The Umbrellas of Subchapter K
John C. Hart
Andrew B. Purcell
Simpson Thacher & Bartlett LLP
January 2020

Table of Contents
Page
I.

Umbrella Partnership History and Structures ................. 2
A. UPREITs .................................................................. 2
1. The Quest for Tax-Free Acquisitions ............... 2
2. Maintaining the Deferral ................................. 11
3. The Laws of UPREIT Physics ........................ 12
4. Proliferation in the 1990s................................ 14
5. The Anti-Abuse Regulations .......................... 15
6. TCJA Effects .................................................. 22
B. UP-Cs ..................................................................... 23
1. Retaining Flow-Through Treatment ............... 23
2. A Step-Up for the C Corporation.................... 29
3. TCJA Effects .................................................. 32
C. UP-PTPs ................................................................. 35
1. Background ..................................................... 35
2. The Nature of a Fund Sponsor’s Income ........ 42
3. The PTP Rules – 90% Qualifying Income
Exception ........................................................ 45
4. The UP-PTP Structure .................................... 47
5. Retaining Flow-Through Treatment; Step-Up
for the PTP ...................................................... 48
6. Additional Umbrellas...................................... 49
7. TCJA Effects .................................................. 51
II. Tax Receivable Agreements ......................................... 54

A. First Generation TRAs not Involving UmbrellaPartnerships ............................................................ 55
1. O’Sullivan Industries, Inc. – 1994 .................. 55
2. Endo Pharmaceuticals – 2000 ......................... 56
3. “Supercharged” IPO – Genworth Financial –2004... ............................................................. 59
B. Umbrella Partnership TRAs ................................... 62
1. Background ..................................................... 62
2. Overview of Basic TRA Terms ...................... 62
3. Additional TRA Provisions and Variations .... 68a) New Basis versus “Historic” Basis .......... 69b) NOLs ....................................................... 72c) Impact of Change of Control Transactions
on TRAs................................................... 74d) Disallowance Provisions ......................... 78e) Creditor Issues ......................................... 79f) Treatment of TRA Payments to
Beneficiaries ............................................ 82g) Commentary on TRAs ............................. 87
III. Tax Protection Agreements ........................................... 88
A. Standard Provisions ............................................... 88
B. Points of Negotiation ............................................. 93
C. Archstone Litigation ............................................ 107
D. Tax Treatment of Tax Protect Payments ............. 112
IV. Respecting the Umbrella Partnership Form andVariations .................................................................... 114
A. Respecting the Umbrella Partnership Form ......... 114
B. Non-Public Status of the Umbrella Partnership ... 123
V. Umbrella Partnerships and Compensation Issues ....... 130
A. Limitation on the Deductibility of Executive
Compensation ...................................................... 130
B. Long-Term Incentive Plan Units ......................... 133

ii

The Umbrellas of Subchapter K
This paper discusses “umbrella partnership”
structures in which partners in a private partnership achieveenhanced liquidity through exchange rights into publicly
traded equity. 1 Umbrella partnerships have been used sincethe 1990s with publicly traded real estate investment trusts(“REITs”) and C Corporations and in the last ten years withpublicly traded partnerships (“PTPs”).
The discussion below recounts the history of umbrella
partnership structures in each of the three areas; addresses
key features and tax issues for the tax agreements that havebecome standard in each area; and discusses certain core
premises on which the intended tax treatment of thestructures depends.

1

In the 1964 film The Umbrellas of Cherbourg, a shopgirl
in an umbrella store (played by Catherine Deneuve) meetsa wealthy customer and eventually marries him. The
obvious parallel is that, just as umbrellas gave the film’s
shopgirl access to an affluent life, umbrella partnerships
allow private business owners tax-efficient access toenhanced liquidity.

Tax reform legislation enacted in December 2017
(P.L. 115-97, previously known as the “Tax Cuts and Jobs
Act”; referred to herein as the “TCJA”) did not contain any
provisions expressly addressing umbrella partnerships. But
the TCJA reduced the top federal income tax rate on
corporations from 35% to 21% and made certain otherchanges that may indirectly affect umbrella partnershiptransactions. Certain implications of the TCJA for umbrella
partnerships are also discussed below.
I.

Umbrella Partnership History and StructuresA.

UPREITs1.

The Quest for Tax-Free Acquisitions

Private real estate is often owned through an entity
treated as a partnership for tax purposes (or, in the case of asingle owner, through a disregarded entity). For a public realestate holding company, a REIT is usually the preferredvehicle to avoid an entity-level tax. 2 A publicly traded2

See generally sections 856, 857. Unless otherwise
specified, all section references are to the U.S. Internal2partnership might be considered, 3 but there may bedisadvantages when compared to a REIT. For instance,
partners in a PTP (or the PTP on their behalf) may berequired to pay an income tax in states where the PTP
operates and may be subject to burdensome state filing
requirements. In contrast, nonresident owners of REIT
shares are not generally subject to tax or filing requirementsin the states in which the REIT holds real estate. In addition,
the “related party rent” rules are more stringent in the PTP
context then the REIT context.4

Revenue Code of 1986, as amended, and the Treasury
regulations promulgated thereunder.
3

A PTP is treated as a corporation unless at least 90% of its
income is “qualifying income” within the meaning ofsection 7704(d). See sections 7704(a), 7704(c)(2).
Subject to certain exceptions, income from real estate will
typically be qualifying income for PTP purposes, meaningthat a business that would qualify for REIT treatment willoften have the option of organizing as a PTP without being
characterized as a corporation. The qualifying income
rules are described in greater detail below.

4

Rental income will qualify neither as “good income” forpurposes of the REIT’s 95% gross income test nor as
qualifying income for PTP purposes if received from aperson 10% or more of whom is actually or constructively
owned by the REIT or the PTP, as the case may be. See

3

A disadvantage of REITs, however, is that assets
cannot be transferred to a REIT in exchange for REIT stock
on a tax-free basis except in limited circumstances. Section
351(a), which provides for nonrecognition of gain ontransfers to controlled corporations, is not available toshareholders who contribute property to an “investmentcompany.” 5 A contribution to an investment company
includes a contribution to a REIT if the contributors’ interests
are diversified as a result of the transfer, 6 which would

sections 856(d)(2)(B), 7704(d)(3). However, different
constructive ownership rules are applied depending onwhether the lessor company is a REIT or a PTP. A REIT
will constructively own an interest in a tenant owned by ashareholder owning 10% or more of the stock of the REIT.
See section 856(d)(5)(A). On the other hand, a PTP will
constructively own an interest in a tenant owned by apartner holding only 5% or more of the interests (by value)in the PTP. See section 7704(d)(3)(B).
5

Section 351(e)(1).

6

Treas. Reg. section 1.351-1(c)(1). A contribution to an
investment company also includes a contribution to aregulated investment company (“RIC”), and a contribution
to a corporation more than 80% of the value of whose
assets are held for investment and are money, stocks or
securities, and certain other investment assets, in either

4generally occur upon the transferors’ contribution of
nonidentical assets. 7 In this regard, cash raised from thepublic equity markets will be considered nonidenticalproperty to the contributed real estate. 8

case where the transfer results in a diversification of thetransferors’ interests. Section 351(e)(1).
7

Treas. Reg. section 1.351-1(c)(5).

8

Under an exception contained in the investment company
regulations, a contribution by each transferor of a“diversified portfolio of stocks and securities” to thecorporation is not deemed to result in a diversification of
the transferors’ interests. See Treas. Reg. section 1.3511(c)(6). No similar rule protects transfers of diversified
portfolios of real estate from the investment company rule,and, in fact, the preamble to the investment company
regulations states that Treasury specifically considered anddeclined a commenter’s invitation to adopt a rule allowing
diversified portfolios of real estate to be transferred to a
REIT. See TD 8663 (May 1, 1996). Nevertheless,without explanation, in several private letter rulings, theInternal Revenue Service has allowed taxpayers to transfer
non-identical property to a REIT in exchange for REIT
stock under section 351(a). See PLR 201622001 (andidentical 201622014) (contribution of interests inpartnerships holding presumably diversified portfolio ofreal estate; contribution of cash does not cause transferors
not contributing cash to be “diversified”); PLR 200450018(transferors contributed identical partnership interests to
REIT, which also received cash proceeds from an IPO);
PLR 9801016 (similar); PLR 9744003 (shares of another
REIT, partnership interests and cash transferred to a REIT
by different shareholders). See also PLR 199947001(transferors contributed identical partnership interests to a5

Before 1992, many private owners of real estate kept
their holdings private because the investment company rule
prevented them from incorporating their holdings into a
REIT and accessing the public markets on a tax-efficientbasis. In addition, even those owners who were willing totake their real estate businesses public through an offering ofstock of a regular C corporation (and suffer a tax at the entity
level) often could not incorporate on a tax-free basis.
Though the investment company rule would not typically
apply to a real estate holding corporation not electing REIT
status, 9 tax-free treatment under section 351(a) may besignificantly limited where the transferors’ liabilities that are
assumed by the transferee corporation exceed the transferors’basis in the contributed property. Specifically, if thecontributed properties are secured by liabilities in excess of
their adjusted basis, which is often the case where highly
newly formed REIT, but engaged in some amount of precontribution diversification at the partnership level).
9

See supra note 6.

6leveraged property has been depreciated over theprecontribution period, the contributing partner would
recognize gain in the amount of the difference under section
357(c).
In 1992, the “umbrella partnership REIT” (or“UPREIT”) structure emerged as a more tax-efficient way forinvestors to acquire and hold diverse real property assets. In
an UPREIT structure, the initial real estate owners contribute
their real estate business (whether held directly or through apartnership) to a newly formed limited partnership – the“umbrella partnership,” “operating partnership” or “OP” – inexchange for limited partner interests (or “units”) in theOP. 10 A newly formed REIT, which is the general partner of10

If a real estate holding partnership contributes its assets
directly to the OP and then liquidates, the OP will succeed
to the real estate holding partnership’s basis in the assets.
See section 722. On the other hand, if the real estateholding partnership liquidates prior to the contribution,
each owner of the real estate holding partnership will takea basis in his share of the liquidated assets equal to his
basis in his partnership interest in the real estate holding
partnership. See section 732(b). The OP will thensucceed to this asset basis upon the owners’ contributionof the real estate assets. Thus, by choosing the form of the

7the OP, receives cash in a public offering of stock, whichcash is then contributed to the OP in exchange for additional
partnership interests. Where the IPO also includes a“secondary” component, a portion of the proceeds is used topurchase interests in the OP from the initial owners, also
known as the “sponsors.” To the extent the sponsors remain
partners in the OP, they are granted, as part of their OP units,
the right to exchange their OP units for shares of the public
REIT. Thus, the sponsors would continue to own interests in
the OP until such time as they want to sell their interests, atwhich point the sponsors would exchange a portion of theirpartnership interests for interests in the REIT and sell the
REIT shares into the public market.

contribution transaction the owners of the real estateholding partnership may be able to maximize the basis that
the OP takes in the contributed assets.

8

Public Shareholders

Sponsors

REIT
GP

LPs

OperatingPartnership
By allowing the sponsors to contribute their property
interests to a partnership rather than a REIT, the UPREIT
structure takes advantage of the ability to transfer property
tax-free to a partnership under section 721(a) as well as themore flexible rules governing liability assumption in thepartnership context. 11 Additionally, OP interests may be
11Unlike contributions to corporations, in which gain isrecognized if liabilities assumed exceed the basis of thecontributed property, such gain may be avoided in thepartnership context if liabilities are properly allocated tothe contributing partner. See Treas. Reg. sections 1.7075(a), 1.752-1(a)(1), 1.752-3. It is also worth noting that a9used as a tax-efficient acquisition currency for futureacquisitions of real property. Unlike section 351(a), which
requires the transferors to own at least 80% of the stock of
the transferee company immediately after a transfer, section
721(a) has no such requirement. 12
Because the REIT will be general partner of the OP,
the sponsors’ ownership of limited partner units will notafford them control of the business. To continue controllingthe business after it converts into UPREIT form, sponsors

narrower version of the investment company rules does
apply to contributions to partnerships. Specifically, thetax-free treatment of a contribution to a partnership under
section 721(a) is denied if the partnership would be an
investment company if it were a corporation. See section
721(b). A partnership is not presumed to have made a
REIT election in determining whether it would be an
investment company if it were a corporation. Treas. Reg.
section 1.701-2(d), Ex. 4(i). Therefore, a transfer to apartnership will be considered to be a transfer to an
investment company only if 80% of the of the value of thepartnership’s assets are held for investment and are money,stocks or securities, and certain other investment assets,
and the transfer results in a diversification of thetransferors’ interests. Treas. Reg. section 1.351-1(c)(1).
12

Subsequent contributors of property to the REIT will often
receive consideration amounting to less than 80% of the
REIT.

10

will sometimes form an advisor entity to conduct theoperations of the REIT pursuant to an advisory agreement.
The REIT may have no employees of its own and therefore
be completely reliant on the advisor entity, which will beowned and controlled by the sponsors. 13
2.

Maintaining the Deferral
After an UPREIT has been formed, the contributing

partner’s tax deferral will last only until the umbrella
partnership disposes of that partner’s contributed property ina taxable transaction. Upon such a disposition, the built-in
gain on the disposed-of asset – that is, the difference between
the fair market value of the asset at the time of contribution
and its adjusted basis – will be allocated, under section

13

See, e.g., S-11 of Paladin Realty Income Properties, Inc.
(filed with the SEC on July 22, 2011); S-11 of CB Richard
Ellis Realty Trust (filed with the SEC on July 30, 2008).
In one UPREIT IPO, the current real estate owners
retained control through ownership of high-vote shares in
the REIT. See Form S-11 for Empire State Realty Trust,
Inc. (filed with the SEC on February 13, 2012) (high-voteshares have equal dividend rights but fifty times the voteof common shares).

11

704(c) and its regulations, to the partner that contributed theasset. To ensure that the contributing partners’ deferral on
the built-in gain lasts for a certain minimum duration,
contributing partners and the OP may enter into a “taxprotection agreement” requiring the partnership to indemnify
them for any gain recognized as the result of the sale ofcontributed property for a specified period of time (or as aresult of the discharge or shifting of a liability allocated tothe contributing partner). The agreement will be particularly
important to contributing partners who do not participate in
the management of the REIT (or its advisor) and therefore
have no control over the timing of the disposition of the OP’s
assets. Tax protection agreements are discussed in further
detail below in Part III.
3.

The Laws of UPREIT Physics
A fundamental characteristic of the UPREIT structureis that each OP unit is similar economically to a share of
REIT stock. This economic result is achieved through the
combination of a few features. First, substantially all of the

12assets of the REIT are interests in the OP, and the REIT does
not generally engage in any business activities aside fromserving as general partner of the OP. Second, “structuralparity” is present between the OP and the REIT in that asingle OP unit is exchangeable for a single share of REIT
stock. 14 Finally, each OP unit is entitled to receive
distributions equal to the dividends paid on a share of REIT
stock. These features, taken together, allow sponsors torealize the tax benefits of owning interests in the OP whileachieving similar economics and much of the liquidity theywould have had if they owned shares directly in the REIT. 15

14

The one-to-one exchange ratio is typical, but umbrella
partnership units may be designed to be convertible into
(and therefore economically equivalent to) some otherfixed number of REIT shares. The REIT may have theright to elect whether to redeem a unit with a share of
REIT stock or with cash in an amount equal to the value ofa share of REIT stock.

15

Certain limitations may be placed on the transferability
and exchange of OP units. See the discussion below in
IV.B.

13

To ensure that this economic parity is maintained, any
issuance of additional REIT shares to the public must be
followed by a contribution of the proceeds by the REIT to theOP (or to the sponsors in a secondary sale) in exchange foran additional number of equivalent OP units. Without thisrequirement, the REIT shareholders’ interests in the OP
would be diluted, but the interests of the holders of OP units
would not. Similarly, any redemption of REIT shares
generally must be funded by the OP’s redemption of anequivalent number of its units from the REIT. Moreover,this mirroring requirement applies to all securities of the
UPREIT – any equity or debt instrument in the REIT must be
mirrored by an equity or debt instrument with equivalentterms issued by the OP to the REIT.
4.

Proliferation in the 1990s
In late 1992, Taubman Centers, Inc., became the firstpublic REIT to operate through an UPREIT structure. Six
other public UPREITs were formed in 1993: General Growth
Properties, Carr Realty, Manufactured Home Communities,

14

Mark Centers Trust, Tucker Properties Corp., and Spieker
Properties Inc. During the two year period from the end of
1992 to the end of 1994, the market capitalization of REITs
nearly tripled, rising from $16 billion to $44 billion, and thentripled again by the end of 1997, rising to $140 billion. At
the end of 2018, the figure stood at $1.05 trillion. 16
5.

The Anti-Abuse Regulations
The viability of the UPREIT structure was briefly

threatened following the proposal of the partnership anti-

16

See http://www.reit.com/DataAndResearch/US-REITIndustry-MarketCap.aspx. For examples of UPREITs, see,e.g., Agreement of Limited Partnership of Excel Trust,
L.P. dated April 15, 2010 (filed with the SEC as Exhibit
10.1 to Form S-11/A of Excel Trust, Inc., on April 16,2010); Second Amended and Restated Agreement of
Limited Partnership of Paladin Realty Income Properties,
L.P. dated February 6, 2008 (filed with the SEC as Exhibit
10.2 to Form S-11/A of Paladin Realty Income Properties,
Inc., on July 18, 2008); Amendment No. 1 to the Second
Amended and Restated Agreement of Limited Partnershipof Mack-Cali Realty, L.P. dated August 21, 1998 (filedwith the SEC as Exhibit 3.1 to Form S-3/A of Mack-Cali
Realty Corp. on August 24, 1998); Second RestatedAgreement of Limited Partnership of Highwoods Realty
Limited Partnership, dated as of January 1, 2000 (filedwith the SEC as Exhibit 10.1 to Form 10-K of Highwoods
Properties, Inc., on December 22, 2005).

15

abuse regulations in 1994. 17 Under the regulations, if apartnership is formed or availed of in connection with atransaction a principal purpose of which is to reduce
substantially the present value of the partners’ aggregate
federal tax liability in a manner that is inconsistent with theintent of Subchapter K, the Internal Revenue Service (“IRS”)
has the authority to recast the transaction for U.S. federal
income tax purposes as appropriate to achieve tax results thatare consistent with such intent. 18 Under one potential recast
specifically mentioned by the regulations, the partnership is

17

Prop. Treas. Reg. section 1.701-2, 59 FR 25584 (May 17,1994).

18

Treas. Reg. section 1.701-2(b). To be consistent with theintent of Subchapter K, (i) the partnership must be bonafide and each partnership transaction or series of relatedtransaction must be entered into for a substantial businesspurpose, (ii) the form of each partnership transaction must
be respected under substance over form principles, and(iii) generally, the tax consequences under Subchapter K toeach partner of partnership operations and of transactions
between the partner and the partners must accuratelyreflect the partners’ economic agreement and clearlyreflect the partner’s income. See Treas. Reg. section
1.701-2(a).

16disregarded as separate from one or more of its partners. 19 In
light of the economic parity between ownership of umbrella
partnership units and REIT shares in a typical UPREIT
structure, practitioners questioned whether the broad
language of the anti-abuse regulations would be used tochallenge UPREITs. 20
In response to a series of comment letters from tax
advisers, 21 the IRS added an example to the final anti-abuse

19

Treas. Reg. section 1.701-2(b)(1).

20

See comment letter from the National Association of Real
Estate Trusts, June 24, 1994, 94 TNT 139-71 (proposingthat the final regulations incorporate an example
demonstrating that an UPREIT transaction is not abusive).
Arguments for respecting the UPREIT structure are
discussed below in IV.B.

21

See, e.g., comment letter from the New York State Societyof Certified Public Accountants, July 6, 1994, 94 TNT
139-62 (noting that while an IRS official “reportedly
stated that the regulation was not meant to apply to the socalled UPREIT structure . . . [i]t is in no way apparent
from the language of the regulation that it does not apply
UPREITs.”); comment letter from Douglas J. Antonio of
Sugar, Friedberg & Felsenthal, June 10, 1994, 94 TNT
121-11 (“The Proposed Regulation as currently worded isso vague and ambiguous that it creates a stifling effect onlegitimate economic transactions. . . . The effect on
UPREIT transactions caused by the uncertainty generated
by the language of the Proposed Regulation will have an

17

regulations, finalized in late 1994, essentially blessing the
UPREIT structure. In Treas. Reg. section 1.701-2(d),Example 4 (the “Example”), two existing partnerships with
substantial real estate holdings contribute all of their real
property assets to a new operating partnership (“NewPartnership”) in exchange for limited partner interests in New
Partnership, after which the contributing partnerships
terminate. The general partner of New Partnership is a newly
formed REIT, which offers its stock to the public andcontributes substantially all of the proceeds from the public
offering to New Partnership. The limited partners in New
Partnership are given the right, beginning two years after theformation of New Partnership, to require the redemption of
their limited partner interests in exchange for cash or stock of
the REIT (at the REIT’s option) equal to the fair market
value of their respective partnership interests at the time of
the redemption. The Example concludes that such a structure
annual effect on the economy measuring well into thebillions of dollars.”).

18

is consistent with the intent of Subchapter K and will notconstitute an abusive transaction under section 701.
Notably, certain features of the UPREIT structure
described in the Example differ from the features generally
present in UPREITs. First, the Example notes that the REIT
“may make other real estate investments and other businessdecisions, including the decision to raise additional capitalfor those purposes.” Typical UPREIT structures, on theother hand, do not contemplate the REIT’s acquisition ofassets outside of the partnership, as discussed above. In
addition, in the Example, partnership units are exchangeable
for REIT shares of equal value to the exchanged units, rather
than at a fixed exchange ratio, as is the typical arrangement.
This, however, is less of a difference than it might seem
given that the structural parity should cause the value of the
OP units to track the value of the REIT stock. Moreover,typical UPREIT structures generally do not provide for the
two-year bar on exchanges that is present in the Example.
Finally, in the Example, only “some” of the limited partners

19possess the right to exercise a conversion privilege, whereas
in a typical structure all partners (other than the REIT) havethe right to convert units to REIT shares. 22
Because of these differences, many real estatepractitioners (as well as the National Association of Real
Estate Investment Trusts, the national trade grouprepresenting REITs) expressed concern upon the initial
promulgation of the Example that it did not actually blesstypical UPREIT transactions. However, based on statementsby senior U.S. Treasury officials, it is now well-accepted thatthe anti-abuse regulations were not intended to apply tocommon UPREIT transactions, and that the differences

22

Consider whether a variant of the UPREIT known as the“DownREIT” may be more consistent with the structure
sanctioned in the Example. In a DownREIT, the REIT
may make investments outside the OP, including throughother OPs. Partners in these OPs, however, often have theright to exchange their OP units for a fixed number of
REIT shares.

20between the Example and a typical UPREIT transaction
should not be a cause for concern. 23

23

See Unofficial Transcript of IRS Hearings on Partnerships,
Doc PS-27-94, 94 TNT 147-18 (July 25, 1994) (MichaelThomson, acting Deputy Tax Legislative Counsel,
agreeing with a witness’s observation that senior membersof the Treasury Department announced that the partnershipanti-abuse regulations were not intended to apply to
UPREITs); “Samuels Says Partnership Anti-abuse,
Consolidated Return Rules No Concern,” Daily Tax Rep.
(BNA) No. 93, at G-3 (May 17, 1994) (reporting that
Leslie Samuels, Assistant Treasury Secretary, said that the
proposed partnership anti-abuse rules do not apply tocommon real estate funding vehicles, known as
UPREITs); Blake D. Rubin, Andrea R. Macintosh andJonathan I. Forrest, “Doing a Deal with a REIT From the
Owner’s Perspective,” 27 J. of Real Estate Tax’n 15 (Fall1999) (“While there are slight differences between theexample and the typical UPREIT structure, given thenumber of UPREIT deals in the market, challenges basedon these differences in structure are unlikely.”). See also
Blake D. Rubin, Andrea M. Whiteway, and Jon G.
Finklestein, “Representing the Owner in UPREIT and
DOWNREIT Transactions,” J. of Real Estate Tax’n (Third
Quarter 2007) (“[T]he UPREIT structure has become wellestablished and it is unlikely that the typical UPREIT
structure would be subject to challenge.”). One
commentator recently suggested that the conclusion in
Example 4 be reexamined. See Monte A. Jackel, “ThePartnership Antiabuse Rule and UPREIT Structures
Revisited,” 150 Tax Notes 113 (Jan. 4, 2016).

21

6.

TCJA Effects
The TCJA includes a number of provisions that affectpartnerships and REITs, but no provisions expressly
addressing UPREITS. Individuals holding REIT shares cangenerally claim a deduction equal to 20% of REIT dividends
received (other than capital gain dividends). 24 The TCJA
reduced the top corporate rate on C corporations from 35% to21%, reduced the top personal income tax rate from 39.6% to37% and provided a 20% deduction for certain partnershipbusiness income allocated to partners who are individuals. 25
As a result of those changes, the benefit of flow-throughtreatment at the OP and REIT levels relative to holding theentire business through a C corporation has lessened24

See section 199A as added to the Code by section 11001
of the TCJA. The 20% deduction applies only through
2025.

25

See sections 1(j) and 11(b) as amended by sections 11001
and 11011 of the TCJA. The individual rate reduction
applies only through 2025.

22

somewhat, but is still generally significant. 26 Consequently,
the UPREIT structure is likely to continue to be widely used
to hold eligible real estate investments where access to public
capital markets is sought.
B.

UP-Cs
1.

Retaining Flow-Through Treatment

The UPREIT structure described above was aprecursor to what has come to be known as an “UP-C,” or“Pubco” structure. The UP-C looks very similar to an
UPREIT, but substitutes a regular C corporation for a REIT,
and accordingly is an IPO structure that can be used forbusinesses whose assets and activities are not REIT-eligible(i.e., non-real estate). In the words of one commentator, “thePubco structure expands the UPREIT beyond its real estateroots into corporate America.” 27 Many U.S. companies have26

See discussion below at I.B.3.

27

Eric Sloan and Matthew Lay, “Beyond the Master Limited
Partnership: A Comprehensive Review of Publicly Traded
Partnerships,” Taxes: the Tax Magazine (March 1, 2010).

23

used the UP-C structure in connection with their initial public
offerings, including barnesandnoble.com inc., 28 Charter
Communications, 29 Accenture, 30 Evercore, 31 Emdeon, 32
Duff & Phelps, 33 Graham Packaging, 34 DynaVox, 35 and PBF

28

Prospectus of barnesandnoble.com inc. (filed with the SEC
on May 26, 1999, although dated as of May 25, 1999). In
fact, since barnesandnoble.com is widely credited as being
the first non-REIT to use this structure, the UP-C issometimes referred to as the barnesandnoble.com
structure.

29

Prospectus of Charter Communications, Inc. (filed with the
SEC on Nov. 8, 1999).

30

Prospectus of Accenture Ltd. (filed with the SEC on July18, 2001).

31

Prospectus of Evercore Partners Inc. (filed with the SEC
on Aug. 11, 2006).

32

Prospectus of Emdeon, Inc. (filed with the SEC on Aug.
12, 2009).

33

Prospectus of Duff & Phelps (filed with the SEC on Oct.
1, 2007).

34

Prospectus of Graham Packaging Company Inc. (filed with
the SEC on Feb. 11, 2010).

35

Prospectus of DynaVox Inc. (filed with the SEC on April
23, 2010).

24

Energy. 36 More recent examples of UP-C structures include
Shake Shack, 37 Summit Materials, 38 and Planet Fitness. 39
The establishment of an UP-C structure is very
similar to that of an UPREIT. Specifically, a new C
corporation is created, which issues common stock to the
public in an initial public offering. Cash proceeds from the
IPO are invested directly into the umbrella partnership(which may be an LLC treated as a partnership for tax
purposes) in exchange for a managing interest, and a portionof the proceeds may be used to purchase interests in theumbrella partnership from the pre-IPO owners. The pre-IPO
owners’ interests in the umbrella partnership are then36

Prospectus of PBF Energy Inc. (filed with the SEC on
Dec. 13, 2012).

37

Prospectus of Shake Shack Inc. (filed with the SEC on
Dec. 29, 2014).

38

Prospectus of Summit Materials, Inc. (filed with the SEC
on July 8, 2015).

39

Prospectus of Planet Fitness, Inc. (filed with the SEC on
June 22, 2015).

25

converted into limited partner interests (or nonmanaging
member interests). 40 Similar to the right granted to theformer real property owners in an UPREIT, the pre-IPO
owners in an UP-C structure will enter into an exchange
agreement with the umbrella partnership, pursuant to which
their partnership interests are exchangeable for stock in the C
corporation or, often, the cash equivalent thereof. 41 It is
common for the pre-IPO owners to receive special noneconomic voting shares in the C corporation. These shares
typically give the pre-IPO owners voting rights tied to thenumber of umbrella partnership units held by the holder at

40This transaction would generally be governed by section
721(a) and would be treated in the same fashion as acontribution to an umbrella partnership in an UPREIT
structure, as discussed above.

41

The C corporation may exercise its right to deliver cash inlieu of shares so as to safeguard against triggering of loss
limitations under section 382. For a general discussion,see Eric B. Sloan, “Partnerships in the Public Space,” 921
PLI/Tax 218A-1 (2011).

26

any given time, and therefore may allow the pre-IPO owners
to continue to control the business. 42
Despite its structural similarities to the UPREIT, the
UP-C is designed to achieve different tax objectives. As
described above, UPREITs developed as a way for real estate
owners to raise capital in a going-public transaction without
triggering tax on the contribution of their assets to the REIT.
The tax on contribution is not as much of a concern in the C
corporation context, because the investment company rule
will not typically apply when operating business assets arecontributed to a C corporation. However, even if thesponsors could incorporate their business without any current
tax using a C corporation, a C corporation is far less tax

42

See, e.g., Form S-1 of Evercore Partners Inc. (as filed with
the SEC on May 12, 2006) (“Each limited partner ofEvercore LP will be issued one or more shares of our Class
B common stock. The shares of Class B common stock
have no economic rights but will entitle the holder,without regard to the number of shares of Class B common
stock held, to a number of votes that is determined
pursuant to a formula that relates to the number ofEvercore LP partnership units held by such holder.”).

27

efficient than a REIT (or a partnership) because it is subject
to an entity-level tax. Accordingly, by using an UP-C
structure, these owners can use a corporate IPO vehicle while
continuing to hold their interests on a tax-efficient basis at
the flow-through level, and their share of the business’
income will not be subject to an entity-level tax. 43
Additionally, the flow-through structure allows the characterof the income to flow through to the pre-IPO owners,
preserving the potential benefit of a preferred tax rate on
capital gains and the use of excess capital losses.

43

As a corollary, allocations of income to the partners will
increase their basis in their interests, reducing gain upon
future sale and thus preserving the single level of tax onearnings.

28

Public Shareholders

Non-economic
voting shares

Common shares

Sponsors

C Corporation
Nonmanaging
interests

Managing interest

OperatingPartnership2.

A Step-Up for the C Corporation
Another major benefit of the UP-C relates to theexchange of interests in the OP for stock of the publiccompany when the sponsors desire liquidity. When theseexchanges take place, the corporation will obtain a step-up in
the tax basis of its proportionate share of the assets of thepartnership (which has in place an election under Section

29754), 44 which will serve to increase depreciation andamortization deductions. In a typical non-UP-C publiccompany, future sales of interests in the public corporation
do not give rise to a step-up in the basis of the assets of the
public company. In contrast to an UPREIT, which does not
generally pay an entity-level tax, the C corporation in an UPC may enjoy substantial cash tax savings as a result of thisstep-up.
The ability to pass along a step-up to the C
corporation in connection with a taxable exchange ofumbrella partnership units led to the adoption of what is
generally known as a “tax receivable agreement” (or “TRA”)
in UP-C transactions. 45 TRAs provide the historic owners

44

Sections 754 and 743.

45

Evercore Partners Inc. appears to have been the first UP-C
structure to use a TRA. (Although Lazard implemented a
TRA in connection with its IPO in 2005, a year prior to
Evercore’s IPO, the Lazard transaction featured an UPPTP structure, as described below.) As described more
fully below, the TRA has evolved as a nearly ubiquitouscomponent of umbrella partnership IPO structures,
although there were IPOs well before the advent of the30

additional consideration upon exchange reflecting asubstantial portion (often 85%) of the value of any tax
savings attributable to the basis step-up resulting from an
exchange. These TRA arrangements are addressed more
fully in Part II, with specific reference to some of the morenotable IPO transactions that have implemented suchagreements. 46

UP-C structure that featured agreements that shifted thetax benefits to historic equityholders.
46

The tax efficiencies created by an UP-C structure exist
irrespective of any TRA-like arrangements that provide forthe allocation of certain of such benefits. In the IPO ofbarnesandnoble.com, for example, the pre-IPO owners of
the business (Barnes and Noble and German media empire
Bertelsmann AG) did not enter into a TRA with the public
corporation.
Recently, UP-C structures have been used in effect totransfer U.S. corporations to foreign acquiring
corporations without an actual transfer and thus without
having to comply with section 367(a) for tax freetreatment. See Amy S. Elliott, “Up-C Structures inInversions May Raise Policy Concerns,” 149 Tax Notes
610 (Nov. 2, 2015). UP-C structures may also be used in
the special purpose acquisition company (“SPAC”)_
context, where the partnership that is the subject of the
UP-C structure is the target company for the SPAC
acquisition. See Phillip W. DeSalvo, “The Evolution of the
UP-C,” 161 Tax Notes 439, 440-444 (Oct. 22, 2018).

31

3.

TCJA Effectsa.

Continued Flow-Through Benefit

As noted above, the TCJA includes a number ofprovisions that affect partnerships and reduces the corporate
income tax rate from 35% to 21%, but it includes noprovisions expressly addressing UP-Cs. The TCJA changes
will affect UP-C structures, but the structure’s major benefitof allowing pre-IPO owners to continue to hold their interestin pass-through form will continue and will continue to bebeneficial in many cases.
One way to consider the TCJA impact on UP-C
structures is to measure the federal income tax rate to anindividual holding OP units versus what rate would apply tothe individual as a shareholder in a C corporation both underprior law and under the TCJA regime.
Operating Income. Assuming for the comparison that
operating income is distributed, under prior law the
maximum rate for an individual owner at the OP level would
be 39.6% (ignoring the self-employment tax or net

32

investment income tax that might apply for both OP income
and corporate dividends). The maximum to an individual
holding shares in a C corporation would be 48%: the top
corporate rate of 35% plus the top dividend rate to theindividual of 20% applied to the 65% of after-tax earnings
available to be dividended, or 13%. Thus the UP-C benefit
to pre-IPO owners at the OP level for distributed earnings inthis example would be about 8% (39.6 versus 48).
Using the assumptions and approach above, under the
TCJA, the individual’s top rate at the OP level would be 37%
less the benefit of the new 20% deduction for certain
business income. The amount of that deduction (for higher
income taxpayers) depends on the amount of W-2 wages paid
and certain investments made by the partnership, but could
reduce the top rate to 29.6% if the deduction is fully
available (80% of 37%). The combined top rate on
distributed earnings would be 36.8% (21% on the corporation
plus 20% of the remaining 79% or 15.8%). Thus the UP-C
tax rate benefit on distributed earnings eligible for the 20%

33

deduction would be 7% compared to 8% previous as noted
above.
Capital Gains. In an exit or other asset sale, the preIPO owner would be taxed once, generally at a 20% rate
(subject to exceptions for recapture and other items), and thebuyer would obtain a step-up in tax basis reflecting its
purchase price. In a traditional corporate structure, underprior law, that sale could be taxed twice, once at a maximum
35% rate to the corporation, and once at a maximum 20%
rate to the shareholder on the remaining 65%, as discussed
above, or a combined rate of 48%. Alternatively, the sharesof the corporation could be sold, but the buyer would not
obtain a stepped up tax basis in the assets and would
presumably discount the purchase price accordingly.
Under the TCJA, the double tax would aggregate
36.8%. In both cases, the comparison would be to theindividual’s 20% rate, so what had been a 28% benefit is now
reduced to about 17% under the TCJA. Also, any discountapplied by a buyer of shares would reflect the 21% corporate

34

rate rather than the prior 35% rate, and thus presumably
would be lower. Nevertheless, the UP-C benefit for pre-IPO
owners at the OP level versus the traditional C corporation
structure remains significant.
b.

TRA

As noted above, in an UP-C structure, exchanges by
OP unitholders create a stepped-up tax basis to the C
corporation, and parties generally enter into a TRA underwhich the corporation pays a portion of that benefit(generally 85%) to the exchanging unitholder. Because the
TCJA reduced the top corporate tax rate from 35% to 21%,the step-up tax benefit will generally be smaller, leading tosmaller TRA payments. Given the continuing (albeit lower)
value of step-up benefits, however, TRA arrangements will
presumably continue.
C.

UP-PTPs
1.

Background

In February 2007, the Fortress Investment Group
closed its initial public offering and became the first of a35

wave of investment fund sponsors using umbrella partnership
structures with a publicly traded partnership, or UP-PTP.
After the Fortress transaction closed, several other private
investment fund sponsors went public using a similar
structure, including Och-Ziff, 47 Blackstone, 48 KKR, 49

47

See Form S-1 of Och-Ziff Capital Management GroupLLC (filed with the SEC on July 2, 2007).

48

See Form S-1 of the Blackstone Group L.P. (filed with the
SEC on March 22, 2007).

49

See Form S-1 of KKR & Co. L.P. (filed with the SEC on
July 3, 2007).

36

Carlyle, 50 Oaktree, 51 and Ares. 52 The UP-PTP structure,
which substitutes a publicly traded partnership for a
corporation as the public vehicle, follows the same general
contours of the UP-C structure. The UP-PTP structure
generally affords an investment fund sponsor all of thebenefits present in a typical UP-C structure and may also
provide additional benefits over UP-C, as described below.

50

See Form S-1 of the Carlyle Group L.P. (filed with the
SEC on Sept. 6, 2011).

51

See Form S-1 of Oaktree Capital Group, LLC (filed with
the SEC on July 17, 2011). The IPO of the investmentbank Lazard Ltd. in 2005 is an interesting footnote in thehistory of UP-C and UP-PTP structuring. Lazard wasactually an UP-PTP structure that preceded the IPOs of
Blackstone and Fortress by a couple of years. However,Lazard’s use of a PTP structure appears to have been
structured in an effort to avoid the application of thesection 7874 anti-inversion rule. The anti-inversion rules
were later revised to treat foreign PTPs as U.S.
corporations in certain circumstances. See 71 FR 32437,
TD 9265 (June 6, 2006); TD 9453 (June 9, 2009). For agood general discussion of the Lazard IPO and section
7874, see Robert S. Bernstein, “Use of Foreign Publicly
Traded Partnerships and the Lazard IPO,” 32 Corp. Tax’n45 (2005).

52

See Form S-1 of Ares Management, L.P. (filed with the
SEC on April 28, 2014).

37

Many of the investment fund sponsors that went
public using the UP-PTP structure, however, have sinceconverted to the UP-C structure or a regular C corporation
structure. 53 Blackstone, KKR, Apollo, Ares, and Och-Ziff
have all converted to the UP-C structure in the recent past, 54
while Carlyle has converted to a regular C corporation

53

Fortress ended its usage of the UP-PTP structure when it
was acquired by SoftBank. https://www.fortress.com/
shareholders/news/2017-12-27-softbank-group-completesacquisition-of-fortress-investment-group. Similarly,
Oaktree ceased to use the UP-PTP structure after it
engaged in a business combination transaction with
Brookfield Asset Management.
https://ir.oaktreecapital.com/k-1-and-tax-information.

54

See https://www.blackstone.com/the-firm/pressreleases/article/blackstone-completes-conversion-to-acorporation; https://media.kkr.com/news-releases/newsrelease-details/kkr-completes-conversion-corporation-andannounces-2018-investor;
https://www.globenewswire.com/newsrelease/2019/09/05/1911352/0/en/Apollo-GlobalManagement-Completes-Conversion-to-a-Corporationand-Provides-Details-Regarding-2019-Investor-Day.html;
https://www.aresmgmt.com/about-ares/news/aresmanagement,-lp-completes-corporate-conversion-and-isrenamed-ares-management-corporation;
https://shareholders.sculptor.com/k-1-and-taxreporting/default.aspx. Och-Ziff was renamed Sculptor
Capital Management several months after its conversion to
the UP-C structure.

38

structure. 55 Issuers have undertaken these conversions
despite the fact that the C corporation in the UP-C structure
is subject to an entity-level tax, which makes the UP-C
structure less tax efficient than the UP-PTP structure as a
general rule, although the TCJA’s corporate rate reductionlessened this impact. Both Blackstone and KKR noted thatthe change was designed to broaden their respective investor
bases through two main mechanisms. 56 First, certain
investors wish to avoid receiving tax information reporting in
the form of IRS Schedule K-1 due to the complexity of that
form, 57 and converting to the UP-C structure allows such
55

See https://www.carlyle.com/media-room/news-releasearchive/carlyle-group-completes-conversion-corporation.

56

See https://media.kkr.com/news-releases/news-releasedetails/kkr-completes-conversion-corporation-andannounces-2018-investor;
https://s1.q4cdn.com/641657634/files/doc_financials/2019/q1/SupplementalMaterialsCorporateConversion.pdf.

57

See http://www.whartonugpevc.com/articles /2018/3/29/
ares-management-makes-corporate-conversion (“Under
the limited partnership structure common amongalternative asset managers, ordinary investors were mostly
prevented from participating, due to the extremelycomplex Schedule K-1 tax reports.”).

39

investors to receive IRS Form 1099-DIV instead of Schedule
K-1. Second, the UP-C structure may permit an investment
fund sponsor’s stock to be included in certain market
indices, 58 which in turn may encourage certain passive
institutional investors, such as mutual funds, to buy and own
the investment fund sponsor’s stock. 59 Ares mentioned that –58

See https://s1.q4cdn.com/641657634/files/doc_financials/2019/q1/SupplementalMaterialsCorporateConversion.pdf(noting that the conversion “[r]emoves restrictions for [a]substantial portion of [the] index/ETF market[,]” making
Blackstone stock “[e]ligible for inclusion in CRSP,MSCI[,] and Total Market Indices”).

59

See http://www.whartonugpevc.com/articles/2018/3/29/
ares-management-makes-corporate-conversion(“Institutional investors were . . . often restricted frominvesting, since partnerships are excluded from both index
funds and exchange-traded funds.”);https://www.wsj.com/articles/blackstone-to-becomecorporation-swapping-from-partnership-structure11555588261 (“. . . [private equity] firms hope [convertingto the UP-C structure] will make their stock more
attractive to mutual funds and other institutional investors.
Those investors typically don’t invest in publicly tradedpartnerships.”);https://www.bloomberg.com/news/articles/2019-0418/blackstone-plans-to-convert-to-a-corporation-after-kkrares (“Blackstone said . . . that it expects the conversion
will make it vastly easier to own its stock, estimating it
will initially remove restrictions on at least $4.5 trillion of
investor capital in the U.S.[.] That would substantially40

in addition to expanding its investor base – its own
conversion from the UP-PTP structure to the UP-C structure
had the goals of improving liquidity and trading volume. 60
While the strong trend towards converting to the UPC structure has rendered the UP-PTP structure somewhat of arelic, 61 there are certain important differences between thetwo structures and some significant incremental tax benefitsof using an UP-PTP structure versus an UP-C structure –benefits that may become more relevant if corporate tax rates
are ever increased above their post-TCJA levels. The mostimportant such difference relates to the fact that, as discussed
below, many investment funds generate significant amountsof “qualifying income” for purposes of the rules governing

close the gap between Blackstone’s valuation and that ofother top companies.”).
60

https://www.aresmgmt.com/about-ares/news/aresmanagement,-lp-reports-fourth-quarter-and-full-year2017-results?id=8622.

61

A noteworthy exception to the trend is Lazard, which hasretained its UP-PTP structure. See Form 10-K of Lazard
Ltd (filed with the SEC on February 26, 2019).

41

PTPs. To appreciate the reasons why an UP-PTP might beused by private fund sponsors and the significant incremental
benefits that flow from such structures, a digression into thestructure and business of private equity and hedge funds, aswell as the relevant PTP rules, may be useful.

2.

The Nature of a Fund Sponsor’s Income
In private investment funds, fund managers are

generally entitled to a profits interest in excess of their capitalinterest (a “carry” or “carried interest”) and a management
fee, which is often calculated as a percentage of fundcommitments or invested capital. The specific structures
used vary greatly between fund sponsors, but below is a basic
structure for a typical private equity fund.

42

Sponsors

100%

100%

ManagerGP

LPs
Carried Interest

Management Fee

Fund

As the diagram shows, the fund sponsor receives its
two income streams – carry and management fees – throughdifferent vehicles. The carried interest is received by thesponsor in its capacity as the general partner of the fund andis generally structured as a “profits interest.” Under current
law, the receipt by a service provider of a profits interest,
which entitles the service provider only to share in future43

profits, is generally not a taxable event at the time of grant. 62
Rather, the service provider is taxable only on its allocable
share of future partnership profits.
The management fee, on the other hand, is received
by the adviser entity – typically a different entity than thegeneral partner – pursuant to a management contract, and not
as an interest in the partnership. In this regard, themanagement fee would generally be taxable as ordinary
income for services and not as a distributive share of income
from the fund. Generally, both the general partner and the62

See Rev. Proc. 93-27 (IRS generally will not attempt totreat transfer of a partnership profits interest to a partner
for services as a taxable event); Rev. Proc. 2001-43(supplementing Rev. Proc. 93-27). Prior to the issuance ofRev. Proc. 93-27, it was uncertain whether the IRS would
successfully take the position that receipt of such a profits
interest was nontaxable. Compare Sol Diamond, 56 T.C.
530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974) (taxable)with Campbell v. Commissioner, 943 F.2d 815 (8th Cir.
1991) (nontaxable). Under proposed regulations issued in
2005, the partnership and all of its partners would be
required to elect treatment under which receipt of apartnership interest would be taxable in the amount of theinterest’s liquidation value. See Prop. Treas. Reg. section
1.721-1(b) and section 1.83-3(l), 70 FR 29675 (May 24,2005).

44

entity organized to act as the adviser would be treated as
partnerships for tax purposes.
3.

The PTP Rules – 90% Qualifying Income
Exception
Subject to certain exceptions, a PTP is treated as acorporation for U.S. tax purposes. For this reason, a typicaloperating business, such as those that have used the UP-C
structure described above, could not maintain its status as apartnership upon becoming a publicly traded company.
There is, however, an exception to the general rule treating
PTPs as corporations for companies 90% or more of whose
income constitutes “qualifying income” within the meaningof section 7704(d) and applicable Treasury regulations.
Qualifying income generally includes interest, dividends,
rents from real property and gains from the disposition of real
property, or of a capital asset (or property described in
section 1231(b)) that is held for the production of income thatis qualifying income. 63
63

Qualifying income under section 7704(d) also includes
income or gains derived from a broad category of activities45

As discussed above, the carried interest in a fund isgenerally structured as a partnership interest in the entities
through which the fund makes its investments. Accordingly,
the income generated by the carried interest takes its
character from the partnership’s underlying income. For
example, if a fund makes investments in entities treated ascorporations for U.S. tax purposes, the income generated by
the fund and any distributive share allocable to the carriedinterest would generally consist of dividends and capitalgain, both of which constitute qualifying income. On theother hand, to the extent a fund’s income constitutes fees orincome from operating entities owned in pass-through form,
such income would not generally constitute qualifying

related to mineral or natural resources, income and gains
derived from commodities (not described in section
1221(a)(1)) or futures, forwards, and options with respect
to commodities, and income from categories relevant
under the REIT and RIC qualification tests. The
regulations expand the definition of qualifying income toinclude certain other types of investment income. See
Treas. Reg. section 1.7704-3(a).

46

income. In this respect, management fees would not
generally satisfy any of the categories of qualifying income.
4.

The UP-PTP Structure
As mentioned above, an UP-PTP is structured much

like an UPREIT or UP-C, but with a PTP employed as thevehicle in which the public invests through an offering oflimited partner units in the PTP. The sponsors control thebusiness through a general partner interest in the PTP, andmay exchange their non-publicly traded equity for the
publicly traded PTP units. The operating business initiallyowned by the sponsors is typically an investment fundmanager that earns (through separate entities) nonqualifying
income in the form of management fees, and qualifying
income in the form of capital gains, with the nonqualifying
income often exceeding 10% of the total income of theoperating business. The PTP will invest in the portion of theoperating business that generates nonqualifying income
through a corporate subsidiary. Though the underlying
income earned by the corporation would not constitute47

qualifying income, from the perspective of the PTP, the only
income that would be realized would be in the form of
dividends and capital gains – both of which are forms of
qualifying income. In this way, the PTP can satisfy the 90%
test and preserve the benefit of avoiding an entity level tax
with respect to any income not earned through thecorporation. Therefore, unlike operating companies whose
only option is an UP-C structure (or simply a corporation
without an umbrella partnership), private investment firms
can use a PTP vehicle as the public vehicle and thereby avoid
a second layer of tax on qualifying income such as that
attributable to carried interest.
5.

Retaining Flow-Through Treatment; Step-Up for the
PTP

As in a standard UP-C structure, the fund sponsors in
an UP-PTP are able to continue to enjoy the benefits of fullpass-through treatment prior to exchanging their interests andexiting. Ownership through the PTP entails bearing
corporate income tax on the portion of the income passing
through the subsidiary corporation, which the holders of48

interests in the umbrella partnership avoid. In addition, as in
the typical UP-C IPO structure, sponsors generally benefit
from a TRA allowing them to monetize a portion of thedepreciation and amortization deductions recognized by the
corporation in connection with the corporation’s acquisitionof interests from the sponsors. 64
6.

Additional Umbrellas

Because it may be necessary to use a corporate
subsidiary for income that would not constitute qualifying
income for purposes of the PTP rules, UP-PTPs generally use
at least two umbrella partnerships – one umbrella partnership
whose income is “good” income for PTP purposes and whichflows directly (or through one or more flow-through entities)
up to the PTP, and one umbrella partnership whose income is64

The anti-churning rules of section 197(f)(9) deny anamortization benefit for intangible assets that have been
held or used by the taxpayer or a related person at any time
between July 25, 1991 and August 10, 1993. In the UPPTP context, the anti-churning rules would not apply to abasis increase under section 743 so long as the corporation
is not related to the exchanging holder. See Treas. Reg.
section 1.197-2(h)(12)(v).

49

“bad” income for PTP purposes and flows up to the corporate
subsidiary owned by the PTP. Additional umbrella
partnerships may be used if, for example, an additional
foreign corporation is used for foreign income that would notnecessarily constitute qualifying income.
The principles of structural parity present in the
UPREIT and UP-C structures must also be present in the UPPTP structure. Maintaining this parity requires the holder ofinterests in the umbrella partnerships to own the same
number of units in each such partnership. The sum of the
distributions received by the sponsors with respect to all of
their umbrella partnership interests are then the same as whata holder of the equivalent PTP units would receive (less any
taxes or costs in the public structure). The umbrella
partnership units are exchangeable for interests in the PTP at
a ratio of one unit in all umbrella partnerships for one PTP
unit.

50

7.

TCJA Effects

As noted above, the TCJA includes a number ofprovisions that affect partnerships, but it includes noprovisions expressly addressing UP-PTPs. Under the TCJA,

51

individuals holding PTP units can generally claim adeduction equal to 20% of income effectively corrected witha US business that is allocable to them from the PTP (otherthan capital gains). 65 As also noted above, the TCJA reduced
the top tax rate on C corporations from 35% to 21%, reduced
the top personal tax rate from 39.6% to 37% and provided a
20% deduction for certain partnership business income
allocated to partners who are individuals. 66 As a result of
those changes, the benefit of flow-through treatment at the
OP level relative to holding the entire business through a C
corporation has lessened somewhat, but is still generally
significant. 67 Moreover, as discussed above in the UP-C
structure the TRA benefit to exchanging OP unitholders willcontinue albeit at a lower amount in light of the reduction incorporate tax rates under the TCJA.

65

See section 199A(c)(1) as added to the Code by TCJA
section 11011.

66

See note 25 above.

67

See discussion above at I.B.3.

52

The benefit at the PTP level relative to an UP-C has
always been a function of how much income the PTP had toearn through a corporate subsidiary. Often, the income of the
PTP not earned through a corporate subsidiary is long-term
capital gain or dividend income. A PTP can continue to earnsuch gain or income without an entity-level tax (and a 20%
tax to individuals holding PTP units) whereas in the UP-C
structure, the public C corporation would pay tax at a top rateof 21% (and an individual holding shares and receiving adividend of the 79% being taxed at a top rate of 20%, for an
aggregate of about 37% (21% plus 20% of 79%). Other
income not earned through a corporate subsidiary of the PTP
and allocated to an individual unitholder will be taxed to theunitholder at a top rate of 29.6% (if the 20% deduction isavailable or 37% (if no 20% deduction is available), but
again with no entity level tax. Thus, for a PTP earning
substantial income or gain directly and not through a
corporate subsidiary, a significant benefit to the public entity53remains even after enactment of the TCJA in an UP-PTP
versus an UP-C structure.
II.

Tax Receivable Agreements
As mentioned above, TRAs have become an integral

part of umbrella partnership IPO structures. In fact, umbrella
partnership sponsors often insert provisions in shareholder
agreements, partnership agreements and even debt
documents that contemplate the potential use of a TRA inconnection with a public exit. However, while umbrella
partnership IPO structures have made TRAs morecommonplace, TRA arrangements predate the use ofumbrella partnerships. This section describes some of thehistory of TRAs, both prior to, and including their use inumbrella partnership structures, and then describes common
features of umbrella partnership TRAs and their tax treatment
to the beneficiaries.

54

A.

First Generation TRAs not Involving UmbrellaPartnerships
1.

O’Sullivan Industries, Inc. – 1994

One of the earliest reported TRAs was entered into in
1994 by O'Sullivan Industries Holdings, Inc., (“O’Sullivan”)
a designer and manufacturer of furniture products. 68 Prior toits 1994 IPO, O’Sullivan was owned by Tandy Corporation.
In connection with its IPO, O’Sullivan entered into a “taxsharing and tax benefit reimbursement agreement” with
Tandy. This agreement was based on the fact that the IPO
was structured as a “qualified stock purchase” (or “QSP”)
under section 338, 69 resulting in a step-up in the tax basis of
O’Sullivan’s assets. Under the tax sharing and tax benefit

68

The TRA in O’Sullivan is described in the registration
statement associated with the going-private transaction of
the company in 1999. See Form S-4/A of O’Sullivan
Industries Holdings, Inc. (filed with the SEC on October
29, 1999).

69

See the discussion below of the “supercharged” IPO of
Genworth Financial. See also FSA 2111 (June 2, 1997)(addressing the IRS’s analysis of a qualified stock
purchase IPO structure).

55

reimbursement agreement, O’Sullivan agreed to pay Tandy“nearly all” of any tax benefits it received as a result of theincreased deductions. 70
2.

Endo Pharmaceuticals – 2000
In 1999, in connection with its IPO, Endo

Pharmaceuticals Holdings Inc. (“Endo”) acquired all of thestock of Algos Pharmaceutical Corporation (“Algos”) in
exchange for Endo stock and warrants to purchase additional
Endo stock. As a result of the transaction, the historicalEndo stockholders owned approximately 80% of the
combined company, and former Algos stockholders owned
20%. 71 At the time of the transaction, Endo employees held
a number of outstanding and unexercised Endo stock options.

70

Five years after the IPO, O’Sullivan was acquired in aleveraged buyout. A controversy arose between the parties
as to the effect of the newly incurred acquisition debt on
the payments required to be made under the tax agreement.
The disagreement resulted in litigation between the parties.
See O’Sullivan S-4/A.

71

See Form S-4/A of Endo Pharmaceutical Holdings Inc.
(filed with the SEC on June 14, 2000).

56

To ensure that any post-transaction exercise of these options
would dilute only the historical Endo shareholders, Endo
agreed to use its reasonable best efforts to cause the historicalEndo stockholders to contribute their shares of Endo
common stock to a newly formed LLC subsidiary, Endo
Pharma LLC (“Endo Pharma”). Endo Pharma agreed toprovide the Endo stock due to an employee upon such
employee’s future exercise of an option.
Though it was Endo Pharma that assumed theobligation to provide Endo stock upon exercise of theoptions, as a matter of tax law, it was Endo that would
receive the corresponding compensation deduction. Thus,
the parties entered into a tax sharing agreement which
provided that Endo would pay Endo Pharma (and indirectly,
the transferring shareholders) any tax benefits realized as aresult of these option exercises. The payments to Endo
Pharma were required only upon the occurrence of certain57

“liquidity events,” and equaled 100% of the tax savings
attributable to the compensation deductions at issue. 72
Although the tax sharing agreement and the relevantfacts in the Endo transaction were somewhat unique, it isimportant as an early example of equityholders’ negotiating
for the right to additional, contingent consideration on adisposition of property based on tax benefits expected to beenjoyed by the acquirors.

72

The tax savings were to be measured on a “with andwithout” basis. The Endo agreement actually included an
example in order to illustrate the computation: “By way of
example, and solely for the avoidance of doubt, if Endo
has a loss for tax purposes in Year 1 of $100, consisting of$65 of deductions attributable to the exercise of Endo LLC
Options and $35 of deductions attributable to interest
expense, and in Year 2 Endo has $40 of taxable income
prior to application of the NOL, $35 of the $40 NOL
applied against Year 2 income will be deemed to be
attributable to the interest expense and $5 of the NOL will
be deemed attributable to the exercise of the Endo LLC
Options. Therefore, the Tax Benefit Amount would be theTaxes that would have been payable by Endo if its NOL in
Year 2 had been only $35. The NOL carryforward to Year
3 of $60 would then be treated as consisting entirely of
deductions resulting from the exercise of the Endo LLC
Options.” Form of Tax Sharing Agreement (attached as
Exhibit G to Appendix A of Endo Pharmaceutical
Holdings’ S-4/A).

58

3.

“Supercharged” IPO – Genworth Financial – 2004
In 2004, General Electric (“GE”) sold a substantial

portion of its insurance business by offering shares of
Genworth Financial (“Genworth”) to the public in an IPO. In
the transaction, a GE subsidiary transferred shares of several
subsidiaries to Genworth in exchange for Genworth stock.
As part of a plan, GE sold 30% of the Genworth stock to the
public through a firm-commitment underwriting. 73 GE did
not contractually obligate itself to dispose of any additional
Genworth equity beyond the 30%, but it did state that it“expect[ed] to reduce its interest to below 50% within two
years of the completion of this offering.” 74
73

See Prospectus of Genworth Financial, Inc. (filed with the
SEC on May 25, 2004). The underwriters also had an
overallotment option covering another 4% of the
Genworth stock.

74

Genworth Prospectus. Selling more than 50% of its
interest was necessary to qualify the transfer as a QSP, as
described in the text immediately below. In the private
letter ruling issued to GE in connection with thetransaction, GE actually represented to the IRS that “Asale to the public of less than 50% of [Genworth] (after the[[s]ubsidiaries] have been transferred by [GE] to[Genworth]) would not achieve the objectives of [GE] inconnection with the planned disposition of the59

By selling more than 30% of its Genworth stock in
the IPO transaction to persons not treated as transferors forpurposes of section 351, GE was able to “bust” the tax-freenature of the contribution to Genworth. In addition, bycommitting to reduce its ownership in Genworth to below
50%, the transfer of assets to Genworth could be treated as a
QSP under section 338. 75 Since the exchange was treated as a[[s]ubsidiaries]. In addition, [GE] would not affect the
proposed transfer of the [[s]ubsidiaries] to [Genworth] andthe Initial Public Offering without being reasonably
certain, based on advice received from their financial
advisers, that they will be able to effect a disposition of
sufficient additional shares of [Genworth] to reduce theirownership of [Genworth] below 50% through one or more
additional public offerings.” PLR 200427011.
75

Section 338(d)(3) defines a QSP as a transaction, or seriesof transactions within a 12-month period, in which thepurchasing corporation acquires, by means of a statutory
purchase, stock possessing at least 80 percent of the voting
power and value of the target's outstanding stock(excluding certain “plain vanilla” preferred stock). A“purchase” is defined in section 338(h)(3) and excludes
certain tax-free acquisitions or transactions between
related entities. Specifically, under section
338(h)(3)(A)(iii), an acquisition is not a “purchase” if thestock is acquired from “a person the ownership of whose
stock would, under section 318(a) (other than paragraph(4) thereof) be attributed the person acquiring such stock.”
For these purposes, the relevant attribution rule is section
318(a)(3)(C), which is triggered by an ownership

60

QSP, GE was able to elect under section 338(h)(10) to treat
the transfer of shares as a taxable asset acquisition for U.S.
federal income tax purposes. Accordingly, Genworth
obtained a stepped up, fair market value tax basis in theacquired insurance assets. 76 In connection therewith, GE
entered into a “Tax Matters Agreement” with Genworth
which required Genworth to pay GE 80% of the tax savings
resulting from this tax basis increase. 77

percentage of 50%. Accordingly, by committing to sellmore than 50% of the Genworth stock in connection withthe transaction, GE was able to avoid this relatedness ruleand thereby avoid this exception to the statutory“purchase” definition.
76

For a discussion regarding the applicability of the antichurning rules of section 197 to the Genworth IPO, see
Robert Willens, “General Electric ‘Supercharges’ the
Genworth Financial IPO,” 104 Tax Notes 661 (Aug. 9,2004). See also Treas. Reg. section 1.197-2(h)(8) andTreas. Reg. section 1.197-2(k), Ex. 24.

77

The magnitude of the TRA payments (excluding certain
contingent payments and interest) was capped at $640
million, but this cap could increase if the estimates done at
the time of the IPO proved inaccurate. See Genworth
Prospectus.

61

B.

Umbrella Partnership TRAs
1.

Background

Although it did not feature a TRA, thebarnesandnoble.com IPO was significant in that it introduced
a structure that afforded companies a basis step-up inconnection with initial public offerings and on-going
secondary market sales by sponsors. Lazard, in 2005,
appears to have been the first issuer to combine a TRA withan umbrella partnership structure to allow the sponsors toshare in the benefit of this step-up. Since then, employing a
TRA has become fairly standard in public UP-C or UP-PTP
transactions. The following sections describe some of thecommon terms of the TRAs used in connection withumbrella partnership IPOs, as well as certain innovations or
enhancements that have emerged in the market.
2.

Overview of Basic TRA Terms
Certain terms have become fairly standard in TRA

arrangements in umbrella partnership structures. TRAs
typically provide that the umbrella partnership have in effect62

an election under section 754 for each taxable year in which
an exchange occurs. This election will result in a basis
adjustment to partnership assets in the case of taxable
exchanges (via section 743(b)) and partnership distributions(via section 734(b)). 78 Below is a summary list of some of
the more typical features of TRAs.
Supporting Documentation. The public corporation isrequired to deliver to the exchanging partner (or other TRA
beneficiary) within a specified number of days following thefiling of its U.S. federal income tax return, 79 a schedule
showing the basis adjustments triggered by any exchanges,
along with the computation of any “realized tax benefit” forthe year. This schedule, as well as supporting work papers, issubject to standard dispute resolution and reconciliation
procedures that are spelled out in the TRA.

78

Basis adjustment under section 1012 or section 732 may
also be relevant in the event that an exchange results in the
OP being treated as a disregarded entity for U.S. federal
income tax purposes.

79

This period is typically 45, 90 or 180 calendar days.

63

Payment of Realized Tax Benefits. Within a specified
number of days of the schedule’s becoming final, thecorporation is required to pay the partner a “tax benefit
payment” equal to 85% 80 of the realized tax benefit for theyear attributable to the exchange, plus interest at an agreed
rate (computed from the due date of the applicable tax
return). 81 The tax benefit for the year is computed by80

Nearly all umbrella partnership TRAs provide for an
85%/15% split of tax benefits. A few notable exceptions
are Virgin Mobile USA Inc. (100%), Crumbs Bake Shop,
Inc. (75%) and Spirit Airlines, Inc. (90%). The Spirit
Airlines, Inc. TRA, however, does not relate to tax basis
adjustments, but instead relates to the use of net operating
losses that existed at the time of the IPO. This TRA
innovation is discussed more fully below. One
commentator has noted that “[t]here’s no magic to the
85/15. It was something that was developed in the early
deals that has stuck.” Amy S. Elliott, “IPO Agreementsthat Shift Basis Step-Up to Sellers Proliferate,” 132 Tax
Notes 334 (July 25, 2011) (quoting Phillip Gall at a May
2011 PLI conference).

81

The TRAs typically also provide for additional payments(or negative adjustments) if a schedule is amended as aresult of (i) determinations by taxing authorities, (ii)material inaccuracies, (iii) changes as a result ofcarrybacks or carryforwards of tax items, and (iv)
payments under the TRA itself (which have the effect offurther increasing basis, as discussed below).

64

comparing the hypothetical 82 tax obligation that would havebeen due in the absence of the basis adjustments (and in theabsence of any imputed interest attributable to TRA
payments under the Code provisions dealing with interest on
deferred sale transactions, such as section 483), 83 with the82

The defined term for this hypothetical tax liability is
generally the “Non-Stepped Up Tax Liability,” or the“Hypothetical Tax Liability.”83

In the typical TRA arrangement, the taxable exchange by
pre-IPO owners of their interest in the umbrella
partnership triggers the payment obligations under the
TRA. Since those exchanges are taxable sales, any
additional payments made to the pre-IPO owners in
respect of such exchange (whether pursuant to the TRA
itself or otherwise) are analyzed as additional saleconsideration giving rise to further basis adjustments.
Since TRAs will always provide for payments beyond theyear in which the initial exchange occurred, a portion of
the amounts paid to such exchanging equity holders will
be recharacterized as “unstated interest” under section 483.
These recharacterized payments, in turn, will give rise tointerest deductions benefitting the public company, and thebenefits attributable to these interest deductions are
typically covered under the TRA. The portion of the TRA
payments that are not recharacterized as unstated interest
are treated as additional purchase price, which serve tofurther increase the basis of the partnership’s assets(sometimes referred to as “step-up on the step-up”). In thecase of intangible assets amortizable under section 197(which comprise much of the value of TRAs), theadditional basis is amortized ratably over the remainder ofthe 15-year amortization period, beginning with the first65

actual tax liability for the year (i.e., on a “with and without”
basis). 84
Company’s Right to Terminate. Typically, the publiccompany can elect to terminate the TRA at any time withrespect to some or all of the partnership interests held by the
pre-IPO owners. In such event, the company is required to
pay to the TRA beneficiaries an “early termination payment.”
The early termination payment is generally defined as thepresent value (using an agreed-upon discount rate) of all tax
benefit payments that would have been required to be madeto the applicable partner under the TRA, using certain“valuation assumptions.” These assumptions include (1) for

day of the month in which the basis increase occurs.
Treas. Reg. 1.197-2(f)(2)(i).
84

Since the rules that mandate basis adjustments can also
create a step-down in tax basis, TRAs will typically referto a “realized tax detriment,” which represents the excessof the company’s actual taxes over the hypothetical tax
obligation that would have been due in the absence of thebasis adjustment. These tax detriments, where applicable,
can serve to adjust downward any tax benefit paymentsthat would otherwise be due.

66each taxable year ending on or after termination date, thecompany will have sufficient taxable income to use thedeductions arising from the basis adjustments (as well as theimputed interest deductions) during such taxable year, (2) thetax rates in effect as of the early termination will remain in
effect, (3) loss carryovers available as of the termination will
be used on a pro rata basis for each year following thetermination, and (4) all unexchanged partnership interests are
actually exchanged as of the termination date. 85
Change of Control. In the event of a “change ofcontrol,” the TRA payments will be calculated based on
certain assumptions intended to avoid significant distortions

85

The valuation assumptions also include assumptions as tothe timing of the disposition of nonamortizable assets.
Specifically, nonamortizable assets are customarily treatedas being disposed of on the 15th anniversary of the relevant
basis adjustment (or other appropriate period depending
upon an assumed holding period for the asset). Private
investment fund TRAs (i.e., the UP-PTPs) typically also
provide that “private equity fund related assets” aredeemed to be disposed of pro-rata over the number ofyears remaining under the applicable fund agreement.

67

that may otherwise result from the company’s inheriting oftax attributes from M&A counterparties. 86
Subordination. Payments under the TRA are
typically subordinated to any payments due in respect ofindebtedness of the company and its subsidiaries. 87
Late Payments. Late payments under the TRA willbear interest at an agreed rate. 88
TRA Term. The TRAs typically have a term that lasts
until all relevant tax benefits have been used or have expired(or until an early termination of the TRA).
3.

Additional TRA Provisions and Variations
Although the TRA terms described above are typical,

the terms of a given TRA may vary significantly from the

86

These assumptions are described in greater detail in
II.B.3.c) below. Also as discussed below, a TRA may
alternatively provide that a change of control is anacceleration event.

87

See the discussion regarding creditor issues in II.B.3.e)
below.

88

The most common rate used for late payments attributable
to lack of available cash is LIBOR plus 100 basis points.

68

above terms. This section discusses certain issues andpressure points that arise in the negotiation of TRAs. As
described below, some of these issues are not necessarily
unique to umbrella partnership TRAs, but are discussed here
because of their significance to TRAs in general.
a)

New Basis versus “Historic” Basis

In general, TRAs compensate sponsors for a portionof the value of the step-up in basis to the corporation
resulting from the IPO or future exchanges. Thesearrangements are premised on the assumption that the publicdoes not value such tax benefits and therefore would pay thesame amount for shares of a company that did not own these
attributes. However, there have been at least seven TRAs
that provide for the payment of tax benefits attributable to theamortization of all tax basis in certain assets, and not simply
the step-up in tax basis resulting from taxable exchanges by
pre-IPO owners.
In 2007, Duff & Phelps Corporation, a financial
advisory and investment banking firm, sold its shares in an

69initial public offering. In connection with the IPO, thecompany entered into a TRA with the existing unitholders ofDuff & Phelps Acquisitions, LLC, through which thebusiness had been run. The TRA, like the ones describedabove, provided for the payment by the corporation to theexchanging unitholders of 85% of the tax benefits
attributable to basis increases triggered by such exchanges.
However, the agreement also provided for the payment of
85% of any tax benefits attributable to “IPO Date Intangible
Assets.” This includes any historic tax basis in such assets. 89
The way this economic term was implemented was toprovide in the agreement that in computing the “Hypothetical
Tax Liability” of the corporation, the “Non-Stepped Up Tax

89

Form of Tax Receivable Agreement (filed with the SEC as
Exhibit 10.6 to Form S-1/A of Duff & Phelps Corporation
on September 21, 2007). The TRA defined “IPO Date
Intangible Assets” as “each asset that is held by [Duff &Phelps Acquisitions LLC], or by any of its direct orindirect subsidiaries treated as a partnership or disregarded
entity for purposes of the applicable Tax, immediately
prior to the IPO Date and is described in Section 197(d) of
the Code.”70Basis” of the “IPO Date Intangible Assets” is deemed to be
zero. Although an exchange of units was still necessary to
trigger a payment under the TRA, the actual computation for
the relevant year would reflect not only the amortization of
the increased basis created by the exchange, but also by anyother amortization of basis for such asset during the relevant
year. 90
Although this TRA feature is somewhat unique, itsjustification is not all that different from the “base case” TRA
that calls for contingent consideration to be paid to sponsors
by virtue of tax basis that will arise in the future. According
to one tax practitioner, “[i]t’s true that the corporation would
have gotten that existing basis even in a full-on
incorporation, but if investors value stocks based on

90

Other issuers that have also used “historic basis” TRA
arrangements include DynaVox, RE/MAX Holding,
GoDaddy, Virtu Financial, Planet Fitness, and HostessBrands.

71

EBITDA, the investors wouldn’t have taken into account any
tax basis from existing basis either.” 91
b)

NOLs

A few recent IPO issuers have used TRAs thatcompensate pre-IPO owners for tax attributes (mostsignificantly, net operating losses) that exist at the time of the
IPO and that the now publicly traded business expects to beable to use to reduce its tax burden going forward. 92 Thesearrangements do not relate to future increases in tax basis,but instead compensate pre-IPO owners for future realizationof tax attributes that the public company can use from day
one. Although these arrangements have arisen primarily in
UP-C transactions, a TRA that is based on NOLs has no
specific connection to an umbrella partnership structure, butrather is based on the fact that a business may go public using

91

Elliott, supra note 80 (quoting Gall).

92

Virgin Mobile actually implemented a TRA in 2007 basedon the utilization of NOLs that existed at the time of its
IPO.

72

a vehicle that has (or whose subsidiaries have) significant
loss carryforwards.
An NOL-based TRA was used in connection with the2010 IPO of Graham Packaging. Graham Packaging
employed an UP-C IPO structure, using an existing
corporation controlled by a sponsor group that had been usedas the vehicle to acquire interests in the Graham operating
partnership in 1998. The 1998 acquisition gave rise to a
stepped-up basis (and resulting amortization deductions) thatleft the corporate “blocker” entity with a significant amountof NOL carryforwards. Graham Packaging entered into a
TRA based on these NOL carryforwards, 93 which provided

93

The Graham Packaging transaction actually featured two
separate TRAs, one of which was comparable to the more“typical” TRA that is based on future taxable exchanges
by historic equityholders of their partnership interests.
Additionally, the TRA relating to the NOLs, covered otherattributes as well, specifically, capital losses, charitabledeductions, AMT credit carryforwards, and a prior basis
step-up that arise as a result of an earlier capitalization.

73

for the payment to the corporation’s shareholders of 85% of
the cash tax savings attributable to these NOLs. 94
c)Impact of Change of Control Transactions
on TRAs

Nearly all umbrella partnership TRAs contain special
provisions dealing with “change of control” transactions
involving the public company. A change of control isusually defined, with some variations, as any of the following
events: (i) a person or group of persons becoming thebeneficial owner of 50% 95 of the company’s stock; (ii) the
directors of the company as of the IPO date ceasing toconstitute a majority of the board; (iii) an adoption of a planof liquidation of the company (other than a liquidation into
an entity under common control by the company’s
shareholders); and (iv) a merger or consolidation of thecompany or any of its subsidiaries unless (1) the company’s

94

See “Monetizing the Shield: Tax Receivable Agreements
in Private Equity Deals,” Debevoise & Plimpton Private
Equity Report, Fall 2010, Volume 11, Number 1.

95

In the Lazard TRA the threshold percentage was 20%.

74

board immediately prior to the transaction continues toconstitute a majority of the board, and (2) the company’s
shareholders continue to own more than 50% of the voting
power of the company. 96
The consequence of a change of control transaction
will typically be that the valuation assumptions describedabove (in connection with the company’s right to electively
terminate the TRA at any time) will be triggered for purposesof computing future payments under the TRA. Specifically,
the TRA will provide that “for each taxable year ending on orafter the date of a change of control, all tax benefit
payments…shall be calculated by utilizing [the valuation

96

Several investment firms with UP-PTP structures haveused a simpler definition of “change of control” in their
TRAs. Specifically, the TRAs of Blackstone, Apollo and
KKR define “change of control” as “the occurrence of any[person], other than a person approved by the [current
general partner/manager/managing partner], becoming the[general partner/manager] of the [publicly tradedpartnership].” Presumably this difference is attributable tothe fact that since these issuers use a partnership as the
public entity, the sponsor will continue running thebusiness so long as it (or an approved assignee) holds thegeneral partner interest.

75

assumptions].”97 This TRA feature presumably arose becauseof a concern on the part of the TRA beneficiaries that futuretransactions undertaken by the public company (at a time
when the current management and shareholders have been
replaced) may disproportionately harm the rights of the TRA
beneficiaries. Accordingly, upon the occurrence of a changeof control, any future TRA computations assume the publiccompany has sufficient taxable income to make use of the(compensable) tax attributes available in any given year.
The use of these valuation assumptions (specifically,
the one that relates to taxable income) in change of control
situations will yield an odd result in the case of TRAs that
relate to pre-IPO NOLs of the public company. Since these97

See, e.g., Fortress, Blackstone, Apollo, Duff & Phelps,
Virgin Mobile, Och-Ziff, Emdeon, DynaVox, KKR,
Crumbs Bake Shop. Typical SEC disclosure relating to
the change of control feature will provide that “upon amerger, asset sale or other form of business combinationor certain other changes of control, [Issuer’s] (or its
successor’s) obligations…would be based on certain
assumptions, including that [Issuer] would have sufficienttaxable income to fully utilize the deductions arising fromthe increased tax deductions and tax basis.”76

tax attributes exist at the time of the IPO (as opposed tobeing created upon future exchanges), using the standard
valuation assumptions could require the company to pay for
all these NOLs in the first tax year following a change ofcontrol. For these reasons, several issuers with TRAs thatcover NOLs have modified the standard change of control
provision. For example, in Graham Packaging, the TRA
provides for the calculation of present value assuming a
stream of taxable income that is “in accordance withmanagement’s pre-existing projections” rather than an
outright assumption that all attributes will be used. In thisway, the change of control transaction does not give rise toinflated TRA payments, and allows the new owners to avoid
ongoing obligations under the TRA. 98

98

The IPO of Vantiv, Inc. implemented a different approachto the change of control situation. Under the Vantiv TRA,a change of control does not automatically terminate the
TRA. On the other hand, a change of control also does notnecessarily trigger the assumption that the company will
earn sufficient taxable income in future periods. Instead,the TRA provides that in the event of a change of control,
if the company did not have an obligation to make any
actual TRA payments in the prior two years, the TRA

77

d)

Disallowance Provisions

Because TRAs relate to the use of tax attributes, theparties must consider whether their TRA should provide forclawbacks or adjustments of any sort if a previously claimed
tax attribute is disallowed. Most TRAs never require theirbeneficiaries to repay amounts that have been previously paid
under the TRA. However, various TRAs do employ certain
adjustment mechanisms to mitigate the risk of disallowanceto the public company. For example, the Lazard TRA
provides that 20% of each payment that otherwise would be
due under the TRA is to be deposited into an escrow accountuntil the expiration of the applicable statute of limitations. 99
continues to operate without any valuation assumptions,using the actual tax savings. If, however, the company did
have a TRA obligation during the prior two years, then the“typical” valuation assumptions kick in, including theassumption that the company will have sufficient taxable
income to use against available tax attributes. See Tax
Receivable Agreements (filed with the SEC as Exhibits
10.30, 10.31, 10.32, and 10.33 to Form S-1/A of Vantiv,
Inc. on March 5, 2012).
99

Although the escrow provision is not common, most TRAs
provide for the annual tax benefit schedule to be amended
from time to time to reflect determinations by taxing
authorities or tax carrybacks. See supra note 81. Each

78

e)

Creditor Issues

As is the case with many partnership agreements, theoperating agreements governing umbrella partnerships willfeature a tax distribution provision to ensure that the partners
have sufficient cash to pay their tax liabilities attributable tothe partnership. These tax distributions, like any other
distributions to be made by the umbrella partnership, areusually required to be made on a pro rata basis.
When a partnership incurs third-party debt, it iscommon for the restricted payment covenant to contain an
exception dealing with these tax distributions. A TRA
arrangement, however, presents additional issues that must
be considered when negotiating a restricted payment
covenant. This is because the public corporation will need

year, the TRA payment is subject to reduction if a prioryear’s schedule has been amended to reflect a
disallowance of a tax attribute that had been previously
claimed. As mentioned above, however, in no event canthese negative adjustments give rise to a payment from thebeneficiaries to the company.

79

funds from the partnership to pay its taxes as well as to meetits contractual TRA obligations.
Conceptually, it may be reasonable to expect that
lenders would agree to allow distributions to be made to the
public company to make payments under the TRA. This
follows from the fact that in a “typical” IPO (without an
umbrella partnership), there is no basis step-up, and in suchcases the lenders would permit the company to pay its taxes
on that basis. Accordingly, lenders are arguably in the same
position as would be the case in the absence of the additionaltax efficiencies introduced by the umbrella partnership
structure. Moreover, 15% of such savings will actuallyremain in the credit group. Despite this, lenders may
nonetheless view the beneficiaries of a TRA no differently
than unsecured creditors of the corporation. 100 Furthermore,even if a lender viewed the TRA payments as quasi-tax

100

The TRA obligation is likely not indebtedness for tax
purposes, but see PLR 201027035 (implying that a TRA
could be indebtedness for tax purposes).

80

distributions, a blanket provision allowing the borrower tomake payments that are owed under the TRA may beperceived as over-inclusive, since, as described above, there
are certain scenarios (such as early terminations and changesof control) where payments under the TRA will not correlate
to actual tax savings.
A tax distribution can be drafted to disregard any tax
deductions resulting from adjustments to asset basis under
section 743. In such cases, the amounts distributed shouldroughly equal the amounts needed by the public company to
pay its taxes and make its TRA payments. In fact, in
situations where distributions (including tax distributions)must be made pro rata, this solution may even be necessary
to ensure that the umbrella partnership’s other partners (i.e.,
those who do not have a section 743 tax shield) receive
enough cash to cover their taxes. In any event, where anumbrella partnership negotiates a credit agreement, the issuesof tax distributions, pro rata economics and TRA obligations
are certain to arise. Issuers often disclose to investors the81risk that a company’s debt obligations will prevent it frommaking all TRA payments when due. 101
f)

Treatment of TRA Payments to
Beneficiaries

Payments received pursuant to a TRA are mostnaturally characterized as additional proceeds from the saleof the partnership interest. 102 While there is no authority on
the issue, other characterizations do not seem plausible. It is
hard to see how the payments could be characterized as fees,
as they are not provided in exchange for services. Another101

See, e.g., Form S-1/A of Graham Packaging (filed with the
SEC on January 15, 2010) (“Because we are a holding
company with no operations of our own, our ability tomake payments under the income tax receivableagreements is dependent on the ability of our subsidiaries
to make distributions to us. Our credit agreement andoutstanding notes restrict the ability of our subsidiaries tomake distributions to us, which could affect our ability tomake payments under the income tax receivableagreements.”); Vantiv, Inc. S-1/A (filed with the SEC on
November 30, 2011) (“There may be a material adverse
effect on our liquidity if, as a result of timing discrepancies
or otherwise, distributions to us by [the umbrella
partnership] are not sufficient to permit us to makepayments under the tax receivable agreements after wehave paid taxes.”).

102

See supra note 83.

82

remote possibility is that the TRA payments are dividends ona special class of stock deemed issued upon the exchange.
Assuming the TRA payments are sales proceeds, andbecause all TRA payments will not be made within the
taxable year of the exchange of the umbrella partnershipinterest, the sale is eligible to be reported on the installment
method. 103 Due to the indeterminacy of the total amount of
the TRA payments, the treatment of the sale will be governedby the intricate subset of installment sale regulations
pertaining to contingent payment sales. 104 These rules allow
the seller to recover basis somewhat in proportion to
payments if the contingent obligation states the maximum
amount of aggregate payments the seller may receive. 105
Specifically, in each year, basis will be recovered in the
proportion that all payments received in that taxable year

103

Section 453(a), (b).

104

Treas. Reg. section 15A.453-1(c)(1).

105

Treas. Reg. section 15A.453-1(c)(2).

83

bear to the maximum amount permitted to be paid. If there is
no stated maximum, but there is a fixed period over which
payments under the obligation may be received, basis is
generally recovered ratably over the life of the obligation. If
there is no such stated maximum or fixed period, as is often
the case in TRAs, 106 basis is generally recovered ratably overa fifteen year period. 107
The first method will generally allow an exchanging
partner to recover his basis earliest, due to the large upfront

106

See discussion above at II.B.2. The Carvana, Pluralsight,
and Adeptus Health TRAs include a maximum statedselling price.

107

Treas. Reg. section 15A.453-1(c)(3), (c)(4). Where there
is no such stated maximum or fixed period, the IRS willclosely scrutinize the obligation to determine whether asale has realistically occurred, and may further adjust thebasis recovery within the fifteen-year period if allocatingbasis in level amounts would “substantially andinappropriately accelerate recovery of the taxpayer’s basis
in early years” of the fifteen-year period. Treas. Reg.
section 15A.453-1(c)(4). The IRS is not entitled to impose
an adjusted schedule under this provision, however, if the
taxpayer can demonstrate that the IRS’s proposal isunreasonable or that the otherwise applicable schedule
does not allow the taxpayer to recover basis twice as fast
as the IRS’s proposed schedule. Treas. Reg. section
15A.453-1(c)(7)(iii).

84

payment in the form of corporate stock. Stating a payment
limit, however, is not universal in TRAs. Nevertheless,setting such a limit, even if it is high, may be useful because
it accelerates basis recovery.
A partner may be subject to an interest charge on thetaxes deferred by using the installment method if the
taxpayer holds installment obligations in an amount greaterthan $5 million; 108 this interest charge will generally
eliminate the advantage of the installment method. For sucha partner – or a partner with significant basis in thepartnership units to be exchanged – the best solution may beto elect out of the installment method. The partner willrecognize gain in the year of the exchange in the difference
between the basis in the exchanged units and the sum of thefair market value of the stock received and the fair market
value of the TRA obligation. 109 Some taxpayers may argue
108

See section 453A.

109

See Treas. Reg. section 15A.453-1(d). Further income
from the TRA would then be recognized under the
taxpayer’s regular method of accounting. The corporation85

that the value of the TRA obligation cannot reasonably beascertained, and therefore the exchange is properly treated as
an “open transaction,” with the result that no amount inrespect of the TRA obligation should be included in income
until it is paid.110 Under the regulations, however, only in“rare and extraordinary cases” will the taxpayer be entitled toassert that the transaction is “open.” 111

will receive a basis step-up upon each payment, without
regard to the method chosen by the taxpayer.
110

See Burnet v. Logan, 283 U.S. 404 (1931).

111

See Treas. Reg. section 15A.453-1(d)(2)(iii). A taxpayer
may also apply to the IRS for a letter ruling allowing basis
recovery on a customized schedule if the available
methods would “substantially and inappropriately” defer
recovery of basis. Treas. Reg. section 15A.453-1(c)(7). To
obtain the ruling, the taxpayer must demonstrate that his
proposed method is reasonable and that it would likely
result in basis recovery twice as fast as the basis would
have been recovered under the otherwise applicable rules.
A taxpayer whose basis would otherwise be amortizedover a fifteen-year period would have a chance of a
success, but may be daunted by the application process.
Finally, a taxpayer may attempt to recover basis under an“income forecast” method in proportion to a projected
stream of payments. This forecast method is available
where the property sold is a “mineral property, a motion
picture film, a television film, or a taped television show.”Treas. Reg. section 15A.453-1(c)(6). A taxpayer may seeka ruling that another type of property is eligible for this

86

g)

Commentary on TRAs

Although Congress has considered denying capitalgain treatment for sales involving a TRA 112 and journalists
have complained about them, 113 TRA arrangements seem not
to raise legitimate tax policy concerns. No tax policy
consideration is apparent to penalize parties who sellproperty for a price that includes a contingent component
based on the future use of tax attributes of the property. One
commentator has been quoted as commenting, “Let’s face it,method; taxpayers do not appear to have met thischallenge. See PLR 9013014 (stock ruled to be ineligible).
112

See H.R. 3996, 110th Cong. (1st Session 2007). Thislegislation would have treated parties to a TRA as related
persons for purposes of section 1239, resulting in gain on apartner’s transfer of partnership units to a corporation
being treated as ordinary income. The policy of section
1239 is to prevent net tax-reducing transactions between
parties not acting at arm’s length. The parties to a TRA
have commercially adverse interests and their transactions
do not raise these concerns.

113

See, e.g., Johnston, David Cay. “Tax Loopholes Sweeten a
Deal for Blackstone.” New York Times July 13, 2007, A1. The article refers to sponsors’ receiving payments in
respect of a corporation’s tax benefits under a TRA as a“loophole” and appears to mistake the payer of thosebenefits for the government.

87every time you’re selling assets, if you deliver a basis step-up
to a buyer, you get paid more. That’s all this is.” 114
III.

Tax Protection Agreements
A.

Standard Provisions

Tax protection agreements (“TPAs”) are used in an
UPREIT structure to preserve the deferral benefits to the realestate owners. As mentioned above, the primary objective ofan UPREIT structure is to defer taxation of built-in gain on
property contributed by the initial business owners and futurecontributors of property to the UPREIT. There are several
ways in which this purpose may be frustrated. If the OP
disposes of the contributed property, the tax on thecontributor’s built-in gain will be allocated to the contributor
under section 704(c) and its regulations. A distribution ofcontributed property (to partners other than the contributing
partner) would have similar results under section
704(c)(1)(B) if done within seven years of the contribution.
114

Elliott, supra note 80 (quoting Eric Sloan at a June 10,2011 Texas Federal Tax Institute in San Antonio).

88Finally, if the contributing partner’s liabilities are reduced
after the contribution, 115 the reduction will be treated as a
distribution from the OP, which will be taxable to the extent
it exceeds the partner’s outside basis. 116

115

The contributing partner’s liabilities will be reduced if thepartnership assumes the partner’s individual liabilities or
reduces the partner’s share of partnership liabilities.
Section 752(b).

116

If the partnership assumes or takes property subject to aliability, the partnership’s assumption of the liability may
be treated, in part, as sales consideration for thecontributed property under the “disguised sale” rules ofsection 707(a)(2) and Treas. Reg. section 1.707-5(a). Sale
treatment will result in gain or loss to the contributing
partner, a cost basis to the partnership in the portion of theproperty deemed sold, and a reduction in any built-in gain
specially allocable to the contributing partner under
section 704(c). A subsequent reduction of the liability (orreduction of the portion allocated to the contributing
partner) may also be treated as sales consideration if the
reduction was anticipated at the time of contribution, theanticipated reduction is not subject to the entrepreneurial
risks of partnership operations and the reduction in thepartner’s share of liabilities is part of a plan the purpose ofwhich is to minimize deemed sale treatment. See Treas.
Reg. section 1.707-5(a)(3), (f), Ex. 3. These rules do not
generally apply if the liability is a “qualified liability,”
which includes a liability incurred more than two years
prior to the contribution (or contribution agreement, if
earlier) or otherwise not incurred in anticipation of thetransfer to the partnership. Treas. Reg. section 1.7075(a)(5), (a)(6).

89

A TPA limits the ability of the OP and its REIT
general partner to take actions that would trigger theseresults. The basic TPA will provide that, during apredetermined “protection period” (which is also sometimes
called the “lock-out period” or “lock-up period”) the
partnership may not dispose of the contributed property
without compensating the contributing partner for the
resulting tax liability. The typical damages provision will
indemnify the contributing partner for the entire tax liability,
but a less generous indemnity may cover only the excess ofthe current tax liability over the net present value of the tax
liability that would be due if the partnership sold thecontributed property at the expiration of the protection
period. The theory behind this calculation is that thecontributing partner’s benefit in the UPREIT structure issimply one of deferral; therefore the partner is only damaged
to the extent the present value of the tax is increased from the90

acceleration of the sale. 117 TPAs may also take a middle
approach by indemnifying the contributing partner on adeclining percentage basis as the expiration approaches.
The other common function of a TPA historically has
been to obligate the OP to maintain a minimum amount ofnonrecourse partnership liabilities encumbering thecontributed property. The amount of these liabilities that areallocated to the contributing partner are added to thepartner’s basis and therefore increase the amount that may be
distributed to the partner in a tax-free manner. This basis
increase is important to a partner who has contributed
property subject to a liability, as the partnership’s assumptionof the liability is treated as a deemed distribution to thepartner. This debt maintenance obligation applies during a

117

An economically equivalent variant, albeit one that does
not appear to exist in the market, would require thepartnership to indemnify the contributing partner for theentire tax liability in exchange for a note from the partner,
payable at the expiration of the protection period, in theamount of tax that would have been payable had the saleoccurred at that point.

91

fixed period (which may or may not be the same as theprotection period for sales of the contributed property) andthe OP is required to indemnify the contributing partner fortaxes resulting from breach. 118
As discussed below, a common method for achievinga specific allocation of debt to the contributing partner has
been for that partner to issue a “bottom dollar guarantee.”
Such a guarantee can be called on only after all assets of thepartnership have been applied to repay the loan and thelender has no other remedy. Even though such a guarantee
may expose the guarantor to little or no risk, the liability
subject to the guarantee would be allocated to thecontributing partner under regulations in effect until October
2016. Under new regulations, such bottom dollar guarantees

118

Liabilities allocated to an individual partner must also be“qualified nonrecourse financing,” or else the contributing
partner may be subject to the at-risk recapture rules ofsection 465(e). Qualified nonrecourse financing includes
most nonrecourse debt secured by real property, but, in
addition to other requirements, the lender must be a person
who is actively and regularly engaged in the business oflending money. See sections 465(b)(6), 49(a)(1)(D)(iv).

92will no longer be effective to support an allocation of debt to
the guarantor for tax purposes (although, as described in note
135 below, arrangements in place in October 2016 are
grandfathered from the new rules for seven years). Although
allocating debt to the contributing partner may be moredifficult under the new rules, the continued existence ofnonrecourse debt at the OP may shield the contributing
partner from gain recognition to some extent and thus debt
maintenance covenants may well continue to be common.
B.

Points of Negotiation

Among the points to be resolved in drafting a TPA
are:
The duration of the protection period. The protection
period may range anywhere from a few years to the life of
the contributing partner. Seven to ten years is fairly
common. 119 The protection period will often expire upon thecontributing partner’s death.
119

Once the protection period has expired, the partnershipmay sometimes have an obligation to make efforts toredeem a contributing partner’s interest with an in-kind

93Permitted dispositions. Typically, the partnershipwill be permitted to dispose of protected property in anontaxable transaction such as a transfer of the protected
property in exchange for like-kind property under section
1031, in exchange for stock of a controlled corporation under
section 351(a) or in exchange for a partnership interest under
section 721(a). These transactions will not trigger anallocation of income to the contributing partner. Instead, thebuilt-in gain or loss in the protected property will bepreserved in the property received in the exchange. 120 The
agreement will typically provide that the property received
will be subject to the same restrictions as the original 704(c)property.

distribution before selling the contributing partner’s
protected property. Assuming the redemption takes place
more than seven years after the contribution, the section
704(c) gain will not be recognized on the distribution inliquidation. Section 737. Instead, the contributing
partner’s basis will be preserved in the distributed
property. Section 732(a).
120Treas. Reg. section 1.704-3(a)(8), (a)(9).

94704(c) allocation method. Three methods are
generally available for a partnership to take account of acontributing partner’s built-in gain: the traditional method,
the traditional method with curative allocations, and theremedial method. The contributing partner will prefer that
the TPA require the partnership to elect to use the traditional
allocation method with respect to the protected properties,
under which the contributing partner does not recognize any
built-in gain until the partnership disposes of the contributed
property. The traditional method with curative allocations
and the remedial method, on the other hand, may require
allocations of additional income to the contributing partner
while the partnership holds the property to eliminate thedisparity between the partner’s capital account and his basis
in the property.
State and local tax coverage. If a contributing partneris indemnified for state and local taxes resulting from a
breach by the OP, and then moves to a high-tax jurisdiction,
this will result in a higher than anticipated indemnification

95

payment. The partnership may therefore insist that the stateand local tax indemnity be limited to either an agreed-uponrate or to the rates imposed in an agreed-upon locality.
Federal tax rates. The parties may be inclined tocompute the TPA indemnity based on assumed rates rather
than actual rates. While ideal for avoiding disputes, anassumed rate may not adequately estimate actual taxes. A
solution is to use a formula that is typical in tax distributions– namely, to assume the character of income but not actual
rates. For example, the indemnity may assume that theprotected partner will pay tax on the indemnified gain at the
maximum federal, state and local rates for long-term capitalgain applicable to an individual resident of a specific place inthe year the gain is included in the partner’s income.
Gross-up. A partner will incur additional tax
liabilities upon receipt of a tax protect payment, and parties
to a TPA must consider whether to require the OP to pay
additional amounts to cover tax on the tax protect payment
itself. It may be wise to calculate the gross-up amount96

assuming the character of, or rate imposed, on the tax protect
payment in light of the uncertainty over how the tax protect
payment should be reported. 121
Amount of gain on sale indemnified. The customary
tax indemnity for violation of the prohibition on sale will belimited to the tax imposed on the built-in gain speciallyallocated to the contributing partner under section 704(c). A
broader indemnity may cover tax imposed on the entire
amount of gain allocated to the contributing partner,
including any tax imposed on the post-contribution
appreciation in the property.
An indemnity for tax on all gain attributable toprotected property may be important to the protected partner
if the partnership later admits new partners and revalues theprotected property. The additional appreciation will create
another layer of 704(c) built-in gain that is allocated among
the contributing partner and the existing partners at the time121

See below at III.D.

97

the new partners are admitted. 122 If the contributing partner
is not entitled to tax distributions, he may be allocated gain
disproportionate to distributions at the time the property issold. This is particularly problematic if the new partners arelarge – for instance, if a REIT contributes proceeds of apublic offering – and the contributing partner’s right to sharein the distributions of sales proceeds is highly diluted. If,
however, the tax on this gain is indemnified by a TPA, thepartner may receive cash from the partnership to pay the tax
without even suffering an offset against future
distributions.123

122

These are “reverse 704(c)” allocations. See Treas. Reg.
section 1.704-3(a)(6)(i).

123This issue is not specific to property contributed by afounding partner. All partners will be allocated a reverse
704(c) layer at the time of a revaluation of property andtherefore may find themselves in the same predicament.
Partnerships do not generally indemnify partners for tax onreverse 704(c) gain. In certain circumstances, forexample, to facilitate a merger into an UPREIT, apartnership may provide partners the option to redeem
interests to the extent necessary to pay tax attributable toreverse 704(c) gain.

98

Merger protection. A heavily negotiated item may bewhether the partnership may merge with another entity
without indemnifying the contributing partner for 704(c) (orother) gain resulting from the transaction. Other transactions
may raise the same issue – for example, the partnership’s
right to convert to a corporation or to liquidate free of tax
protection payments. This type of provision is examined indetail in the discussion of the Archstone litigation below.
Nonrecourse liability allocation. Under the
regulations governing allocations of nonrecourse liabilities, aliability encumbering 704(c) property is allocated to thecontributing partner to the extent it exceeds the basis of thecontributed property; the partnership, however, has theoption of allocating liabilities encumbering the property to
the contributing partner up to the partner’s built-in gain withrespect to the property. 124 The contributing partner may
124

A partner’s share of the partnership’s nonrecourse
liabilities equals the sum of (1) the partner’s share ofpartnership minimum gain, (2) the amount of gain thatwould be allocated to the partner under section 704(c) if
the partnership disposed of property subject to nonrecourse99request that the partnership allocate to him a portion of theseliabilities, further increasing his basis and deferring taxationof distributions. This flexibility to allocate nonrecourse
liabilities may take on more importance in planning for asset
contributions to the OP in light of the new restrictions on useof bottom dollar guarantees discussed above and below.
Replacement Liabilities. The stated maturity of a loan
often terminates the partnership’s debt maintenanceobligation with respect to that liability. Some TPAs,
however, may require that the partnership make reasonable
efforts to replace repaid loans with new liabilities secured by
the contributed property.

liabilities for no consideration other than satisfaction of theliabilities and (3) the partner’s share of any remaining
nonrecourse liabilities (“excess nonrecourse liabilities”)
determined in accordance with the partner’s share ofpartnership profits. The partnership may elect to allocate
an excess nonrecourse liability encumbering 704(c)property to the contributing partner to the extent of thepartner’s built-in gain (and to the extent the liability was
not already allocated to such partner under (2) above).
Treas. Reg. section 1.752-3(a).

100Guarantees. As the contributing partners’ built-in
gain diminishes over time, 125 the amount of nonrecourse
liabilities that may be allocated to the contributing partner
diminishes as well. 126 To maintain a sufficient level of
liabilities allocated to him, a contributing partner may request
the right to guarantee partnership liabilities, thus making
those liabilities recourse to the contributing partner andproperly allocable to him to the extent he “bears the
economic risk of loss.” 127 Historically, to minimize theprobability of loss while continuing to bear the economic
risk, the contributing partner would provide a “bottom dollar

125

Treas. Reg. section 1.704-3(a)(3)(ii).

126

Partnership nonrecourse liabilities that encumber acontributing partner’s 704(c) property may generally beallocated to that partner. Nonrecourse liabilities allocatedto the contributing partner also include the partner’s shareof partnership minimum gain and the partner’s share of
any remaining nonrecourse liabilities in accordance withthe partner’s share of partnership profits. Treas. Reg.
section 1.752-3. These latter allocations will be relatively
small if the contributing partner has a small interest in thepartnership.

127

See Treas. Reg. sections 1.752-1(a)(1), 1.752-2(a).

101

guarantee” of a liability, that is, a guarantee of only a portionof the liability and only to the extent the lender has not beenable to collect the guaranteed portion from the partnership or
its collateral.
Even if it was unlikely the guaranteeing partner
would have to make a payment on the bottom dollar
guarantee, the guarantee would be effective in allocating theguaranteed portion of the liability to the partner. The test for
determining whether a partner bore the economic risk of loss
for a liability did not depend on the probability of the loss; it
was a mechanical test that asked only whether the partner
would be obligated to satisfy the liability if all partnership
liabilities came due, the partnership’s cash and assets became
worthless, its properties were disposed of for no
consideration, and the partnership liquidated. 128 Because the128

Treas. Reg. section 1.752-2(b)(1). The recourse liability
test assumed that partners were deemed to be able tosatisfy their obligations, irrespective of their actual net
worth, unless the facts and circumstances indicated a plan
to circumvent or avoid the obligation. Treas. Reg. section102amount guaranteed on a bottom basis would be payable by
the guarantor partner in this hypothetical scenario, theguaranteed portion of the liability was properly allocable tohim. 129
In October 2016, the IRS issued temporary
regulations – which were largely adopted in final regulationsin October 2019 – that eliminated the use of the bottom
dollar guarantee technique. 130 Under the regulations asfinalized in October 2019, “a bottom dollar payment
obligation” of a partner to make a payment with respect to a

1.752-2(b)(6), prior to amendment by T.D. 9877 (October
4, 2019).
129

In addition, the regulations provided an example applying
the partnership minimum gain rules to a fact pattern
including a bottom dollar guarantee without suggesting in
any way that the guarantee would be disregarded. Treas.
Reg. 1.704-2(m), Ex. 1(vii).

130

See T.D. 9877 (October 4, 2019); T.D. 9788 (October 5,2016) (containing Temp. Treas. Reg. section 1.752-2T).
Similar regulations (with some significant differences) had
previously been proposed. See REG-119305-11, 79 FR
4826 (January 30, 2014).

103

partnership liability would not be recognized. 131 A “bottom
dollar payment obligation” is generally defined as any
payment obligation other than one in which the partner or
related person is or would be liable up to the full amount ofsuch partner’s payment obligation if and to the extent thatany amount of the partnership liability is not otherwise
satisfied. 132 The new rules do not require that the partner
guarantee the entire debt, so long as the guarantee relates tothe “top dollars” of debt, and multiple partners can eachguarantee a vertical slice of the top dollar. 133 The regulations
also apply a facts and circumstances test to evaluate whether
there is a plan to avoid payment, which would cause theobligation to be ignored. 134

131

Treas. Reg. section 1.752-2(b)(3)(ii).

132

Treas. Reg. section 1.752-2(b)(3)(ii)(C)(1).

133

Treas. Reg. section 1.752-2(b)(3)(ii)(C)(2).

134

Treas. Reg. section 1.752-2(j)(3)(ii). Factors that could
raise issues include an obligation by the partnership tohold liquid assets in excess of reasonably foreseeable
needs, the presence of the guarantee having no effect on
the terms of the partnership debt and the lender not

104

In light of the new rules, a party transferring
properties to an UPREIT who wishes to maintain a given
level of debt allocation by relying on a guarantee will have totake on much more meaningful economic risk than was thecase under prior law. 135
In any case, even under the former regulations thetreatment of a bottom guarantee is less clear where further
measures are taken to reduce the risk of enforcement of theguarantee – for example, where the guarantor partner has anannually recurring option to terminate the guarantee. Such alimitation presents a risk under the recourse liability

requiring receipt of the guarantee documents. For an
excellent discussion of UPREIT TPA approaches under
the new rules see Stephen Giordano, “Tax Protection in
UPREIT Deals Under New Partnership Regs,” 157 Tax
Notes 507 (Oct. 23, 2017).
135

The regulations contain a grandfather rule that would, until
October 5, 2023 and with certain limitations, allow apartnership to retain allocations of recourse liabilities toany partner under the former rules (which allowed bottom
dollar guarantees) to the extent that the partner’s share ofrecourse liabilities exceeded its outside basis on October 5,
2016, thereby preventing an immediate income inclusion
to the partner. Treas. Reg. section 1.752-2(l)(3).

105

allocation regulations’ anti-abuse rule, under which anarrangement may be disregarded if it merely “create[s] theappearance” of a partner’s bearing the economic risk of loss
“when, in fact, the substance of the arrangement isotherwise.” 136

136

Treas. Reg. section 1.752-2(j). The anti-abuse provision
was recently invoked by the Tax Court in Canal Corp. v.
Commissioner to disregard a partner’s indemnity
obligation, where the partner was a subsidiary of aconsolidated group of corporations whose assets (aside
from its partnership interest) had a value of approximately
21% of the guaranteed liability, and which had no
obligation to retain those assets. See 135 T.C. No. 9(2010). However, the tax-related motive of a guarantee,
alone, should not cause it to be disregarded if it isotherwise a substantive obligation. See Treas. Reg.
section 1.737-4(b), Ex. 2 (partner’s tax-motivatedagreement to become solely liable for repayment of apartnership debt was substantive and therefore increased
partner’s basis). Note, however, that treatment ofguarantees is not entirely clear under proposed at-risk
regulations. Compare Prop. Treas. Reg. sections 1.4656(d) (guarantee of debt does not increase at-risk amountuntil guarantee is collected on and taxpayer has no
remaining rights against the obligor) and 1.465-24(a)(partner’s at-risk amount is increased if partner may beheld personally liable for repayment of a partnership
liability under state law), 44 FR 32235 (June 5, 1979). Fora general discussion of liability allocation issues in TPAs,
see E. Kelsey Lemaster, H. Neal Sandford and Karen F.
Turk, “Tax Issues in Recent REIT Deals: Tax Protection
Agreements,” 596 PLI/Real 529 (2012).

106

C.

Archstone Litigation

The drafting of the tax protection provisions requires
great care. If the agreement is litigated, the tribunal may
hold the drafting parties to a high standard of technicalcompetence and may be reluctant to ignore literal provisions
to effectuate the spirit of the arrangement. Take, forexample, the multi-jurisdictional litigation involving the2007 acquisition of the formerly publicly traded Archstone
real estate portfolio by a private investment group led by
Tishman Speyer and Lehman Brothers. The Archstonebusiness was organized as a publicly traded UPREIT, wherecertain holders of OP units were subject to tax protection
from the OP. The acquisition was effected through twomergers. The publicly traded Archstone REIT was merged
into a new REIT formed by the acquisition parties and the
public shareholders were fully cashed out. Concurrently, a
subsidiary of the surviving REIT merged into the OP.
Holders of OP units were given a choice of per-unit
consideration: either (1) a preferred unit in the newly107constituted partnership with a fixed rate dividend and aliquidation preference, or (2) an amount of cash equal to theamount the acquirers paid for each outstanding REIT share.
Unitholders choosing to continue as preferred equity holders
in the new partnership would retain their rights under the
existing TPAs. However, unitholders choosing cash wererequired to waive the right to any tax indemnification
payments that might be due under the tax protection
agreements as a result of the exchange. 137
The unitholders sued the surviving REIT, thesurviving OP, the deal sponsors and their advisers. The
plaintiffs alleged that the newly issued preferred units did notconstitute fair value for the exchanged units, that the cash
consideration was also not fair value because of the resulting
non-indemnified tax liability, and that, therefore, the choice
between the two offers was a “Hobson’s choice.” The claims
137

Ruby et al. v. Tishman Speyer Properties, LP et al., First
Amended Complaint at 19–34 (filed Nov. 12, 1998,
Superior Court of the State of California, County of Los
Angeles).

108

included breach of contract (under both the organizational
agreement of the umbrella partnership and the tax protection
agreements), breach of fiduciary duty, violation of the
securities laws, and so on. 138
One group of plaintiffs, who had elected to receive
cash in the merger rather than the tax-deferred preferredunits, pursued their tax protection claims in arbitration.
These plaintiffs’ tax protection agreements were identical,
and each contained provisions under which neither the OP
nor the REIT was permitted to “cause or permit a sale,transfer, exchange, distribution, or any other transaction that,for federal income tax purposes, is treated as a sale, transfer,
exchange, distribution, or disposition . . . of all or any portionof the [contributed property] or any interest therein” during
the protection period. 139

138

Id. at 41–48.

139

Ruby/Archstone Arbitration, Arbitration Panel’s Decision
at 4 (Oct. 26, 2011).

109

The arbitration panel’s decision began by stating a
principle of contract interpretation: that language in anagreement is to be interpreted consistent with what areasonable person in the position of the parties would havethought it to mean. The panel determined that, due to thesophistication of the negotiating parties, the “reasonable
person” in this case was deemed to be a tax lawyer withexperience in REIT and partnership tax law. 140
The panel ruled against the unitholders, concludingthat an exchange of OP units for cash pursuant to the merger
agreement was not a sale, transfer, exchange, distribution or
disposition of all or any portion of the contributed property“or any interest therein,” nor was the exchange treated as oneof these types of transactions for federal income tax
purposes. According to the panel, the plaintiffs’ OP units –which were the property interests the partners disposed of –did not constitute “contributed property” or an “interest

140

Id. at 6–9.

110

therein.” Therefore, the panel concluded, the tax protection
agreements contained only property level protection. The
panel added that, if merger protection had been
contemplated, a “reasonable person (a tax attorney withREIT experience)” representing the company would haveexpected to receive an explicit request or demand for suchprotection. 141
As a secondary matter, the panel agreed with thecompany that, in any event, it had not caused or permitted atransaction that was taxable to the plaintiffs. 142 The company
had argued that it was the plaintiffs that had caused thetaxable exchange by declining the tax-deferred choice ofconsideration. The panel essentially agreed, stating that theplaintiffs had not provided sufficient evidence to prove thatthe alternative consideration – that is, the tax-deferred141

Id. at 9–14.

142

Id. at 5–6.

111

preferred units in the surviving entity – was inadequate, as
the plaintiffs had argued. 143
D.

Tax Treatment of Tax Protect Payments

There is no clear guidance on how an indemnity
payment made under a tax protection agreement should betreated. 144 One possibility is that a tax protect payment is acontingent payment by the partnership in exchange for thecontributed property. The case for this treatment, however,does not appear as strong as it does in the TRA context.
Payments under a TRA are part of the price demanded by aselling partner in exchange for a sale of an interest in thepartnership. A property-contributing partner, on the other
hand, would likely view a tax protect payment ascompensation for damages rather than as part of the price ofthe contributed property; in fact, such a partner may prefer to143

Id. at 14–15, 21–25.

144

See generally Terence Floyd Cuff, “Investing in an
UPREIT—How the Ordinary Partnership Provisions Get
Even More Complicated,” 102 J. of Tax’n 42 (Jan. 2005).

112

never receive a tax protect payment, and would be happy if
the partnership simply did not breach the TPA and trigger
any adverse tax consequences.
Another possibility is that a tax protect payment istreated under section 707(a)(1) as a transaction between thepartnership and a partner not acting in his capacity as apartner – i.e., as a fee. The payment would therefore be
ordinary income to the indemnified partner and as deductible
by the partnership. Even if the partner is acting in his partner
capacity, the partner would be treated as receiving ordinary
income in a nonpartner capacity if the indemnification
payment is treated as a guaranteed payment governed bysection 707(c) – that is, a payment “determined without
regard to the income of the partnership” made to a partner“for services or the use of capital.” 145 This treatment isdefensible because the indemnity payment is typically basedon the section 704(c) allocation to the contributing partner,

145

Treas. Reg. section 1.707-1(c).

113which, while constituting taxable income of the partnership,
is not economic income or book income.
Finally, the contributing partner might be treated as areceiving the tax protect payment as a nontaxable distribution
by the partnership under section 731. Presumably, thistreatment would also require the partnership to speciallyallocate income to the indemnified partner in the amount of
the payment. Certain tax protection agreements, in fact,
explicitly take this position, which is favorable to thecontributing partner since the income allocated to him will
likely be capital gain from the sale triggering the tax protect
payment.
IV.

Respecting the Umbrella Partnership Form andVariations
A.

Respecting the Umbrella Partnership Form

As discussed above, in light of the Example in thepartnership anti-abuse regulations (and Treasury’s
subsequent comments), practitioners generally believe the
IRS will not attempt to disregard the umbrella partnership

114

and treat its owners as owning equity in the public company
from day one. Even apart from the Example, however, it
seems unlikely the IRS could successfully challenge anumbrella partnership whose structural features match insubstance those of a typical UPREIT transaction. 146 Thereappear to be few instances where the IRS has attempted torecharacterize an equity interest as being in an entity otherthan the entity that is, in form, the issuer, and even in suchcases, the IRS has generally not prevailed. For example, theIRS unsuccessfully argued that stock in a corporation should
be characterized as an ownership interest in assets orbusiness entities owned by the issuing corporation where146

In a DownREIT structure (mentioned above in note 22),
different limited partners may own interests in different
operating partnerships. Each of the operating partnerships
may pay distributions to limited partners equal to
distributions paid on the number of REIT shares thosepartners are entitled to acquire by exchange. Unlike in an
UPREIT structure, however, the amount distributed to alimited partner does not depend on the particularpartnership through which the limited partner participates.
Depending on the specific facts, these structures might beconsidered to be at a higher risk of challenge than otherumbrella partnership structures.

115

stock rights “tracked” the performance of those underlying
assets or business entities. 147 Though the arrangements at

147

In Union Trusteed Funds v. Commissioner, 8 T.C. 1133
(1947), a RIC issued seven different series of special
stock, each linked to a separate investment fund.
Dividends were payable on each class of stock from theearnings and surplus generated by the segregated assets
pertaining to such class. Upon dissolution, theshareholders of each class were entitled to receive assets ofsuch class available for distribution, and their
proportionate share of any general assets not pertaining to
any class. Each class of stock was charged with liabilities
pertaining to such class as well as a proportionate share of
the general liabilities of the corporation. The IRS asserted
that the capital losses attributable to one series of stock
should not be able to be used to offset capital gains
attributable to a different series. In essence, the IRS
argued that each series represented stock of a different
corporation. The Tax Court ruled that, despite any logicalappeal to such an argument, there was no basis in law forsuch ruling. The holding of Union Trusteed Funds asapplied to series funds was overturned in 1986 by theenactment of what is now section 851(g) (each segregatedportfolio of assets in a RIC is treated as a separate
corporation if the beneficial interests in such portfolio are
owned by holders of a class of stock of the RIC that ispreferred over other classes of stock in respect to such
portfolio). In Maxwell Hardware Co. v. Commissioner,
343 F.2d 713 (9th Cir. 1965), two investors contributed
cash to an existing corporation with substantial net
operating losses in return for a special class of shares. The
investors hoped to use the corporation's losses to shelter
the income of the corporation’s real estate department,
newly formed from the proceeds of the issuance of special
shares. The special shares tracked the real estate assets
such that the investors generally received 100 percent of
the downside risk and 90 percent of the upside potential

116issue were quite different from umbrella partnership
structures, they are nevertheless examples of respecting
separate entities despite a linkage between an interest in one
entity and the assets or stock of another.
Rev. Rul. 69-265 is an important and helpful ruling inthis area. The ruling addressed a corporation’s acquisition ofsubstantially all the assets of another corporation in atransaction intended to qualify as a reorganization under
section 368(a)(1)(C). The consideration used in theacquisition was voting stock that was exchangeable for stockof the parent of the issuing corporation. The issue wasassociated with the real estate department. Despite thesubstantial similarity between the special shares and a
direct investment in the real estate assets, the court
determined that absent a “sham,” there was no basis forrecasting shares of the corporation as a direct interest in
the real estate department. See also section 1298(b)(4)(authorizing regulations to treat tracking stock as stock ofa separate corporation if necessary to carry out the
purposes of the PFIC regime; no such regulations currently
exist). The fact that Congress has in specific instances
limited the use of tracking stock perhaps indicates its
acknowledgment that such interests represent equity of
their nominal issuer under general tax principles.

117

whether the right to exchange the stock constituted separate
property from the stock itself, in contravention of therequirement of section 368(a)(1)(C) that the considerationconsist solely of voting stock. The ruling held that theexchange right would constitute property separate from thestock if exercisable against the parent corporation. The
ruling also held, on the other hand, that if the exchange rightwas exercisable only against the issuing corporation, the rightwould be treated no differently than the right to redeem stock
for property of the issuer – that is, as a characteristic of thestock and not as a separate property right.
Read broadly, Rev. Rul. 69-265 holds that an equity
interest in one entity will not be recharacterized as an equity
interest in a different entity for which it may be exchanged(even where the interest received is equity in the owner of thefirst entity) provided that the exchange right is against theoriginal issuer of the stock. This holding is therefore helpful
as applied to the recharacterization risk of an umbrella
partnership structure. To be sure, the structure described in118the ruling did not explicitly include the other features ofstructural parity present in typical umbrella partnership
structures, and was focused primarily on the issue of whether
the exchange constituted a separate property right. 148 Still, it
is helpful in that it shows that the IRS will respect entities as
separate and treat the nominal issuer of an exchange rights as
the actual issuer despite the presence of related parties andother possible characterizations.
More general authorities on tax ownership may also
provide helpful guidance in this area. Courts generally
employ a “facts and circumstances” approach to determining

148

This ruling supports the view that a partner’s transfer ofproperty to an umbrella partnership in exchange for aconvertible unit is not treated as a partial “disguised sale”
under section 707(a)(2). Under those rules, if a partner
contributes money or property to a partnership, and thepartnership transfers money or property to that partner (oranother partner) in a related transaction, the entirety of thetransactions might be treated as a sale of a partnershipinterest. See section 707(a)(2)(B). Rev. Rul. 69-625
suggests that the conversion right, if exercisable only
against the umbrella partnership (as it typically is), should
not be viewed as money or property, but rather as part of
the umbrella partnership interest that the partner may
receive on a tax-free basis under section 721.

119ownership, 149 and have focused on the power to control
disposition as the most critical component of tax
ownership. 150 An owner of an umbrella partnership interest
generally does not have the power to dispose of an interest in
the publicly traded entity until the time the initial interest isconverted into public equity. In addition, umbrella
partnership arrangements often include a “dry period”

149

See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561,
573–74 (1978); Grodt & McKay Realty Inc. v. Comm’r, 77
T.C. 1221, 1237 (1981).

150

See, e.g., Richardson v. Shaw, 209 U.S. 365 (1908);
Cepeda v. Comm’r, T.C. Memo. 1994-62. For example,
borrowers in a typical securities lending arrangement aretreated as the owners of the borrowed securities for U.S.
federal income tax purposes (despite the fact that lenders
retain economic upside and downside of the stock) since
the borrower typically possesses the right to freely transfer
or rehypothecate the security. See Provost v. UnitedStates, 269 U.S. 443 (1926). In a repurchase agreement,on the other hand, where the seller typically has acontractual right to reacquire the same property, a court
has held that the seller retains ownership of the security for
U.S. federal income tax purposes, presumably based on thebuyer’s limited right to dispose of the security. See Union
Planters Nat’l Bank of Memphis v. United States, 426 F.2d
115 (6th Cir. 1970). See also Rev. Rul. 82-150, 1982-2
C.B. 110 (holding that the purchaser of a deep-in-themoney option on non–publicly traded stock was treated as
the owner of the underlying stock).

120

beginning when the structure is put in place and lasting one
year (or potentially longer) during which the exchange rightis not exercisable. 151 Moreover, the exchange right may
entitle the holder of a partnership interest only to cash equal
to the value of an interest in the public entity, rather than theinterest itself (although the public entity generally has theright to satisfy the tender with equity in the public entity
rather than cash). If a partner is never entitled to actually
own an interest in the public entity, it seems even less likelythat the partner would be a deemed owner of such aninterest. 152
151

See, e.g., Amended and Restated Limited Partnership
Agreement of CNL Macquarie Growth, LP (filed with the
SEC as Exhibit 10.1 to Form S-11/A of CNL Macquarie
Global Growth Trust, Inc. on August 20, 2009) (one-year
dry period); Form of Exchange Agreement (filed with the
SEC as Exhibit 10.4 to Form S-1/A of Och-Ziff on
October 25, 2007) (five-year period where exchange
requests are limited at the discretion of the operating
partnership); but see Form of Exchange Agreement (filedwith the SEC as Exhibit 10.35 to Form S-1/A of Graham
Packaging on January 22, 2010) (no dry period).

152

Additionally, exchangeable or convertible securities are
generally treated as having already been converted for
U.S. federal income tax purposes only in situations where
the possibility of conversion is virtually certain. In Rev.

121

Other rights that are typically considered indicative ofan equity interest in an issuer are (1) the right to vote, (2) theright to participate in the issuer’s current earnings andaccumulated surplus, and (3) the right to share in the issuer’s
net assets upon liquidation. 153 In form, owners of theumbrella partnership do not generally have rights to vote thepublic company shares or share in the issuer’s earnings on acurrent basis or on liquidation. In light of the strict structuralparity present in typical umbrella structures, this distinction
is perhaps largely one of form. Still, as Rev. Rul. 69-265 (andRul. 83-98, a convertible debt instrument was treated as
equivalent to the underlying equity since the conversion
right was significantly in the money and there was a “veryhigh probability” of conversion by the holder. In addition,
the issuer had a right to effectively force conversion by aholder as it had a call right for cash beginning two years
after issuance, which a holder would be forced to convert
in order to avoid receiving less value for its debt. In an
umbrella partnership structure, a partner may never receive
equity of the public entity, and the umbrella partnershipwill often retain the unilateral discretion to satisfy its
exchange obligation by delivering cash. Neither theumbrella partnership nor the public entity will typicallyhave the right to force an exchange in any event.
153

See Himmel v. Comm’r, 338 F.2d 815, 817 (2d Cir. 1964).

122other guidance) demonstrates, these distinctions cannot bedismissed. 154
B.

Non-Public Status of the UmbrellaPartnership
The exchange right of the partners of the umbrella
partnership units may need to be limited to avoid any concernthat the umbrella partnership will itself be characterized as a
PTP. A partnership will be treated as a PTP if interests in thepartnership are traded on an “established securities market”

154

The seminal authority for respecting entities as separate is
Moline Properties, Inc. v. Commissioner, 319 U.S. 436(1943) (a corporation’s sales of its real property not treatedas sales made by its sole shareholder). See also, e.g., Nat’lCarbide Corp. v. Comm’r, 336 U.S. 422 (1949) (statingthat “a corporation formed or operated for businesspurposes must share the tax burden despite substantial
identity, in practical operation, with its owner” after a
taxpayer asserted that because it was acting merely as anagent of its parent, deficiencies in income and declaredvalue excess profits taxes were not chargeable to itself, butrather to its parent); N. Ind. Pub. Serv. Co. v. Comm’r, 105
T.C. 341 (1995), aff’d, 115 F.3d 506 (7th Cir. 1997)(rejecting the Commissioner’s arguments that the
taxpayer’s foreign subsidiary should be disregarded andthat payments of interest by the taxpayer to foreign holders
should be subject to withholding, where there is a businesspurpose or the corporation engages in a business activity).

123

or are “readily tradable on a secondary market (or thesubstantial equivalent thereof).” 155 An established securities
market is defined by the regulations to include only certain
securities exchanges and interdealer quotation systems. 156
An interest is readily tradable on a secondary market or thesubstantial equivalent thereof if “taking into account all of
the facts and circumstances, the partners are readily able tobuy, sell, or exchange their partnership interests in a mannerthat is comparable, economically, to trading on an establishedsecurities market.” Such facts and circumstances include
interests being regularly quoted by a person making a market
or dealing in the interests, or the existence of other readily
available means to facilitate exchanges of the interests. 157
The regulations provide a number of safe harbors
within which partners may transfer their interests without

155

Section 7704(b).

156Treas. Reg. section 1.7704-1(b).

157

Treas. Reg. section 1.7704-1(c).

124causing interests in the partnership to be considered readily
tradable. Of potential relevance is the “private placement”
safe harbor, under which interests will not be consideredreadily tradable if the partnership has fewer than 100
members at all times during the taxable year, and interests inthe partnership are not required to be registered under the
Securities Act of 1933. 158 Other safe harbors provide thatcertain “private” transfers of interests are disregarded indetermining whether partnership interests are readily
tradable, including carryover basis transfers, transfers
between family members, new issuances of partnership units,and “block transfers” of more than 2% of the interests in thepartnership. 159
To protect the OP from being characterized as a PTP,
the OP agreement will typically place limitations on transfersof partnership units. For example, the agreement may

158

Treas. Reg. section 1.7704-1(h)(1).

159

Treas. Reg. section 1.7704-1(e)(1), (e)(2).

125

require the general partner’s consent for any transfer ofpartnership units, and the general partner’s consent may be
withheld if the transfer would result in the partnership being
treated as a PTP. The agreements may include provisions
permitting transfers to be made without the general partner’s
consent if they fall within one of the safe harbors provided by
the PTP regulations. In some cases, these limitations may
apply not only to transfers between limited partners, but also
to transfers pursuant to an exchange of OP units with thegeneral partner for publicly traded equity. For an OP withfewer than 100 members that does not require SEC
registration (thus falling within the private placement safe
harbor), such restrictions may not be needed (other than torestrict a transfer that would eliminate the private placement
safe harbor).
Protection against PTP characterization is particularly
important in the context of UP-C and UP-PTP structures. As
explained above, if a partnership is characterized as a PTP, it
will be taxed as a corporation unless 90% of its income is126

qualifying income, as described above. The OP in an UP-C
typically recognizes general income that does not meet the
90% test, so if it were characterized as a PTP, it would
subject the business enterprise (including the pre-IPO
owners) to an additional layer of tax. The same would bepartially true if the OPs in a PTP were characterized as PTPs.
The OP that reports nonqualifying income such as fees would
itself be subject to a corporate level tax. There would be no
additional layer of tax imposed on the “qualifying” OP, as
the income flowing through the qualifying OP would be
intended to satisfy the 90% test. 160

160

In the case of either the UP-C or UP-PTP structure, theadditional layer of tax resulting from PTP characterizationof an OP would be somewhat mitigated. Individual
partners would pay tax on distributions from the OP at thecurrently preferred rate for qualified dividend income,rather than at the general progressive rates. See section
1(h). The corporate partner would benefit from thedividends received deduction, likely at the at the 65% rate
for dividends from 20%-owned corporations, but in any
case at the normal 50% rate . See section 243(a)(1), (c).
In either case, the partner-level income would not berecognized until the time of distribution, rather than thetime the income is recognized at the OP level.

127

To avoid that result, an UP-PTP or UP-C with morethan 100 OP-level partners typically will provide limits on
the exchange right. The exchange right may be limited toincorporate elements of the “redemption and repurchaseagreements” safe harbor under section 7704. A redemption
or repurchase agreement is a plan of redemption or
repurchase maintained by a partnership whereby the partners
may tender their partnership interests for purchase by thepartnership (or another partner or related person to that otherpartner). 161 Exchanges of partnership interests are
disregarded under this safe harbor if (1) the agreement
provides that such a repurchase requires 60 days written
notice by the tendering partner, (2) the agreement requires
the purchase price be established either at least 60 days after
receipt of such notice, or not more than four times per year,
and (3) no more than 10% of the partnership’s capitalinterests or profits interests is transferred during the year

161

Treas. Reg. section 1.7704-1(e)(3).

128

(disregarding “private” transfers described above). 162 For
example, exchanges may be offered on a quarterly basis, with60 days’ notice provided by the tendering partner, fulfillingthe first two requirements above.
On the other hand, PTP status could be benign in thecase of an OP in an UPREIT structure. The OP will
presumably operate to satisfy the REIT requirements,
including the requirement that 95% of the REIT’s grossincome come from certain passive sources such as such asrents from real property, capital gains, interest, anddividends, nearly all of which are sources of qualifying
income under the PTP test. By ensuring that 95% of its
income satisfies this REIT requirement, the OP will typicallysatisfy the 90% qualifying income test under which the OP

162

Treas. Reg. section 1.7704-1(f). See Amy S. Elliott, “IRS
Concerned by Aggressive Exchange Rights in Up-Cs, UpREITs,” 149 Tax Notes 1250 (Dec. 7, 2015).

129will avoid characterization as a corporation even if it ispublicly traded. 163
V.

Umbrella Partnerships and Compensation Issues
A.

Limitation on the Deductibility of

Executive Compensation
In general, section 162(m) limits the amount of thededuction which a publicly held corporation can take forcompensation paid to a “covered employee” of such

163

Nevertheless, it is possible for the OP in an UPREIT torecognize income that satisfies the REIT test but is not
qualifying income for PTP purposes – for example,
interest derived from the conduct of a financial orinsurance business. Compare section 7704(d)(2)(excluding this type of interest) with section 856(f)(excluding interest only if its determination depends on theincome or profits of another person). See also supra note 4(stricter related-party rent rule for PTPs). If the OP is
publicly traded and fails the 90% qualifying income test,
not only will the OP be taxed as a corporation – subjecting
the OP to an entity-level tax – but, since the REIT’s
income will be comprised exclusively of dividend income
from the now-corporate OP, it will fail the test requiringthat 75% of a REIT’s gross income be derived fromcertain real estate related sources. Section 856(c)(3).
Therefore, if the OP is taxed as a C corporation, the REIT
will be taxed as a C corporation as well, and the public
shareholders will pay a third income tax when dividends
are distributed.

130

corporation to a maximum of $1 million per year. 164
Historically, OPs in UPREIT and UP-C structures took theview that where the OP pays compensation to covered
employees of the REIT or C corporation for services whichthose employees provided to the OP, the section 162(m)limitation did not apply to limit the REIT’s or C
corporation’s distributive share of OP’s compensation
deductions. 165 Several private letter rulings issued by the
IRS supported this view in the context of UPREITs. 166

164

For purposes of section 162(m), the term “covered
employee” generally includes the REIT’s or C
corporation’s chief executive officer, chief financial
officer, and the three highest-paid executive officers
excluding the chief executive officer and the chief
financial officer. See section 162(m)(3).

165

One argument which practitioners made was that since thecompensation was paid by the OP to the covered
employees for services provided to the OP, thecompensation was paid to these employees in theircapacities as employees of the OP rather than in theircapacities as employees of the REIT or C corporation.
The section 162(m) limitation does not apply topartnerships; it applies only to publicly held corporations.

166

See PLR 200837024; PLR 200614002; PLR 200727008;
PLR 200725014.

131

On December 20, 2019, Treasury and the IRS
published proposed regulations, 167 which rejected thecommonly held view described above. 168 Under the
proposed regulations, if a REIT or C corporation in an
umbrella partnership structure “. . . is allocated a distributive
share of the [OP’s] deduction for compensation paid by the[OP], the allocated distributive share of the deduction is
subject to section 162(m) even though the corporation did not
directly pay the compensation to the covered employee.” 169
This new rule applies to “any deduction for compensationthat is otherwise allowable for a taxable year ending on orafter December 20, 2019[,]” which would include deductions
for guaranteed payments for services under section 707(c),except for “compensation paid pursuant to a written binding
contract in effect on December 20, 2019 that is not materially167

REG-122180-18.

168

See https://www.govinfo.gov/content/pkg/FR-2019-1220/pdf/2019-26116.pdf at 70363.
See id.

169

132

modified after that date.” 170 The proposed regulations
therefore eliminate what may have been a significant
advantage for umbrella partnership issuers.
B.

Long-Term Incentive Plan Units

Umbrella partnerships may issue profits interests toservice partners that may grow to become similar to OP units(and therefore, similar to stock of the publicly traded
company) but without producing ordinary compensation
income to the holder on receipt, vesting or sale. These equity
interests are typically referred to as long-term incentive planunits, or “LTIP” units. LTIP units have been used bynumerous UPREITs, but could be considered in any umbrella
partnership structure. 171

170
171

See id. at 70363–64.
See, e.g., Sixth Amendment to Third Amended andRestated Agreement of Limited Partnership of GGP
Limited Partnership dated November 12, 2013 (filed with
the SEC as Exhibit 10.1 to Form 8-K of General Growth
Properties, Inc., on November 18, 2013); First Amended
and Restated Agreement of Limited Partnership of Empire
State Realty OP, L.P., dated October 1, 2013 (filed with
the SEC as Exhibit 3.1 to Form 10-Q of Empire State
Realty Trust, Inc., on November 12, 2013).

133

When granted, LTIP units do not have any interest in
the capital of the OP, and thus qualify as profits interests
within the meaning of Rev. Proc. 93-27. In that event, theLTIP units are not included in income upon receipt or upon
vesting, assuming the units are vested or if unvested therecipient makes a section 83(b) election or meets therequirements of Rev. Proc. 2001-43. 172 The holder of an
LTIP unit may be entitled to receive current distributions ofoperating cash flow, and corresponding allocations ofincome, out of profits generated after the date of grant paripassu with the OP units. 173
172

See Rev. Proc. 2001-43 (requirements include that thepartnership and recipient treat the recipient as owner of thepartnership interest, the interest not relate to a predictable
income stream and the recipient not dispose of the interest
for at least two years).

173

In some cases, the holder will not become entitled to all orsome of the profits distributions on unvested units until
vesting, which raises the issue of whether thecorresponding income should be allocated to the holder ofthe unvested unit on a current basis. One potential
alternative is to issue additional LTIP units on theunvested LTIP units, instead of the distribution of profits,subject to the same vesting arrangements as the underlying
LTIP units.

134

The LTIP unitholder will also receive a priority
allocation of profits upon a disposition of substantially all of
the OP’s assets. Under this special allocation, the first
dollars of gain on such a sale will be allocated to the LTIP
units until each LTIP unit has a capital account equal to thecapital account of an OP unit, after which any further gain
will be allocated on a per-unit basis among the LTIP units
and OP units. Assuming there is sufficient gain on exit to“catch up” the capital accounts of the LTIP units to thecapital accounts of the OP units, the holders of LTIP units
will achieve the same economics as the holders of regular OP
units. None of the income recognized in respect of the LTIP
units will be compensation.
There is economic risk to the LTIP unitholders under
this arrangement. If, upon a sale of substantially all of theassets of the OP, there is insufficient profit to catch up the
LTIP units, an LTIP unit will be distributed less of theproceeds than an OP unit. The OP limited partnershipagreement will provide that upon an event permitting a135

revaluation of partnership property under the partnership
allocation regulations, 174 any appreciation in partnershipproperty will be credited to the capital accounts of the LTIP
units in priority to the OP units, consistent with theallocations that would be made if all of the revalued property
were sold. 175 This revaluation is not a taxable event. Once
the LTIP unit capital accounts are equal to OP unit capital
accounts, the LTIP units are economically indistinguishable
from the OP units and may be exchanged for OP units,
which, in turn, may be exchanged for stock of the publiccompany. 176 Any gain on such an exchange may result in
174

Treas. Reg. section 1.704-1(b)(2)(iv)(f)(5).

175This manner of crediting the LTIP capital accounts may berequired for the allocations to have substantial economic
effect, as the applicable regulations require the capital
accounts to be adjusted on a revaluation to reflect themanner in which unrealized gain or loss would beallocated to the partners upon a disposition of any
property. Treas. Reg. section 1.704-1(b)(2)(iv)(f)(2). The
OP limited partnership agreement may allocate gain from
non-liquidating asset sales in a different manner.

176

The OP may have the right to force the LTIP unitholder tomake this exchange, which should be of no detriment to
the LTIP unitholder. An LTIP unit with a positive capital
account balance that is less than an OP unit’s balance may

136capital gain, rather than ordinary income, to the service
partner (except to the extent of any “hot assets” held by theOP). 177
Although any partnership could grant similar LTIP
units to service partners, umbrella partnerships are
particularly good candidates for the use of such LTIPs in thatthe fair market value of the partnership’s assets in theaggregate should generally be readily available as it is
implied by the trading price of the stock of the publiccompany. 178

be exchangeable for a fraction of an OP unit. If LTIP units
were exchangeable for full OP units without regard to theircapital accounts, the LTIP units would have an interest in
the capital of the partnership upon grant, thus disqualifying
them from being treated as profits interests under Rev.
Proc. 93-27.
177

See sections 741 and 751.

178

In the simple case of a public company that has no assets
other than OP units and no liabilities, the value of the net
assets of the OP will equal the market capitalization of the
public company divided by the public company’sownership percentage of the OP (taking into accountdilution by the LTIP units).
In a notice of proposed rulemaking issued on July 23,
2015, the IRS proposed regulations concerning disguised137

An LTIP interest will generally be treated as anapplicable partnership interest subject to the special threeyear holding period under section 1061 as added to the Codeby TCJA section 13309, assuming the LTIP interest is issued
in connection with the performance of substantial services in
an applicable trade or business (generally, a portfolio or realestate management business). 179

payments for services under section 707(a)(2)(A) andincluded statements in the preamble regarding theinterpretation of and planned changes to Rev. Proc. 93-27
relating to issuance of partnership profits interests toservice providers. REG-115452-14, 80 Fed. Reg. 43,652(July 23, 2015). Depending on the specifics of final
guidance, it is possible Rev. Proc. 93-27 will no longer
apply to the grant of an LTIP and/or regulations under
section 707(a)(2)(A) will cause distributions on the LTIPs
to be treated as fees (and thus as ordinary income) for tax
purposes. For a discussion of the proposed guidance, see
generally New York State Bar Association Tax Section,
Report on the Proposed Regulations on Disguised
Payments for Services (Nov. 13, 2015).
179

See section 1061(c). To the extent provided in regulations,however, section 1061 shall not apply to any asset not held
for portfolio investment on behalf of any third party
investors. Section 1061(b).

138