United States: Tax Receivable Agreements And Tax Reform Proposals

Last week the House Republicans introduced the Tax Cuts and Jobs Act, their long-awaited first draft of tax reform legislation, bringing Congress one step closer to achieving tax reform. Earlier this year, the House of Representatives and the Senate passed budget resolutions with reconciliation directives, clearing a path for tax reform which is not subject to a potential filibuster by Senate Democrats. These steps, along with the introduction of the House Republicans' legislation, increase the possibility of major federal tax reform in the coming months.

The House Republicans' tax reform plan includes, among other things, a reduction of the maximum federal corporate tax rate from 35% to 20%. It also contemplates changes to the deductibility of various expenses, including restricting the deductibility of certain interest payments and expanding the deductibility of capital expenditures. The Senate is drafting its own tax reform legislation that also contemplates a similar reduction in the corporate tax rate but with a delayed implementation. Among numerous other potential impacts, these potential changes currently being discussed in Congress could have significant consequences for current and prospective parties to so-called "tax receivable agreements" ("TRAs")—agreements that companies are entering into with increasing frequency in connection with initial public offerings ("IPOs") to monetize tax attributes of the post-IPO company for the benefit of pre-IPO owners.

Background

Briefly, TRAs seek to provide to pre-IPO owners of a public company much of the actual tax savings benefit resulting from the public company's use of specified tax attributes. This benefit is typically measured on a "with and without" basis, essentially assuming that the public company first uses tax attributes that are not covered by the TRA (e.g., interest payments and capital expenditures) to shield its income from tax. The two most common forms of TRAs are "NOL TRAs" and "Step-Up TRAs."

  • NOL TRAs. Many companies complete IPOs when they have a substantial amount of net operating loss carry forwards ("NOLs"). Subject to certain limitations, these NOLs may reduce the post-IPO net taxable income and resulting tax obligations of the public company, thereby increasing its after-tax cash balance. An NOL TRA typically will provide, among other things, that the pre-IPO owners are entitled to 85% of the actual cash tax savings the public company realizes as a result of the pre-IPO NOLs.
  • Step-Up TRAs in Up-C Structures. In a basic Up-C structure, a business that was historically conducted through an entity classified as a partnership for U.S. tax purposes would go public through the formation of a new public company that would serve as its general partner or managing member and acquire equity interests in the partnership. The pre-IPO owners obtain liquidity from time to time by transferring their partnership interests to the public company in exchange for public company stock and rights to payments under a TRA. These transfers typically result in the public company receiving a basis "step-up" with respect to the assets of the partnership, which is frequently amortizable over a fixed number of years (typically 15 years to the extent such step-up is attributed to the business's goodwill). Similar to the impact that pre-IPO NOLs have on reducing the public company's post-IPO tax burden, these amortization deductions may reduce the net taxable income and resulting tax obligations of the public company and increase the public company's after-tax available cash balance. A Step-Up TRA typically will provide, among other things, that the pre-IPO owners are entitled to 85% of the actual cash tax savings the public company realizes as a result of these amortization deductions.

TRAs also typically include broad assignment provisions, which enable pre-IPO owners to sell their future entitlements to TRA payments to outside investors.

An increasingly common term of a TRA is a prepayment provision, which provides that a post-IPO change-of-control transaction (a "CoC") will require the public company to make a termination payment based on the present value of the tax attributes subject to the TRA. This calculation often utilizes various assumptions favorable to the pre-IPO owners, including that the public company always has sufficient income to utilize the relevant tax attributes, and that the public company is always subject to the maximum tax rates in effect on the date of the CoC.

Given that TRA payments (other than generally in the context of a CoC) are determined by reference to actual cash tax savings of the public company, a reduction in tax rates will reduce projected TRA payments. As a simplified example, $1,000,000 of deductions that shield $1,000,000 of income that would otherwise be subject to a 35% tax will yield $350,000 in tax savings and a TRA payment of approximately $297,500. A reduction in the federal corporate tax rate to 20% would reduce the tax savings to $200,000 and the TRA payment to $170,000.

Impact of Tax Reform Proposals

Parties that are (or may soon be) direct or indirect beneficiaries (or obligors) under a TRA should carefully consider the potential impact of a reduction in federal corporate tax rates and changes to tax treatment of various expenditures. For example, a reduction in federal corporate tax rates reduces a company's tax liability and thus the corresponding amount of potential tax savings through its tax attributes. As a result, TRA-related liabilities disclosed in a company's financial statements will need to be reassessed. A company's TRA calculations (and ultimately its cash balances) will also be impacted by how tax reform alters the deductibility of various expenses. Based on the "with and without" calculations used under most TRAs, a company's TRA payments are likely to be reduced or delayed if tax reform results in the company having available more deductions from its operating business (because, for example, some capital expenditures are allowed to be deducted currently), and the reverse is likely to be true if tax reform results in the company having available fewer deductions from its operations (because, for example, interest expense deductions are limited).

In addition, to the extent a company's TRA contains a provision accelerating payments upon the occurrence of a post-IPO change of control, some public companies may see buyers seek to discount or delay such payments while tax reform is pending in order to avoid the chance that the prepayment obligation (which is typically calculated using the rates in effect on the date of the CoC) exceeds the value of the tax attributes actually realized (which would be based on future, possibly lower, tax rates). It's often the case that buyers accept the risk that tax rates will not change in the future, but while tax reform is pending, companies and TRA beneficiaries should anticipate that buyers may be more aggressive in protecting against that risk.

Similarly, while tax reform is pending, companies pursuing an IPO that involves a TRA may hear warnings from underwriters as to the potential impact of including provisions accelerating payments upon the occurrence of a post-IPO CoC.

There are a number of variables that will impact whether and to what extent tax reform will occur and how it will impact TRAs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.