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Harvard Law School December 3, 2018

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1 Harvard Law School December 3, 2018
Creative Uses of Partnerships in Acquisitions, Dispositions, and PE Planning Eric Sloan Gibson, Dunn & Crutcher LLP Harvard Law School December 3, 2018

2 Agenda Acquisition and Disposition: Navigating The Disguised Sale Rules Private Equity Topside Planning Making an Investment Exiting an Investment (Sales and IPOs)

3 Statutory and Regulatory Outline
The Code – § 707(a)(2)(B) The Regulations Reg. § (sales by partners to partnerships) Reg. § (distribution safe harbors) Reg. § (impact of liabilities and debt-financed distributions) Reg. § (sales by partnerships to partners, or Reg. § in reverse) Reg. § (oops, strike that) Reg. § (disclosure rules) Reg. § (effective dates)

4 n/r secured by preferred and common
Over-the-Top Loan $170 Note n/r secured by preferred and common Bahar Eric Bahar Eric $190 preferred 1% common 99% common Asset FV: $200 AB: $10 Asset FV: $990 LLC LLC Asset FV: $200 AB: $10 Asset FV: $990 Considerations Will the form be respected? Alternative: A bank lends part (with Eric lending the rest to Bahar).

5 Loan Up LLC LLC Considerations
Cliff James Cliff’s Spouse Cliff James $190 preferred 5% common 95% common Asset FV: $200 AB: $10 $190 Cash LLC $170 note full recourse to Cliff, secured by preferred and common LLC Asset FV: $200 AB: $10 Considerations Cliff’s Spouse must have the wherewithal to repay the loan. Why would you do this? Because James has only cash to contribute. What if loan were made to Cliff directly? Could increase amount of note to $190.

6 Liability Netting Rule (Part 1/2)
Bahar Eric Bank 1 $160 Non-QL $480 QL Bank 2 Asset subject to debt Asset subject to debt Asset FV: $210 AB: $10 Assets FV: $630 AB: $10 $950 cash $950 cash LLC

7 Liability Netting Rule (Part 2/2)
Bahar Eric 25% 75% LLC $160 note $480 note Bank 1 Bank 2 Asset FV: $210 AB: $10 Assets FV: $630 AB: $10 Note: The reduction of Bahar’s share of her $160 note (i.e., 75 percent of $160 = $120) is offset by the 25 percent of Eric’s $480 note that she will get (25 percent of $480 = $120). See Reg. § (a)(4)

8 Qualification of LBO Debt

9 Liquidation: Formation and Capitalization of Sub
Parent $100 Sub $900 loan Lender

10 Liquidation: Sub Purchases Target Stock
Parent Sub $900 note Target Owners $1000 Lender Target stock Target

11 Liquidation: Before and After
Structure After Target Acquisition Desired End Structure Parent Parent Sub Sub $900 note Third Party Lender LLC Target $900 note Lender Target Assets

12 Liquidation: Target Converts to LLC
Parent Sub $900 note Lender Target

13 Liquidation: Formation of LLC
Parent Sub $900 note Target Interests Subject to debt Third Party Lender Assets Target Assets LLC

14 Liquidation: End Structure
Parent Sub Third Party LLC $900 note Lender Target Assets

15 Double Dip Coordination of Reg. §§ and -5 “[I]f capital expenditures were funded by the proceeds of a qualified liability. . . that a partnership assumes or takes property subject to in connection with a transfer of property to the partnership by a partner, a transfer of money or other consideration by the partnership to the partner is not treated as made to reimburse the partner for such capital expenditures to the extent the transfer of money or other consideration by the partnership to the partner exceeds the partner's share of the qualified liability (as determined under § (a)(2), (3), and (4)).”

16 Double Dip (Original Flavor) is Dead
Cliff buys asset Later, Cliff contributes asset to LLC $185 $40 cash $30 interest Cliff James Cliff Other Members Other Members Other Members $150 note Bank $150 note Bank Asset Asset subject to debt $35 Cash Asset FV: $185 Asset FV: $220 LLC $160 assets and cash

17 Double Dip – a New Flavor
Cliff contributes asset to LLC Resulting Structure $40 cash $30 interest Other Members Other Members Other Members Cliff Other Members Other Members Other Members Cliff Bank $150 note Asset subject to debt Asset FV: $220 20% 80% LLC LLC $150 note Bank $120 assets and cash Asset FV: $220 $160 assets and cash What if LLC immediately pays off the $150 note?

18 Cherry Picking – Pre-Transaction Structure
Bahar Cliff Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Asset 3 FV: $100 AB: $100 Cash $100

19 Cherry Picking – Desired End Structure
Cliff Bahar 60% 40% Cash $100 LLC Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Asset 3 FV: $100 AB: $100

20 Cherry Picking – Contributions
Bahar Cliff Asset 1 and Asset 2 $100 Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Asset 3 FV: $100 AB: $100 Cash $100 LLC

21 Cherry Picking – Sale LLC Cliff Bahar $100 Asset 3 Asset 3 FV: $100
60% 40% Asset 3 FV: $100 AB: $100 LLC Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Cash $100

22 Cherry Picking – End Structure
Cliff Bahar 60% 40% Cash $100 LLC Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Asset 3 FV: $100 AB: $100 Considerations Does cherry picking work? Yes, but the IRS is not a fan (except when it is). What (else) can Bahar do to strengthen her position?

23 Private Equity

24 Simplified Overview Structure
Investors Sponsor PE Fund (Delaware) Sponsor Commitment 20% Carried Interest Investor Commitment GP LP

25 Simplified Topside Structure
U.S. Taxable Investors U.S. Taxable Investors Principals U.S. Taxable Investors Taxable and Super Tax-Exempt U.S. Investors U.S. Taxable Investors Tax-Exempt U.S. Investors U.S. Taxable Investors Non-U.S. Investors U.S. Taxable Investors Sovereign Investors Sponsor (Delaware) GP LP LP LP LP PE Fund (Delaware)

26 Some Tax Exempt Super Tax-Exempt
Typical PE Topside Structure for Investment in an Operating Partnership U.S. Taxable Investors Principals U.S. Taxable Investors Taxable, Some Tax Exempt Super Tax-Exempt U.S. Taxable Investors Other Tax-Exempt U.S. Investors U.S. Taxable Investors Sovereign Investors U.S. Taxable Investors Non-US Investors Sponsor GP LP LP LP LP Fund 1 Fund 2 Fund 3 Fund 4 Holdco 2 (Delaware) Holdco 3 (Delaware) Holdco 4 (Delaware) Partnership 2 Partnership 3 Partnership 4 Portfolio Company Considerations Controlled entity status of Holdco 3 USRPHC status of Holdco 4

27 PE: Acquisitions

28 Acquiring Partnerships

29 Acquisition with Rollover
Partial Redemption of Sellers’ Units Sale of Remainder of Sellers’ Units 3 Rollover Investors Sellers Remaining Target Units Rollover Investors Sellers PE Fund Cash Bank Bank Target LLC Target LLC Cash Loan Cash Note 1 2 Basic transaction Target borrows from Bank. Target distributes the borrowed cash to Sellers in partial redemption of their units. PE Fund buys Sellers’ remaining units. Considerations What if Rollover Investors want to get some cash? Does the order of the steps matter? Disguised sale of partnership interest?

30 Acquiring S Corporations

31 Alternative 1: No Asset Step Up
Shareholders PE Fund Cash 80% of Target Stock Target (S Corp) Basic transaction PE Fund buys 80% of the stock of Target from Target’s shareholders. Consequences No asset basis step up for the stock purchase.

32 Alternative 2: § 338(h)(10) Election
PE Fund Shareholders Buyer Corp Cash 80% of Target Stock Target (S Corp) Basic transaction PE Fund forms Buyer Corp, which buys stock of Target from Target’s shareholders. Shareholders and Buyer Corp make a § 338(h)(10) election to treat Target as having sold all of its assets at FMV. Consequences Target is taxed on deemed sales of its assets subject to liabilities to Buyer Corp, followed by a deemed liquidation. Deemed liquidation generally does not result in additional tax. Key is convincing Target Shareholders to accommodate a step-up transaction. Main tax issues to consider: § 1374 BIG tax Inside/ outside basis differences Character differences State tax differences Impact if not S Corp Too much gain is triggered Section 336(e)

33 Alternative 3: F Reorganization and 99-5 transaction
Shareholders Shareholders NewCo Stock NewCo (S Corp) 50% Target Units PE Fund Target Stock Cash Target (S Corp) NewCo Target LLC Basic transaction Target Shareholders form NewCo, a domestic corporation, and contribute all of the stock of Target to NewCo in exchange for all of the stock of NewCo. Target converts into an LLC, a disregarded entity. PE Fund buys all of the Target LLC units from NewCo. Consequences The first two steps should be treated as a tax-free reorganization pursuant to § 368(a)(1)(F). NewCo does not have to make a new S election pursuant to Rev. Rul Same tax consequences for PE Fund as Alternatives 2 and 3. Perhaps different consequences to Target Shareholders (inside/outside basis differences). If S Corp bad, trigger gain, but get step up.

34 Alternative 4: F Reorganization and 99-5 transaction (cont'd)
Shareholders NewCo PE Fund 50% 50% Target LLC Consequences The first two steps should be treated as a tax-free reorganization pursuant to § 368(a)(1)(F). PE Fund’s purchase of 50% of Target shares is treated as the purchase of a 50% interest in each of the Target’s assets followed by a contribution of Target’s assets to Target LLC under Rev. Rul. 99-5, Situation 1. Considerations Book/tax disparity for assets deemed contributed by NewCo. Anti-churning.

35 Alternative 5: F Reorganization/Interest Purchase
Shareholders Shareholders 3 1 NewCo Stock NewCo 50% Target Units 4 PE Fund Target Stock 1 Cash 4 Target (S Corp) NewCo Target LLC Basic transaction Shareholders form NewCo, a domestic corporation, and contribute all of the stock of Target to NewCo in exchange for all of the stock of NewCo. Target converts into an LLC, a disregarded entity. Shareholders contribute cash to Target LLC in exchange for membership interests. PE Fund buys 50 percent of Target LLC units from NewCo. Considerations Purchase of interests vs. assets. Will form be respected? Anti-churning. If debt at Target LLC, disguised sale?

36 Exit from Partnership Investments: Sales

37 Sale of Typical PE Investment in an Operating Partnership
Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Partnership 1 Portfolio Company Objective PE wants to sell Portfolio Company.

38 Sale of Typical PE Investment in an Operating Partnership (cont'd)
Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Partnership 1 Portfolio Company Partnership 1 liquidates and distributes its interest in Portfolio Company to HoldCo and Sponsor.

39 Sale of Typical PE Investment in an Operating Partnership (cont'd)
Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Portfolio Company Sponsor and AIV sell their interests in Portfolio Company; AIV2 sells its shares of HoldCo (likely at a discounted purchase price).

40 Exit from Partnership Investments: UP-C IPOs

41 UP-C Structure – Simplified Ending Structure
Unblocked Investors Public Blocked Investors AIV 1 AIV 2 TRA TRA PubCo Non-Managing Member Managing Member Blocker Non-Managing Member Portfolio Company

42 Pre-IPO Structure Unblocked Investors Sponsor Blocked Investors AIV 1
LP GP GP LP HoldCo Partnership 1 Portfolio Company

43 Pre-IPO Structure – Simplified
Blocked Investors AIV 2 Unblocked Investors AIV 1 Blocker Portfolio Company

44 PubCo – Step 1 Blocked Investors Unblocked Investors AIV 2 Blocker
Cash PubCo Portfolio Company AIV 1 forms a corporation that will be the public registrant (“PubCo”). Portfolio Company is recapitalized. The unblocked units are exchangeable for PubCo shares. (See Rev. Rul regarding the exchange right.)

45 PubCo – Step 2 Blocked Investors Unblocked Investors AIV 2 Blocker
Portfolio Company LLC PubCo forms a limited liability company (“LLC”), a corporation for U.S. federal income tax purposes.

46 PubCo – Step 3 Blocked Investors Unblocked Investors AIV 2 Blocker
Portfolio Company LLC Merger LLC merges with and into Blocker. Blocker’s shareholders receive PubCo shares and an income tax receivable (“ITR”) as merger consideration.

47 PubCo – Step 4 Unblocked Investors Blocked Investors AIV 1 Public
Common Stock Cash PubCo Blocker Portfolio Company PubCo undertakes an IPO.

48 PubCo – Step 5 Unblocked Investors Public Blocked Investors AIV 1
Blocker Units Cash Portfolio Company PubCo contributes the IPO proceeds to Portfolio Company in exchange for units. Portfolio Company will use the cash for general company purposes (e.g., repayment of existing debt, capital expenditures, acquisitions, etc.).

49 UP-C Final Structure Unblocked Investors Public Blocked Investors
AIV 1 AIV 2 TRA TRA PubCo Non-Managing Member Managing Member Blocker Non-Managing Member Portfolio Company From time to time, AIV 1 may exchange Portfolio Company units for PubCo stock and ITRs.

50 Tax Receivable Agreements
What is a tax receivable agreement? What attributes are covered? "With and Without" calculation What is needed? § 754 election. § 743(b) adjustment to step up basis. Other tax attributes (e.g., NOLs, credits) Financial statement treatment. Liability for gross payments. Valuation allowance needed?

51 Characteristics of a TRA
Depends on nature of transaction that gave rise to TRA Taxable purchase Reorganization Current distribution Installment sale Principal and imputed interest Basis recovery Election out When does the actual payment occur?

52 Characteristics of an TRA (cont’d)
Common issues to consider Ordering of multiple exchanges Not enough taxable income Permanent loss of TRA benefit Law changes What is the character of interest on the payment?

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