7.14 Tax Receivable Agreements | DART – Deloitte Accounting Research Tool

A common method for partnerships or limited liability companies (LLCs) to raise capital via an initial public offering (IPO) or through a special-purpose acquisition company (SPAC) is by using the umbrella partnership C corporation (“Up-C”) structure. An Up-C structure involves (1) the formation of a new corporation (often referred to as “PubCo”) for the purpose of completing a public offering and (2) the restructure of transactions to carry on the business of an operating entity (often referred to as “OpCo”) that is usually structured as an LLC or a limited partnership.

To become a public company and complete the Up-C structure, PubCo typically executes a series of reorganization steps that allow it to take advantage of certain tax benefits for pass-through entities. Shares of PubCo are issued and sold to the public in an IPO; PubCo then uses the proceeds from the IPO or newly issued stock to acquire an ownership interest in the existing OpCo. As a result of the IPO and the reorganization steps, PubCo becomes a holding company whose sole asset is its equity interest in OpCo, which generally represents a controlling financial interest in OpCo that must be consolidated in accordance with ASC 810. In the absence of substantive operations before the reorganization steps and IPO, PubCo would not meet the definition of a business, and its legal acquisition of OpCo would therefore not be considered a business combination under ASC 805. Alternatively, the reorganization steps and IPO represent transactions that are under common control (e.g., an equity transaction) and the OpCo units that continue to be held by existing owners are accounted for as an NCI within equity on PubCo’s consolidated balance sheet.

An Up-C structure can benefit the pre-public-offering owners (existing owners) of OpCo by allowing them to maintain ownership for U.S. federal income tax purposes through an LLC or partnership, which would continue to receive the advantages of a single taxation level until the existing owners sell their interests.

An Up-C structure also gives the existing owners the right to exchange their OpCo interests for cash or newly issued shares of PubCo on a one-for-one basis. If they exercise this right, PubCo will be entitled to certain future tax benefits from adjustments under the Internal Revenue Code related to the assets of OpCo. Specifically, PubCo would receive a step-up in the tax basis of the net assets resulting from the exchange with existing owners, which in turn would provide additional tax amortization and depreciation expense in future periods (i.e., a deferred tax asset).

To incentivize existing owners to exchange their LLC or partnership units, PubCo may negotiate and execute a tax receivable agreement (TRA) with them. A TRA gives existing owners that have exchanged their units the right to receive a percentage (usually 85 percent) of the net cash savings, if any, in U.S. federal, state, and local income tax that PubCo realizes or is deemed to realize. The TRA payments capture the value of the future tax benefits transferred to PubCo that would have otherwise been forgone in a traditional IPO.

Under the terms of a TRA, PubCo accounts for the exchange of LLC or partnership units by existing owners as an equity reorganization through which:

A deferred tax asset is recognized as a result of the increase in the tax basis of the net assets. The deferred tax asset is recognized directly in equity as part of the equity transaction.
The corresponding TRA contingent obligation (usually 85 percent of the net cash savings to be realized) is recognized as a reduction of equity on the same date the initial deferred tax asset is recognized.
After initial recognition, any increase or decrease in both the deferred tax asset and the TRA obligation would be recognized in the income statement.

To compute the amount of the TRA obligation, PubCo calculates realized tax benefits by comparing its actual tax liability with the amount that it would have been required to pay in the absence of the future tax benefits from the step-up in tax basis. PubCo then measures the payment obligation under the TRA as the negotiated percentage (e.g., 85 percent) of the realized tax benefits.

When assessing how to classify the TRA payments in the statement of cash flows, PubCo would apply ASC 230-10-45-10, which requires entities to “classify cash receipts and cash payments as resulting from investing, financing, or operating activities” on the basis of the nature of the cash flow. However, certain cash payments may resemble more than one type of cash flow. ASC 230-10-45-22 states:

Certain cash receipts and payments may have aspects of more than one class of cash flows. The classification of those cash receipts and payments shall be determined first by applying specific guidance in this Topic and other applicable Topics. In the absence of specific guidance, a reporting entity shall determine each separately identifiable source or each separately identifiable use within the cash receipts and cash payments on the basis of the nature of the underlying cash flows, including when judgment is necessary to estimate the amount of each separately identifiable source or use. A reporting entity shall then classify each separately identifiable source or use within the cash receipts and payments on the basis of their nature in financing, investing, or operating activities. [Emphasis added]

Currently, there is no authoritative accounting guidance on the classification of TRA payments in the statement of cash flows. We believe that the classification and presentation of such payments should be evaluated on the basis of the substance or nature of the transaction.

When assessing the nature of a TRA, PubCo would consider whether the payments represent cash outflows to NCI holders that are equal to a percentage (e.g., 85 percent) of the cash tax savings realized by PubCo as a result of increases in the tax basis derived from the existing owners’ exchanges of OpCo units for shares of PubCo. ASC 810-10-45-23 addresses distributions to NCI holders and states, in part:

Changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary shall be accounted for as equity transactions (investments by owners and distributions to owners acting in their capacity as owners).

Since the reorganization steps and IPO represent transactions under common control and the authoritative guidance in ASC 810-10-45-23 concludes that payments to acquire NCIs would be considered “distributions to owners acting in their capacity as owners,” payments under the TRA to NCI holders to settle a TRA obligation can be considered payments related to an equity transaction. This is further clarified in Section 6.2.2, which states that distributions to NCI holders (in their capacity as equity holders) are considered equity transactions.

ASC 230-10-45-15(a) suggests that TRA payments should be classified as cash outflows for financing activities because such payments are a settlement of an obligation established through an equity transaction. However, remeasurement of the TRA liability is recognized in the income statement; consequently, the definition of “operating activities” in ASC 230-10-20 suggests that TRA payments could be classified as cash outflows for operating activities because “[c]ash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.” TRA payments therefore have aspects of more than one class of cash flows.

In the absence of guidance on this topic (i.e., on the attribution of TRA payments to the equity transaction or on the cash effect of a transaction included in the determination of net income when both aspects are present), we believe that it is reasonable to apply by analogy the cash flow guidance on contingent consideration payments made after a business combination and on the settlement of zero-coupon debt instruments.

As discussed in Section 7.5.4, an entity is required to classify as financing activities payments made up to the amount of the contingent consideration liability recognized on the acquisition date; any payments made in excess of the initial contingent consideration liability must be classified as operating activities. Note that ASC 230-10-45-15 refers to “payments” to indicate that cumulative payments to date that are related to a contingent consideration liability should first be classified as financing activities up to the amount of the initial liability and that cumulative payments in excess of that initial liability should be classified as operating activities. In addition, Section 6.4.2 discusses the cash flow presentation of zero-coupon debt instruments, which is similar to the presentation of payments made on contingent consideration liabilities. Specifically, an entity is required to classify payments made up to the amount of the principal of the zero-coupon debt instrument (initially recognized on the balance sheet) as financing activities and classify payments made to settle zero-coupon debt instruments related to accreted interest for the debt discount (recognized in earnings) as operating activities.

By analogy, the cumulative TRA payments should be classified as cash outflows for financing activities up to the amount of the TRA liability initially recognized on the date of the existing owner share/unit exchange (initially recognized in equity on the balance sheet), and cumulative TRA payments in excess of those amounts should be classified as cash outflows for operating activities (settlement of amounts recognized in earnings).

The examples below illustrate the classification of TRA payments.

Example 7-19

On October 1, 20X1, Company A, a newly formed corporation, files a Form S-1 registration statement with the SEC to indicate its intent to publicly issue shares (i.e., undertake an IPO). As part of becoming a public company, A executes a series of reorganization steps to take advantage of certain tax benefits for pass-through entities that use an Up-C structure. Company A’s IPO closes on November 1, 20X1, and 10 million shares of A are issued and sold to public investors at $15 per share for proceeds of $150 million. Company A then uses the proceeds from the IPO to contribute $100 million to Company B, a limited partnership operating entity, in exchange for 8,333,333 units of B as well as to purchase 4,166,667 units of B from B’s existing owners for $50 million. Through the Up-C structure, the continuing existing owners of B are granted the right to exchange their B units for cash or newly issued shares of A on a one-for-one basis.

Upon the reorganization and IPO, A is a holding company whose sole asset is its equity interest in B, which represents 60 percent of the economic interests in B. Assume that the reorganization and IPO represent common-control equity transactions under ASC 805-50 and that A has a controlling financial interest in B under ASC 810-10 and therefore consolidates B. The remaining 40 percent of the economic interests in B is classified as an NCI within equity on A’s consolidated balance sheet.

As part of the negotiations for the transactions, A enters into a TRA with the existing owners of B. The TRA provides for the payment of cash by A to the existing owners of B in exchange for their units of B, which is equal to 85 percent of the net cash savings, if any, in U.S. federal, state, and local income tax that A realizes, or is deemed to realize, from the step-up in the tax basis of the net assets resulting from the exchange with existing owners of B.

Immediately after the closing of the IPO on November 1, 20X1, certain existing owners of B exercise their exchange rights and exchange 5 million units of B for 5 million newly issued shares of A, which accounts for the exchange as an equity reorganization. Company A records the following journal entries:

During the fiscal year ending December 31, 20X1, no payments are made to the existing owners of B under the TRA. However, A is able to use certain tax benefits subject to the TRA to reduce cash taxes paid to the IRS so that $2 million is paid to the existing owners of B (which exercised their exchange rights) on December 1, 20X2. No remeasurement adjustments are recorded to the deferred tax asset or TRA liability between November 1, 20X1, and December 1, 20X2. In this example, the TRA liability is initially recognized as equity on the balance sheet, with no adjustments recorded as earnings. The entire amount of the $2 million paid is presented as a financing activity in the statement of cash flows.

Example 7-20

Assume the same facts as in Example 7-19 except that, as of the date of the unit/share exchanges by the existing owners of Company B (November 1, 20X1), Company A has a full valuation allowance against its net deferred tax asset on the basis of projections of future taxable income. Because of the full valuation allowance, A does not recognize an initial net deferred tax asset or an initial TRA liability on November 1, 20X1 (i.e., it is more likely than not that A will not realize the future tax benefits, so the initial net deferred tax asset is $0, which results in a TRA obligation of $0). Company A records the following journal entries:

On December 31, 20X2, on the basis of a reassessment of projected future taxable income, A releases its full valuation allowance because management believes that it is more likely than not that the future tax benefits will be used. Company A records the adjustment to the net deferred tax asset and TRA liability as follows:

Company A is able to use certain tax benefits subject to the TRA to reduce cash taxes remitted to the IRS so that $3 million is paid to the existing owners of B (which exercised their exchange rights) on December 1, 20X4. No subsequent remeasurement adjustments are recorded to the deferred tax asset or TRA liability between December 31, 20X2, and December 1, 20X4. In this example, the TRA liability is initially recognized through net income or loss in the income statement. The entire amount of the $3 million paid is presented as an operating activity in the statement of cash flows.

Example 7-21

Assume the same facts as in Example 7-19 except that during the fiscal year ending December 31, 20X1, Company A records an increase in the deferred tax asset of $5 million as follows because of changes in the geographic mix of A’s earnings that affect A’s tax savings:

Company A is able to use certain tax benefits subject to the TRA to reduce cash taxes remitted to the IRS so that $12million is paid to the existing owners of Company B (which exercised their exchange rights) in each of the fiscal years ending December 31, 20X2, 20X3, and 20X4. In this example, assume that A does not record any additional remeasurement adjustments after December 31, 20X1.

Before the TRA payments, a portion of the TRA obligation is initially recognized through equity (offsetting entry to APIC) and another portion of it is recognized through earnings. The cumulative TRA payments should be classified as cash outflows for financing activities up to the amount of the TRA liability initially recognized on the date of the existing owner share/unit exchange (initially recognized through equity on the balance sheet), and cumulative TRA payments in excess of those amounts should be classified as cash outflows for operating activities (settlement of amounts recognized through earnings). Accordingly, the entire amount of the $12 million paid in the fiscal years ending December 31, 20X2, and December 31, 20X3, is presented as a financing activity in the statement of cash flows because the cumulative payments of $24 million (2 × $12,000,000) are less than the initial TRA liability recorded in equity. For the $12 million paid during the fiscal year ending December 31, 20X4, only $10 million remains [$34,000,000 – (2 × $12,000,000)] from the initial TRA liability recorded in equity. The $10 million is presented as a financing activity in the statement of cash flows, and the $2 million in excess of the initial TRA liability recorded in equity [(3 × $12,000,000) – $34,000,000] is presented as an operating activity in the statement of cash flows.