What’s Up with Up-Cs? 8 Things You Need to Know

They may have a funny name, but Up-Cs are serious business. Short for “Umbrella partnership-C corporation,” an Up-C structure involves a publicly traded corporation that holds an interest in another entity, typically a limited liability company (LLC), that holds all of the business’ operating assets. The latter is taxed as a partnership.

“The essential elements of the Up-C structure are a corporation upstairs and an LLC downstairs,” explains Robert Seber, a partner in Mergers & Acquisitions and Private Equity at V&E. Seber notes that in recent years, more and more LLCs in the energy sector and elsewhere have used Up-Cs when going public. “There were reasons the companies formed as LLCs to begin with, and under Up-Cs, those reasons remain intact.” In addition, LLC owners who eventually exchange their partnership stakes for common shares in the Up-C corporation may see additional benefits.

But choosing to use an Up-C structure isn’t a simple decision, adds V&E tax partner Lina Dimachkieh. “People have to do their analysis and figure out what the numbers look like, what they expect their business to look like, and whether they want some of the additional complexity that comes from being in an Up-C structure,” she says. “There are a lot of considerations to take into account.”

So where do you start? Here’s are some key factors to keep in mind:

  1. There are no corporate taxes for original owners.

An Up-C has a two-tiered ownership structure: Shareholders in the Up-C corporation comprise the “upstairs” tier and the original owners of the company (in addition to the Up-C corporation itself) make up the “downstairs” tier. While the Up-C corporation itself is subject to corporate taxes, the Up-C partnership is not; it is still a pass-through. In other words, corporate taxes don’t take a bite out of the income reaped by the original owners.

  1. Original owners can exchange their Up-C units (and trigger a step-up in tax basis).

Under an Up-C structure, the original owners have more liquidity than they did when the company was solely a private partnership. That’s because they now have the opportunity to exchange their units in the Up-C partnership for shares of the publicly traded Up-C corporation. This exchange triggers a step-up in tax basis for the Up-C corporation, resulting in new tax savings.

  1. Original owners see the bulk of tax savings but “upstairs” shareholders benefit, too.

In a typical Up-C, the bulk of the cash from tax savings (usually 85 percent) goes to the original owners who have traded in their partnership stakes for common stock in the Up-C corporation and generated the tax basis increase underlying the tax savings. The arrangement is codified in a tax-receivable agreement, or TRA, with the original owners receiving payouts periodically as the corporation realizes tax savings.

The remaining cash (typically 15 percent) remains with the Up-C corporation, which can choose to “pay it out as a dividend to its existing shareholders or, if it’s not really a dividend-paying company, can just choose to reinvest that money in the business,” Dimachkieh explains. “The idea is that everybody wins.”

  1. Existing public corporations may also convert to Up-Cs to acquire assets.

A public corporation poised to make a major acquisition using a substantial amount of its equity may also be interested in an Up-C structure because of the tax-deferral opportunity it can provide to the sellers. In ideal circumstances, the public corporation already holds its assets in an LLC that can be used as the new underlying Up-C partnership.

When that’s not the case, however, the Up-C conversion process can become more complex, and the potential tax benefits to the sellers need to be substantial. “It’s not that you’re going to go to a public company and say, ‘Hey, I want tax deferral so let’s convert you into an Up-C,’” Dimachkieh says. “It has to be a big transaction and really worth the effort to go through it.”

  1. Companies can prepare for an Up-C future without immediately converting to an Up-C.

If the owners of a privately held company don’t want to opt for an Up-C structure during an IPO, they can still take steps to make it easier to convert to an Up-C later on. “If we’re representing a company that is IPO-ing as a C-corporation, we often try to plan ahead so that the structure being put into place at IPO is amenable to doing an Up-C in the future without having to go through a lot of drama,” Dimachkieh says. An Up-C-friendly plan, for instance, could include creating an LLC underneath the corporation that holds all of the business’ operating assets.

  1. Day-to-day life in an Up-C may get complicated.

Establishing the Up-C structure is only half the battle. Not only does the Up-C have to manage partnership unitholders’ tax-receivable agreements, Up-Cs have more tax reporting requirements than traditional C-corps. “It’s nothing insurmountable, but it is a more complicated world to live in,” Dimachkieh says.

  1. Tax law changes require new analysis for original owners.

The federal Tax Cut and Jobs Act of 2017 ushered in a steep reduction in the corporate tax rate. The lower rate means that, in some cases, the tax benefits (and matching TRA payments) promised by Up-Cs may not be as significant as they were under the previous tax regime. Partnership unitholders who are subject to “recapture” income taxes at higher ordinary income tax rates, in particular, may determine that being a “downstairs” investor is no longer as attractive a proposition.

  1. TRAs can be a gamble … that pays off.

Sometimes an Up-C, like any other corporation, ends up with little to no tax liability in a quarter or a year because of a lack of taxable income. When this is the case, tax receivable agreements provide original owners no payouts at all … because there are no tax savings to be had in the first place.

One saving grace for the original owners is that the Up-C may, at some point, be acquired by another company. When this happens, the acquiring company may have to adhere to what’s known as a “change of control” provision often embedded in a TRA. Under that provision, the buyer of the Up-C must pay a lump sum to the original owners to compensate them for the periodic tax savings payouts they would have otherwise received. Although there’s no guarantee that an Up-C will actually be acquired, if it is, the payout under the TRA can be substantial.

Determining whether the Up-C structure offers the right future for your business means doing your homework and getting the best advice.