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How IPO Founders Keep Their Taxes Low

Via a popular way of going public, founding partners can enjoy whopping capital gains without the usual tax bite. Investors may be less than happy about it, though.
Robert Willens, CFO.com | US
July 26, 2011

When a partnership goes to the public market for funding, and the offering is successful, the founding partners can enjoy a huge capital gain. But "enjoy" is not exactly the right word for how those founders are likely to feel about the taxes spawned by those gains.

By means of a popular going-public technique called a tax receivable agreement (TRA), however, the founding shareholders can enjoy hefty tax benefits. TRAs increase the tax liability of a new public company by removing a tax asset from the shareholders. For their part, though, investors may find it hard to factor the effects of TRAs into their calculations of the price of the offering.

TRAs are often used in combination with an "Up-C structure." The Up-C structure enables companies to acquire assets by issuing operating partnership units. Those units may make it possible for the founding owners from whom the company acquires assets to defer recognizing taxable gains until the company disposes of those assets. For example, among many other entities, DynaVox employed this structure in connection with its initial public offering last year.

When a partnership transforms itself into a corporation to make a public offering of ownership interests, the newly formed corporation often becomes a partner in the "operating" partnership. The remaining units in the partnership also continue to be held by the founders of the business. In such cases, the founders will be awarded "high-vote" stock in the corporation — equity that enables them to maintain voting control over the corporation's affairs. For their part, public investors will acquire low-vote stock.

Sometimes the IPO's proceeds will be used by the corporation to buy partnership interests from the founders. In addition, the founders will typically acquire an "exchange right" entitling them to trade partnership interests for low-vote shares issued by the corporation. When these exchanges are separate from the incorporation, they're taxable to the founders because immediately after the exchange the founders aren't in control of the corporation.

But the founders can gain a tax benefit through the use of a TRA. Each time the corporation buys a partnership interest in the partnership, or acquires an interest in a taxable exchange for its stock, the corporation's taxable income derived from the partnership will be diminished (because the purchase increases the amount of amortization and depreciation deductions the purchasing partner will enjoy) and, correspondingly, its tax liabilities will be minimized.

To be sure, the fruits of such purchases clearly "belong" to the corporation. After all, the corporation paid a price for the partnership interests that reflected their value. But the TRA, which is almost standard operating procedure in these types of incorporations, shifts the tax benefits to the persons who transferred the partnership interests to the corporation.

The TRA DynaVox is operating under is quite representative. Thus, the TRA in that case provides that ". . .we will enter into a TRA with our existing owners (the founders) that will provide for the payment by [the company] to our existing owners of 85 percent of the (tax) benefits that [the company] is deemed to realize as a result of the current tax basis in the intangible assets of. . . (the partnership) and the increases in basis resulting from our purchases or exchanges. . . ." The corporation goes on to say that these payments will be "substantial."

TRAs may be fully legal; however, the entire import of these agreements in the price of an IPO might not be fully appreciated by all investors. To the extent the TRAs are not taken into account by such shareholders, they may lead to market inefficiencies.

Robert Willens, founder and principal of Robert Willens LLC, writes a biweekly tax column for CFO.com.

 




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