Going public

Generally, for federal income tax purposes, operating as a partnership is preferred to operating as a corporation because partnership income is subject to federal income tax only once, at the partner level, whereas, income of a public corporation is subject to federal income tax twice, first when earned by the corporation, and again at the stockholder level when a dividend is paid or gain is recognized on the sale of stock. However, there also are disadvantages to operating in partnership form. Partnerships generally cannot be publicly traded and retain a single level of federal income taxation, unless the partnership qualifies as an MLP.

THE MASTER LIMITED PARTNERSHIP

MLPs generally are formed by a sponsor as publicly traded limited partnerships. An existing private business can be contributed to the MLP in exchange for equity of the MLP on a tax deferred basis, resulting in a carry-over tax basis in the assets of the business. The MLP structure is best suited for the contribution of a private business operated in partnership form, or as a limited liability company (LLC) treated as a partnership for federal income tax purposes, so all of the operations can continue in partnership form. If the existing business were held in corporate form, the liquidation of the corporation, or conversion to a partnership, would result in the recognition of any unrealized appreciation and taxable gain at the corporate and stockholder levels.

In exchange for the contribution, the sponsor typically receives general partnership interests, incentive distribution rights which are similar to a carried interest, and subordinated or common units. The public subscribes for listed limited partnership interests, or common units, in exchange for cash.

Generally, publicly traded partnerships are treated as corporations for federal income tax purposes, so that the taxable income generated is subject to two levels of federal income tax. If, however, at least ninety percent of the publicly traded partnership's gross income for each taxable year is "qualifying income," then it may be publicly traded and still maintain its status as a partnership, with the taxable income generated subject to only one level of federal income tax, at the partner level. Generally, qualifying income generally includes passive investment income, certain real property rental income and income derived from the exploration, development, production, processing, refining, transportation or the marketing of any mineral or natural resource, including oil and gas. Accordingly, to preserve the MLP structure, the sources of partnership income must be closely monitored and the scope of the partnership's activity generally will be limited to operations that generate qualifying income.

The trading price of MLP common units largely depends upon the amount of cash distributed to holders of common units. Accordingly, the MLP structure only is suited to businesses that can sustain significant cash distributions to investors. MLPs are particularly attractive to US individual investors if they generate significant depreciation through sustained growth and pass through low amounts of taxable income, or tax losses, to common unit holders, while also providing steady cash flow.

MLPs, however, are not an ideal vehicle to attract foreign or tax exempt investors. Because they are flow through entities for federal income tax purposes, common unit holders generally are treated as if they were directly engaged in the activities of the MLP, resulting in US source income and tax reporting requirements for foreign investors and unrelated business taxable income for tax exempt investors. Further, the annual federal tax reporting of each common unit holder's share of partnership income is complex relative to corporate dividend reporting, and common unit holders also can be exposed to state income taxation and filing requirements in the states where the MLP has assets or operations.

THE TRADITIONAL CORPORATE IPO STRUCTURE

The most common form of public offering is a sale of stock by a corporation. Typically, the historic owners can contribute their existing business, whether in partnership or corporate form, to a new corporation for stock of the new corporation without current recognition of taxable gain, however, the new corporation inherits the tax basis in the assets contributed, and generally there is no step up in the tax basis of the assets to their fair market value. Thus, the corporation generally has lower depreciation deductions and greater taxable income than if it acquired the assets in a taxable transaction.

If, however, the historic business owners have unutilized losses, they may want to trigger a gain in the assets of the business that will result in an increase in the tax basis of the assets and generate greater depreciation to the public corporation. For example, the historic owners may purposely structure the contribution of the business to the public corporation as a taxable or partially taxable exchange to trigger such gain and basis adjustment. The public corporation may be willing to enter into a tax receivable agreement with the historic owners that recognized such gain to compensate them for a portion of the corporate cash tax savings associated with the increased basis and greater depreciation deductions.

The taxable income of the corporation is subject to federal income tax at the corporate level, and the stockholders of the corporation also are subject to federal income tax on distributions of earnings and gain upon a sale of the stock. That is, there is "double taxation" of corporate income. Further, any losses generated by the corporation may only be utilized by the corporation or its consolidated group and cannot be passed through to stockholders to offset other income.

Corporate entities, however, can engage in non-taxable corporate reorganizations and acquire other corporations in exchange for stock consideration on a tax deferred basis, which is a valuable tool for growth. Further, corporate stockholders' dividends are reported on IRS Form 1099 which generally is a simple statement of income. As a result, foreign and tax exempt investors generally are willing to invest in corporate stock and are not treated as engaged in a US trade or business as a result of holding such investment. In addition, unlike partners in partnerships, stockholders are not exposed to state taxation in additional jurisdictions as a result of owning stock in a corporation that owns assets and operates in multiple states.

THE UP-C STRUCTURE

The UP-C structure, in contrast, has advantages of both the MLP and traditional corporate IPO structure, without some of the disadvantages associated with those structures. Generally, if the historic business were operated as a partnership, or LLC treated as a partnership for federal income tax purposes, it can affect a public offering by forming a corporate partner to issue shares to the public, and invest the cash proceeds in the historic partnership. The corporate partner may utilize the cash raised in the public offering to purchase units in the partnership from historic partners or subscribe for new units in the partnership.

The historic partners receive shares in the public corporation with voting, but not economic, rights as well as a right to exchange their units in the operating partnership for stock of the public corporation, which generally will be exercised when the historic owners effect an exit of their investment in the business.

The benefits of the UP-C structure include the historic owners continue to own the business through a pass-through entity with the income of the business subject to a single level of federal income tax, and losses from the business flow through to the historic owners which may be utilized to offset other taxable income. In addition, their voting rights with respect to the public corporation allow the historic members to continue to participate in, or even control, the governance of the public corporation and the exchange right provides a liquidity option through the ability to exit the partnership investment in exchange for public corporation stock which can be readily sold for cash.

In addition, historic owners also may receive rights under a tax receivable agreement (TRA), which, generally, provides that the historic partners share in the cash tax savings of the public corporation attributable to additional tax deductions generated through transactions with the historic partners. The tax benefits to the public corporation generally are in the form of increased tax basis in its share of the operating partnership assets and additional depreciation, which may be generated by the historic partners upon a sale of operating partnership units to the public corporation upon formation of the UP-C structure, the agreement to adopt certain tax depreciation allocation methodology to generate additional tax depreciation allocations to the public corporation, or the taxable exchange of a historic partner's units in the operating partnership for stock of the public corporation.

Not all UP-C structures, however, include a TRA. The TRA is a complex agreement that can be time consuming to value and negotiate. If the tax benefits to the public corporation are not expected to be large, or they are not expected to be realized by the corporation for many years, particularly if the corporation is not expected to have net taxable income for many years after carrying forward any available net operating loss, the long deferral of payments under the TRA may make the present value of those payments less significant. If, however, the value of the business at the time of the IPO far exceeds the tax basis in its asset, and significant additional depreciation can be generated for the corporation, a TRA can increase the return to historic partners by thirty or forty percent. So, at the least, owners considering an IPO should calculate the estimated value of a TRA when choosing an IPO structure.

The decision to effect a public offering is not a single decision, but the beginning of a decision process, including choosing the form of the public offering which will be driven, at least in part, by the federal income tax considerations. Careful evaluation of the long-term tax benefits prior to the selection of an IPO structure can yield significant value to the historic owners of the business.

ABOUT THE AUTHOR

Elizabeth McGinley is the head of Bracewell's tax practice. She represents a variety of clients in the oil and gas and electric power industries, including private equity firms investing in oil and gas exploration, production and infrastructure. Her experience includes complex debt and equity financing, joint ventures and project finance, as well as experience with volumetric production payment (VPP) transactions.