A Creative – If Complex – Route to Tax Savings When Going Public
For technology and other startups, going public can be doubly taxing—literally.
“Traditionally, a pre-IPO company is structured as a C corporation, which is legally subject to two tax layers, the first assessed on income earned by the entity, and then on shareholders when selling stock or receiving dividends,” says Morrison & Foerster tax partner Remmelt Reigersman. “Setting up initially as a limited liability company or other entity treated as a partnership for tax purposes keeps it to one layer—as a pass-through, the entity is not taxed—except that when it comes time to go public, the partnership is generally treated as a corporation and taxed accordingly.”
While this may appear unavoidable, an innovative technique known as “Up-C” leverages the LLC advantage to help pre-IPO companies achieve significant tax savings and favorable deal economics while preserving control for the founding partners.
“Named after UPREIT, an umbrella structure originated by real estate investment trusts, Up-C establishes a new corporation above the historic partnership, which retains all the business assets— and the LLC tax advantage—as its subsidiary,” says Anna Pinedo, a Morrison & Foerster securities partner. “The new entity is used for the IPO, downstreaming the proceeds to the LLC.”
As Pinedo explains, Up-C provides upside for everyone. “To maintain control of the business, historic partners must control the PubCo, which is achieved by dual-stock issuance,” she says. “Sold to public investors, Class A shares generate the cash and look after the economic side of the deal, while Class B shares give voting rights to the founding partners.”
The deal includes an “Income Tax Receivable Agreement” between the partners and PubCo. “PubCo purchases partnership units from the founders using proceeds from the IPO,” Pinedo explains. “Differing from a traditional stock purchase, this method creates a step-up in the tax basis, which permits the partners and PubCo to take significant depreciation and amortization deductions over time. PubCo then pays the founders the majority, typically 85 percent, of the federal and state tax benefits it has gained.”
Complicated, yes, but this translates into some very attractive economics. “Say the tax basis step-up is valued at $300 million, with an annual amortization of $20 million over 15 years,” says Reigersman. “Assuming a combined federal and state tax rate of 40 percent, that saves PubCo $8 million a year while paying the historic partners $6.8 million annually—$ 102 million over time.”
Up-C is not for everyone. “From an administrative and compliance perspective, this structure is far more involved than going public via the traditional route,” Reigersman says. “But for larger companies, it can be very effective.”