. Further, such gain or loss is considered to be from the sale or exchange of a capital asset, except as otherwise provided in Sec.
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751 (relating to unrealized receivables and inventory items). Sec.
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751(a) provides that the amount of any money, or the fair market value (FMV) of any property, received by a transferor partner in exchange for all or a part of an interest in the partnership attributable to the partnership's unrealized receivables or inventory items ("hot assets") is considered an amount realized from the sale or exchange of property other than a capital asset.
Thus, Sec. 751(a) requires a partner to recognize ordinary income on the sale of a partnership interest to the extent of the partner's share of gain attributable to hot assets, including unrealized receivables and inventory, and the partner generally cannot defer such gain under the installment method.
These results may be unexpected to the selling legacy partner.
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Therefore, care should be taken in determining the existence of these hot assets by closely reviewing the definitions of unrealized receivables and inventory in Secs. 751(c) and (d), respectively.11 In addition, consideration should be given to the allocation of purchase price resulting from the exchange transaction. Given the disparate treatment between buyer and seller, the allocation of purchase price may be a point of negotiation.
If the legacy partners held their interests for more than one year, favorable long-term capital gain rates should apply to the TRA payments.
Additionally, the legacy partners will need to evaluate the applicability of the Sec.
1411 net investment income tax.
Sec. 1411 imposes a 3.8% tax on a taxpayer's net investment income in excess of a threshold amount.
Malin Corp PLC (~286)
Under Sec. 1411(c)(1)(A)(iii), net investment income includes net gain attributable to the disposition of property other than assets used in a nonpassive trade or business.
Whether a trade or business is a nonpassive activity with respect to a taxpayer is determined under the rules of Sec. 469.
Consequently, legacy partners will need to evaluate whether they materially participate in the operating partnership trade or business within the meaning of Sec. 469. To the extent a legacy partner satisfies the relevant standards and the activity is considered nonpassive, an added benefit of the Up-C structure is that the Sec.
1411 net investment income tax may not apply with respect to that partner. A similar benefit for such a partner would not apply had the partnership converted to a C corporation.
Public Market Dynamics and Considerations
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, or earnings before interest, taxes, depreciation, and amortization, which, by definition, does not take taxes into account.
In a private market context, it is a common practice to pay for the use of tax attributes such as step-ups.
For example, in the merger-and-acquisition market, where a buyer typically wishes to acquire assets and a seller wishes to sell stock, it is common for the buyer to pay the seller for at least a portion of incremental tax costs, including a gross-up payment, to accommodate making an election under Sec. 338(h)(10) in a stock acquisition.12
338(h)(10) election essentially allows a stock sale to be treated as a deemed sale of assets for tax purposes, thereby allowing for the buyer to obtain a valuable step-up for tax purposes. In such cases, the Sec. 338(h)(10) election would be jointly made, and the sellers typically would have agreed to such treatment only because they received additional purchase proceeds as consideration.
The buyer would generally agree to the higher purchase price only to the extent that the present value of the estimated incremental future tax benefit exceeds the additional cost at the time of closing.
In the Up-C structure, the public company makes the TRA payments over time as tax benefits are realized, and it is still entitled to keep a percentage, typically 15%, of the tax benefits.
The portion of the tax benefits retained by the public company can align the interests of the legacy partners and the public company with the goal of maximizing the value of the tax attributes, as each can benefit from the ultimate tax shield created by the structure.
Further, the portion of the tax benefit retained by the public company can potentially increase the value to the public company shareholders.
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.
Example of an Up-C Partnership Structure With TRA Benefits
The following example compares the results of an Up-C structure with that of a typical corporate IPO structure.
Fund investors and other investors each hold 50% interests in AB LLC, a partnership for tax purposes, each having an outside tax basis and tax capital account in their partnership interests equal to zero.
Life sciences group, set up by a number of ex-Elan executives, surpasses IPO target
At a time when the FMV of AB LLC is $21,000 (assume all appreciation is attributable to amortizable Sec. 197 intangible assets), the fund investors and other investors decide to take their business public via an IPO, effective Dec.
31, 20X0. The IPO is expected to raise $10,000, before a $1,000 underwriters' commission.
Ireland’s Malin raises 330 mln euros in biotech IPO, says source-Reuters
Immediately following the IPO, on Jan. 1, 20X1, the fund investors, other investors, and public investors (as a group), will each own a one-third interest in the outstanding value of AB LLC. The effective post-IPO ownership is summarized in Exhibit 5 (below).