Memorandum
Impacts of the Tax Reform Legislation on UP-C Structures
January 16, 2018

Summary
With the recent enactment of H.R. 1, formerly known by the short title Tax Cuts and Jobs Act (the “TCJA”), it
is a good time to review how this tax reform legislation could affect the desirability of umbrella partnership–
C-corporation (UP-C) structures in initial public offerings. Our conclusion is that the UP-C structure
continues to provide meaningful tax benefits to pre-IPO owners of a pass-through business.

UP-C Overview
For businesses taxed as partnerships that are considering an IPO, the UP-C structure can offer owners theliquidity and other benefits of a public listing in a more tax efficient manner than the traditional alternativeof converting into a corporation at the time of an offering.
The UP-C structure is a two-tiered structure in which an entity organized as a limited partnership, limited
liability company or other legal form taxable as a partnership (commonly referred to as the operating
partnership or “OP”) holds all of the assets and operations of a business. Public investors hold their interestin the tax partnership indirectly through an entity (the “Pubco”) organized as a corporation or other legal
form taxable as corporation. The pre-IPO owners continue to hold their interests directly in the OP and,accordingly, their share of the income of the business is not subject to an entity-level tax.
In order to provide the holders of OP Units with liquidity, OP Units held by persons other than the Pubco(“OP Unitholders”) are typically exchangeable for Pubco Shares on a one-for-one basis (in some cases,
subject to the right of the Pubco or the OP to elect to deliver instead the cash value of such shares).
When a holder of OP Units exchanges such units for Pubco Shares, this transaction may result in increases inthe tax basis of the assets of the OP that increase (for tax purposes) depreciation and amortization
deductions and therefore reduce the amount of tax that the Pubco is required to pay in the future. It is
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common in an UP-C structure for the Pubco to share a percentage (which by market practice is typically85%) of any such tax benefits with the exchanging holder. This arrangement is typically set forth in a tax
receivable agreement or “TRA.”
Click here for additional information regarding the UP-C structure.

Impact of the TCJA on UP-C Structures
The major benefit of the UP-C structure—allowing the pre-IPO owners to continue to hold their interest in
pass-through form—would be preserved and could continue to yield benefits under the TCJA.
• Prior Law. Under prior law, partnership income was taxed to an individual partner at a top rate of
39.6% and to a corporate partner at a top rate of 35%. In a traditional corporate structure, income wastaxed to the corporation at a 35% rate, and then the 65% after-tax portion was potentially taxed again
as a dividend at a 20% rate for an individual shareholder (or at a 7% rate for a significant corporateshareholder). Thus, for an individual in an UP-C partnership, flow-through income (other than longterm capital gain) was taxed at a rate roughly 8 percentage points lower than the corporate alternative(assuming the corporation distributes the income as a dividend); (a) 39.6% versus (b) 35%, plus 20%of 65% or 13%, for a total of 48%.
• Current Law: Operating Income. Under the TCJA, partnership business income is generally
taxed at a top rate of 37% to an individual partner; however, “qualified business income” frompartnerships, which is income effectively connected with a U.S. trade or business other than capitalgains, dividend income, and certain compensation-related payments, is eligible for a 20% deduction. 1
In other words, if the partnership’s income qualifies for the deduction, a taxpayer would only be taxed
on 80% of the partnership’s income which would yield an effective rate as low as 29.6% (37% of 80%).
Under the TCJA, income earned by a corporation would be taxed to the corporation at a 21% rate, andthen the after-tax portion (79%) would be potentially taxed again to the shareholder as a dividend.
Thus, for an individual holding an interest in a partnership eligible for the favorable deduction, theflow-through income could be taxed at a U.S. federal income tax rate roughly 7 percentage points
lower than the corporate alternative (again assuming distribution as a dividend); (a) 29.6% versus (b)21%, plus 20% of 79% or 15.8%, for a total of 36.8%. Even if the partnership’s income is ineligible forthe deduction (or partners are subject to the limitation on the amount of the deduction), individual1

For taxpayers with income above a certain threshold ($415,000 for joint filers) the deduction is limited to the greaterof (a) 50% of the taxpayer’s share of W-2 wages paid by the business, or (b) the sum of 25% of such W-2 wages plus
2.5% of the taxpayer’s share of the tax basis of certain depreciable property used in the trade or business. Additionally,owners of specified service businesses (i.e., businesses in the fields of law, health, accounting, financial services or
brokerage services, businesses where the principal asset of the business is the reputation or skill of its employees orowners or businesses which involve the performance of services consisting of investing and investment management)
are generally excluded from the deduction if their income exceeds a certain threshold ($415,000 for joint filers).
Taxpayers with incomes above $315,000 are subject to a phase-in of these limitations.
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Memorandum – January 16, 2018

3partners would still be subject to a rate (up to 37%) that is similar to the rate of the corporate
alternative.
• Capital Gains on Exit or Other Asset Sales. Traditionally, the UP-C structure facilitates taxefficient post-IPO sales of partnership interests or assets. In such cases, the buyer generally obtains astepped up tax basis (reflecting its purchase price) for the assets directly or indirectly purchased andthus may pay a premium, while the sellers pay a single tax on the gain on the portion of their position
still held in pass-through form, generally at favorable capital gains rates for an individual, subject toexceptions for recapture and certain other items. In a traditional corporate structure, the corporation
would pay one tax on the sale of partnership interests or assets at the full rate (35% under prior law
and 21% under current law), and then the shareholders would have gain and potentially a second tax
on receiving sale proceeds on distribution from the corporation. For that reason, in an exit scenario,
the transaction may be structured as a sale of stock of the corporation. In that case, however, thebuyer would not obtain a stepped up tax basis in the underlying assets and may discount the purchaseprice accordingly. Under prior law, individuals paid a top tax rate on long-term capital gains of 20%,compared to the top rate for capital gains of corporations of 35%, or a double tax (corporate andshareholder) aggregating 48% as described above. Under the TCJA, the tax benefit for the UP-C
structure on exits or other capital gains transactions would remain—for the pass-through portion, asingle tax of 20% versus a double tax in a corporate structure aggregating 36.8% as described above
for the TCJA. The buyer would obtain a stepped up tax basis for that portion of the business.
Although the step up would be worth less to a corporate buyer, as deductions would produce only a
21% benefit compared to 35% under prior law, the overall effect would be similar to that applicable
under prior law.

Impact of the TCJA on TRA Payments
Under the TCJA, the top corporate income tax rate has been reduced from 35% to 21%. As the top corporate
income tax rate declines, the benefit of deductions to the Pubco, and accordingly the corresponding TRA
payments to an exchanging OP Unitholder are reduced as well. As an example, $100 of deduction fromincome taxed at 35% is worth $35, while $100 of deduction from income taxed at 21% is worth only $21.
Notwithstanding these reductions, given the continuing albeit lower value of the deduction we expect thatTRAs will continue to be employed.

Application of Section 162(m)Section 162(m) of the Internal Revenue Code of 1986 imposes a $1 million annual limit on deductions forcompensation (other than “performance-based compensation”) paid to a public corporation’s chief executiveofficer, its chief financial officer, and its next three highest-paid executive officers. Under prior law, publiccorporations largely avoided the deduction disallowance under Section 162(m) by structuring annualbonuses, certain equity awards, and other incentive arrangements to qualify as “performance-based
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Memorandum – January 16, 2018

4compensation.” The TCJA eliminates the performance based compensation exemption to 162(m). Thus
going forward, corporations will face difficulty avoiding the application of Section 162(m), and deductions
for employee stock options, annual bonuses, and performance shares for covered employees will be limited
if their value exceeds the annual limit. Partnerships, however, are not covered by Section 162(m); thus, intraditional UP-C structures, where all of the operating expenses of the business, including compensation, areincurred at the OP level, Pubcos have generally taken the view that Section 162(m) does not apply to limit
their share of OPs’ compensation deductions.

Implications for Tax Distributions in UP-C Structures
As is common in tax partnerships, the governing agreements in an UP-C structure typically require the OP tomake pro rata distributions of available cash to the holders of OP Units to fund their tax obligations for theincome of the OP that is allocated to them. These tax distributions are frequently computed based on anassumed highest effective marginal combined U.S. federal, state, and local income tax rate. Under the TCJA,
as was the case under prior law, the highest effective marginal combined rate for individuals is generally
higher than that for corporate entities. For this reason, tax distributions usually result in the Pubco
receiving cash in excess of the amount it requires to pay its taxes and fund its obligations under the TRA. To
avoid accumulating significant cash at the Pubco level (which may impair the one-to-one economic
equivalency of OP Units and Pubco Shares), this "excess" has typically been distributed as a dividend by thePubco to its stockholders.
The TCJA results in an even greater disparity between individual and corporate rates, which is likely toincrease the amount of excess cash received by a Pubco in tax distributions from an OP. In light of thisdevelopment, we expect that UP-Cs may increasingly explore alternative uses of this excess cash in a mannerconsistent with their particular commercial objectives and capital allocation strategies. These may include
stock repurchase programs or reinvestment in the business. Simpson Thacher has developed, and can assist
UP-C issuers in the design of, approaches that would facilitate these alternatives to the traditional dividend
while maintaining the one-to-one economic equivalency of OP Units and Pubco Shares.

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Memorandum – January 16, 20185

For further information, please contact one of the following.
CAPITAL MARKETSTAXJoshua Ford Bonnie+1-212-455-3986
jbonnie@stblaw.com

Marcy G. Geller+1-212-455-3543
mgeller@stblaw.com

William R. Golden III+1-202-636-5526
wgolden@stblaw.com

John C. Hart
+1-212-455-2830
jhart@stblaw.com
Katharine P. Moir
+1-650-251-5035
kmoir@stblaw.com
Andrew B. Purcell+1-212-455-3064
apurcell@stblaw.com

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authoredit are rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of thispublication to any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP
assumes no liability in connection with the use of this publication. Please contact your relationship partner if we can be ofassistance regarding these important developments. The names and office locations of all of our partners, as well as ourrecent memoranda, can be obtained from our website, www.simpsonthacher.com.
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Memorandum – January 16, 2018

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