Up-Cs and Other Supercharged IPOs

In a traditional initial public offering (IPO), a company sells stock to public investors in exchange for cash. Traditional IPOs can be great exit opportunities for pre-IPO owners, yet certain companies can achieve even greater exit benefits through what Robert Willens has termed a “supercharged IPO.” While a traditional IPO is typically a nonevent for tax purposes, a supercharged IPO may create additional tax benefits that would otherwise be unavailable. While most of the current articles written about supercharged IPOs are written for an academic audience, this article instead defines a supercharged IPO and its attributes from a practical perspective.

What is a Supercharged IPO?

In its simplest form, an IPO is a nontaxable event for both a company and its pre-IPO owners. Pre-IPO owners are taxed when they sell their pre-IPO shares, which is often after the IPO occurs. What distinguishes a supercharged IPO from a standard IPO is (a) it creates additional tax basis in underlying assets which in turn generates increased tax deductions, and (b) the benefits are shared between the company and the pre-IPO owners through what is called a tax receivable agreement.

Basis Step-up

First, a company can create additional tax basis in its underlying assets in a supercharged IPO. When a company acquires an asset, it is generally recorded on the company’s book and tax financial statements at its historic or original value. Over time, a company’s non-financial assets, such as buildings, land, trademarks, copyrights, or internally-generated goodwill¹, may appreciate in value. However, the increase in value is normally not reflected in the financial statements for book or tax purposes.

In a traditional IPO, the tax basis of the assets generally remains unchanged. In contrast, a supercharged IPO enables a company’s appreciated assets to be recognized at their current market value and allows some previously unrecorded assets (e.g., internally generated goodwill) to be recognized for tax purposes. Increasing the asset basis to fair market value is called a basis “step-up” by tax professionals.

From a tax perspective, an increase in basis can be beneficial because a larger basis generates more tax deductions in the future as the asset is depreciated or amortized. For example, a supercharged IPO allows internally-generated goodwill to be recognized and amortized over 15 years for tax purposes, thereby giving the company 15 years of tax deductions. These tax-only deductions are often referred to as “tax assets.”²To the extent the company generates sufficient taxable income to use the deductions, the company can realize significant tax savings over the amortization period.

Tax Receivable Agreement

Second, a supercharged IPO often includes one or more tax receivable agreements (TRA). A TRA is a contract between the pre-IPO owners and the “new” public company. In a typical TRA, the public company promises to pay the pre-IPO owners a portion (usually 85 percent) of the benefit realized as a result of the tax assets created by the IPO as the assets are utilized (i.e., as the higher deductions from the step-up in basis reduce taxes that otherwise would have been due to the IRS or other taxing authority). The company retains the full benefit of the remaining tax assets. As discussed later in this article, more recent TRAs include arrangements for pre-IPO owners to receive a portion of benefits from all pre-IPO tax assets of a company, not just benefits that have been created from a stepped-up basis of assets.

What Are the Different Types of Supercharged IPOs?

Since the first supercharged IPO in 1993, the structure of supercharged IPOs has evolved. Originally, companies that underwent a supercharged IPO were operated as a corporation. Today, most companies that utilize a supercharged IPO operate in partnership form. This is mainly because tax provisions limit supercharged IPOs to entities operating in partnership form and some corporations. Additionally, using a partnership as the vehicle for a supercharged IPO has greater tax advantages with fewer downsides. Supercharged IPOs can fall into three broad categories: (a) a Section 338(h)(10) supercharged IPO³, (b) a publicly-traded partnership (PTP) supercharged IPO, and (c) an Up-C supercharged IPO.

Section 338(h)(10)

The 1993 Cooper Industries Ltd. IPO was a Section 338(h)(10) supercharged IPO, the first type of supercharged IPO ever used. In a traditional IPO, pre-IPO owners pay tax only when they sell their pre-IPO shares, which is often years after the IPO occurs. If a corporation makes a Section 338(h)(10) tax election at the time of its IPO, however, the corporation is treated as if it simultaneously sold and purchased its assets. The pre-IPO owners must then pay tax immediately on the gains created in the sale. Because the interests are treated as if they are sold and repurchased⁴, this election creates a stepped-up basis in the company’s assets, which creates a tax benefit.

The tax benefits may or may not outweigh the costs of the pre-IPO owners’ tax liability; thus, a Section 338(h)(10) IPO only makes sense if the present value of the future tax benefits are larger than the immediate tax liability. The Section 338(h)(10) supercharged IPO is less popular than other types of supercharged IPOs because of the immediate tax liability, coupled with the fact that the offsetting tax benefits are uncertain and are realized over several tax years.

While the Section 338(h)(10) election is available for corporations, it is seldom used in practice because of the tax inefficiencies created as a result of the election. Additionally, not all corporations are eligible to make the Section 338(h)(10) election⁵.

Publicly-traded Partnership (PTP)

The 2005 Lazarus Ltd. IPO was the first PTP supercharged IPO. In limited cases, a partnership may sell shares to the public without first becoming a corporation. Similar to the way a corporation might use the Section 338(h)(10) tax election, a partnership can make a Section 754 tax election to create a stepped-up basis. This type of supercharged IPO is rare. For a partnership to sell shares to the public, 90 percent of its income must come from passive income sources, such as interest, dividends, or real estate rentals⁶. Because of this restriction, most existing partnerships are unable to implement a PTP supercharged IPO.

Up-C

Whereas the PTP supercharged IPO is the least common of the three types of supercharged IPOs, the Up-C is becoming the most common because of its significant tax advantages combined with operational flexibility. For a partnership to go public in a traditional IPO, it would first elect to become or convert legally to a C-corporation and then subsequently sell shares to the public.

In an Up-C structure, the original partnership does not convert to a C-corporation but rather forms a new C-corporation parent to partially own the historic partnership. The new parent corporation is “up-stream” from the partnership, hence the term “Up-C.”⁷ The newly created C-corporation is taken public and uses cash from the IPO to purchase an interest in the partnership.

Through a series of steps, the partnership is then recapitalized to allow for partnership special income and loss allocations between the public corporation and the pre-IPO owners. The pre-IPO owners are given the right to exchange their partnership interests for shares of public stock, and the public corporation generally becomes the managing member of the partnership. The Up-C structure allows for certain benefits, including continued “flow-through” treatment of income allocated to pre-IPO owners and potential tax benefits associated with the Section 754 basis step-up, which is created as pre-IPO owners exchange their partnership interests for public stock.

The details of this structure can be complex, especially as new variations of the Up-C emerge in the market. The basic components of the structure, however, are similar between companies.

The following figure from a legal research paper⁸ by Gladriel Shobe illustrates one example of an Up-C arrangement:

Note that the pre-IPO owners give up their voting and management rights in the historic partnership in exchange for “voting-only” (Class B) stock in the new corporation, but their economic rights remain in the historic partnership. This can be advantageous for three reasons:

Maintaining the economic interest in the historic partnership allows pre-IPO owners to defer tax liabilities until the pre-IPO owners’ interests are sold to or exchanged for the stock of the public corporation. As discussed above, the ability to defer tax liabilities is not available in a 338(h)(10) supercharged IPO.
Pre-IPO owners avoid the double taxation that comes with being a corporate entity until they exchange their economic interests; unexchanged owners are taxed only on their allocable income from the partnership, which is not subject to corporate tax.
When partners finally sell their economic interests for cash or exchange their interests and Class B stock for Class A stock, a stepped-up basis in the historic partnership’s assets is created⁹. With a TRA in place, as described below, pre-IPO owners can share in the resulting tax benefits as they are realized by the public company.

Due to its flexibility and the above tax advantages, the Up-C arrangement is the most popular of the three types of supercharged IPOs.

How Are TRAs Used in Supercharged IPOs?

Originally, TRAs ensured that pre-IPO owners were compensated for the tax benefits created in the IPO process, such as a basis step-up in the company’s underlying assets. Just as the structure of supercharged IPOs is continually evolving, so is the structure of TRAs. A new type of TRA, for example, rewards pre-IPO owners not only for the tax assets created in the supercharged IPO but also for pre-existing tax assets, such as net operating losses and tax credits.

This has led some critics to talk about TRAs as a “bizarre siphoning of cash”¹⁰ and “a one-sided agreement”¹¹that only benefits the pre-IPO owners. On the other hand, proponents of TRAs believe that TRAs help improve the efficiency of the IPO transaction. This view is based on the premise that investors who value the company at the time of an IPO may undervalue tax assets.

Over time, a third type of TRA has emerged. In these TRAs, the company agrees to pay the pre-IPO owners for historic tax assets even when tax assets were not created in the IPO. Thus, TRAs are beginning to appear even in traditional IPOs.

Disadvantages of Supercharged IPOs

While this article has mainly focused on the benefits of a supercharged IPO, supercharged IPOs and TRAs have potential downsides as well:

Because of the complexity of the supercharged IPO arrangement, the company will face additional costs to maintain the Up-C structure, such as increased legal, administrative, tax compliance, consulting, and accounting costs. Pre-IPO owners may also face increased tax complexity and trading restrictions.
The company is required to make cash payments to the pre-IPO owners for as long as tax assets subject to the TRA are utilized, which may be many years. If a company wishes to discontinue a TRA, the company may be required to immediately pay the pre-IPO owners a significant amount of cash in settlement of the agreement.
The tax benefits associated with supercharged IPOs are highly sensitive to tax reform, and potential reversals of benefits are possible. Pre-IPO owners are unlikely to be required to refund the company for excess payments, which could be disadvantageous to the company.
Potential buyers may view companies with TRA agreements unfavorably, which may mean the TRA will act as a poison pill in future acquisition transactions.
To utilize the benefits of the existing or created tax assets, the company must have sufficient taxable income in future years. Without taxable income, the company and pre-IPO owners will be limited in their ability to utilize the benefits. Proponents of supercharged IPOs argue that TRAs help align the incentives of pre-IPO owners and the continuing company, as the pre-IPO owners need the company to be profitable in the long run to secure the benefits of the company’s tax assets.

Supercharged IPOs in the Market

Pluralsight

Pluralsight filed its final S-1 in May 2018. The S-1 describes an Up-C structure and a TRA between Pluralsight and its pre-IPO owners. The TRA indicates that Pluralsight has agreed to pay pre-IPO owners 85 percent of the tax benefits created when a pre-IPO owner exchanges his or her historical partnership interests for Class A stock in the new public corporation. As of the end of Q2 in 2018, Pluralsight had not yet accrued liabilities for the TRA because none of the pre-IPO owners had sold or exchanged their interests in the historic partnership.

Because of the potential increase in tax complexity and trading restrictions likely to affect pre-IPO holders, Pluralsight provided the opportunity for pre-IPO owners to “opt out” of the TRA by exchanging their shares in a section 351 transaction at IPO. This opportunity to opt out is relatively unique in Up-C structures.

Shake Shack

Shake Shack filed for an IPO at the beginning of 2015. Embedded in Shake Shack’s S-1 is a TRA between Shake Shack and its pre-IPO owners in an Up-C structure. In this agreement, Shake Shack agreed to pay the pre-IPO owners 85 percent of the tax benefits utilized in the future. As of the end of 2015, Shake Shack reported an accrued liability of $173.1 million for the TRA. Shake Shack disclosed that though this number is significant, the liability will reverse over time. The five-year schedule shows that Shake Shack will owe the pre-IPO owners an estimated $33.6 million over the next five years.

As of 2016, Shake Shack’s TRA liability increased to $272.5 million with an estimated $56.5 million to be paid over the next five years. As you can see, the TRA payments can be quite large. Equally important to recognize, however, is the tax benefit the company is expected to receive as well. Assuming the company received a 15 percent benefit in 2016, the company received estimated tax benefits of $48.1 million¹² over time and $10 million over the next five years.

Conclusion

Supercharged IPOs have been in the market since 1993 but have been used more frequently in recent years by partnerships using an Up-C structure. The purpose of a supercharged IPO is to take advantage of otherwise dormant tax deductions and benefit both pre-IPO owners and the existing company. Benefit sharing is facilitated by using a TRA entered into at the time of an IPO. While not ideal for all entities, those operating in partnership form should seriously consider the economic and tax benefits of a supercharged IPO.

Resources Consulted

Footnotes

Internally-generated goodwill is value created by company operations that isn’t explicitly stated on financial statements. This includes value from a company’s brand, its reputation, or its access to suppliers or clients. Goodwill is measured as the difference between the price an independent agent would be willing to pay to buy the company and the fair value of a company’s assets as recorded on its financial statements.
A tax asset is an expected future tax benefit. For example, a net operating loss creates a future tax benefit because the company will be able to offset taxable income in the future.
All references to Section 338(h)(10) refer to a section in the 1986 Internal Revenue Code unless otherwise noted.
Note that shares are not actually sold and repurchased, but they are simply treated this way from a tax perspective. This treatment allows a company to receive a stepped-up basis in assets.
To be eligible for the Section 338(h)(10) election, a corporation must be either a subsidiary in a consolidated group, a corporation that is eligible to file a consolidated return but chooses not to do so, or an S corporation.
See Section 7704(c), (d).
This structure may also be referred to as an Umbrella Partnership—C-corporation or “UP-C.”
Gladriel Shobe, Univeristy of Colorado Law Review: Supercharged IPOs and the Up-C
Partners that sell or exchange their economic interests are usually taxed mostly at capital gain rates, which is a maximum of 23.8 percent. Before the new corporate tax rates were introduced in 2018, tax arbitrage existed because the stepped-up basis in assets created tax benefits at the corporate level, which is taxed at a maximum of 35 percent. Thus, the net tax benefit was at least 11.2 percent. Under the new tax law, corporations are taxed at a flat rate of 21 percent, thereby reducing the tax arbitrage opportunity.
PEU Report: Carlyle’s “Cash Tax Savings” Won’t Go to Unit Holders
Reuters: Blackstone Partners May Avoid Tax on IPO Gains
$48.1 million = ($272.5 million)/.85 * .15