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Harvard Law School December 3 , 2018

Creative Uses of Partnerships in Acquisitions, Dispositions, and PE Planning. Harvard Law School December 3 , 2018. Eric Sloan Gibson, Dunn & Crutcher LLP. Agenda. Acquisition and Disposition: Navigating The Disguised Sale Rules Private Equity Topside Planning Making an Investment

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Harvard Law School December 3 , 2018

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  1. Creative Uses of Partnerships in Acquisitions, Dispositions, and PE Planning Harvard Law School December 3, 2018 Eric Sloan Gibson, Dunn & Crutcher LLP

  2. Agenda • Acquisition and Disposition: Navigating The Disguised Sale Rules • Private Equity • Topside Planning • Making an Investment • Exiting an Investment (Sales and IPOs)

  3. Statutory and Regulatory Outline • The Code – § 707(a)(2)(B) • The Regulations • Reg. § 1.707-3 (sales by partners to partnerships) • Reg. § 1.707-4 (distribution safe harbors) • Reg. § 1.707-5 (impact of liabilities and debt-financed distributions) • Reg. § 1.707-6 (sales by partnerships to partners, or Reg. § 1.707-3 in reverse) • Reg. § 1.707-7 (oops, strike that) • Reg. § 1.707-8 (disclosure rules) • Reg. § 1.707-9 (effective dates)

  4. Over-the-Top Loan $170 Note n/r secured by preferred and common Eric Bahar Bahar Eric $190 preferred 1% common 99% common Asset FV: $990 Asset FV: $200 AB: $10 LLC LLC Asset FV: $990 Asset FV: $200 AB: $10 Considerations Will the form be respected? Alternative: A bank lends part (with Eric lending the rest to Bahar).

  5. Loan Up James Cliff Cliff James Cliff’s Spouse $190 preferred 5% common 95% common $190 Cash Asset FV: $200 AB: $10 LLC $170 note full recourse to Cliff, secured by preferred and common LLC Asset FV: $200 AB: $10 Considerations Cliff’s Spouse must have the wherewithal to repay the loan. Why would you do this? Because James has only cash to contribute. What if loan were made to Cliff directly? Could increase amount of note to $190.

  6. Liability Netting Rule (Part 1/2) Bahar Eric $160 Non-QL $480 QL Bank 2 Bank 1 Asset subject to debt Asset subject to debt $950 cash $950 cash Asset FV: $210 AB: $10 Assets FV: $630 AB: $10 LLC

  7. Liability Netting Rule (Part 2/2) Eric Bahar 25% 75% LLC $480 note $160 note Bank 2 Bank 1 Assets FV: $630 AB: $10 Asset FV: $210 AB: $10 Note: The reduction of Bahar’s share of her $160 note (i.e., 75 percent of $160 = $120) is offset by the 25 percent of Eric’s $480 note that she will get (25 percent of $480 = $120). See Reg. § 1.707-5(a)(4)

  8. Qualification of LBO Debt

  9. Liquidation: Formation and Capitalization of Sub Parent $100 Sub $900 loan Lender

  10. Liquidation: Sub Purchases Target Stock Parent Sub $900 note Target Owners $1000 Lender Target stock Target

  11. Liquidation: Before and After Structure After Target Acquisition Desired End Structure Parent Parent Sub Sub Third Party $900 note Lender LLC Target $900 note Lender Target Assets

  12. Liquidation: Target Converts to LLC Parent Sub $900 note Lender Target

  13. Liquidation: Formation of LLC Parent Sub $900 note Third Party Target Interests Subject to debt Assets Lender Target Assets LLC

  14. Liquidation: End Structure Parent Sub Third Party LLC $900 note Lender Target Assets

  15. Double Dip Coordination of Reg. §§ 1.707-4 and -5 “[I]f capital expenditures were funded by the proceeds of a qualified liability. . . that a partnership assumes or takes property subject to in connection with a transfer of property to the partnership by a partner, a transfer of money or other consideration by the partnership to the partner is not treated as made to reimburse the partner for such capital expenditures to the extent the transfer of money or other consideration by the partnership to the partner exceeds the partner's share of the qualified liability (as determined under §1.707- 5(a)(2), (3), and (4)).” 

  16. Double Dip (Original Flavor) is Dead Cliff buys asset Later, Cliff contributes asset to LLC $40 cash $30 interest $185 James Cliff Other Members Cliff Other Members Other Members $150 note Bank $150 note Bank Asset Asset subject to debt Asset FV: $220 Asset FV: $185 $35 Cash LLC $160 assets and cash

  17. Double Dip – a New Flavor Cliff contributes asset to LLC Resulting Structure Other Members Other Members Other Members $40 cash $30 interest Other Members Other Members Cliff Other Members Cliff $150 note Bank Asset subject to debt Asset FV: $220 80% 20% LLC LLC $150 note Bank Asset FV: $220 $120 assets and cash $160 assets and cash What if LLC immediately pays off the $150 note?

  18. Cherry Picking – Pre-Transaction Structure Cliff Bahar Cash $100 Asset 2 FV: $60 AB: $10 Asset 1 FV: $90 AB: $30 Asset 3 FV: $100 AB: $100

  19. Cherry Picking – Desired End Structure Cliff Bahar 60% 40% LLC Cash $100 Asset 3 FV: $100 AB: $100 Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10

  20. Cherry Picking – Contributions Cliff Bahar Asset 1 and Asset 2 $100 Cash $100 Asset 2 FV: $60 AB: $10 Asset 1 FV: $90 AB: $30 Asset 3 FV: $100 AB: $100 LLC

  21. Cherry Picking – Sale Cliff Bahar $100 Asset 3 60% 40% LLC Asset 3 FV: $100 AB: $100 Cash $100 Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10

  22. Cherry Picking – End Structure Cliff Bahar 60% 40% LLC Cash $100 Asset 3 FV: $100 AB: $100 Asset 1 FV: $90 AB: $30 Asset 2 FV: $60 AB: $10 Considerations Does cherry picking work? Yes, but the IRS is not a fan (except when it is). What (else) can Bahar do to strengthen her position?

  23. Private Equity

  24. Simplified Overview Structure Sponsor Investors Sponsor Commitment 20% Carried Interest Investor Commitment GP LP PE Fund (Delaware)

  25. Simplified Topside Structure U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors Non-U.S. Investors Taxable and Super Tax-Exempt U.S. Investors Sovereign Investors Tax-Exempt U.S. Investors Principals Sponsor (Delaware) GP LP LP LP LP PE Fund (Delaware)

  26. Typical PE Topside Structure for Investment in anOperating Partnership U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors U.S. Taxable Investors Non-US Investors SovereignInvestors Principals Taxable, Some Tax ExemptSuper Tax-Exempt Other Tax-Exempt U.S. Investors Sponsor GP LP LP LP LP Fund 1 Fund 2 Fund 3 Fund 4 Holdco 2 (Delaware) Holdco 3 (Delaware) Holdco 4 (Delaware) Partnership 2 Partnership 3 Partnership 4 Portfolio Company • Considerations • Controlled entity status of Holdco 3 • USRPHC status of Holdco 4

  27. PE: Acquisitions

  28. Acquiring Partnerships

  29. Acquisition with Rollover Partial Redemption of Sellers’ Units Sale of Remainder of Sellers’ Units 3 Remaining Target Units Rollover Investors Sellers Rollover Investors Sellers PE Fund Cash Bank Bank Target LLC Target LLC Note Cash Loan Cash 1 2 • Basic transaction • Target borrows from Bank. • Target distributes the borrowed cash to Sellers in partial redemption of their units. • PE Fund buys Sellers’ remaining units. • Considerations • What if Rollover Investors want to get some cash? • Does the order of the steps matter? • Disguised sale of partnership interest?

  30. Acquiring S Corporations

  31. Alternative 1: No Asset Step Up Shareholders PE Fund Cash 80% of Target Stock Target (S Corp) • Basic transaction • PE Fund buys 80% of the stock of Target from Target’s shareholders. • Consequences • No asset basis step up for the stock purchase.

  32. Alternative 2: § 338(h)(10) Election PE Fund Shareholders Buyer Corp Cash 80% of Target Stock Target (S Corp) • Basic transaction • PE Fund forms Buyer Corp, which buys stock of Target from Target’s shareholders. • Shareholders and Buyer Corp make a § 338(h)(10) election to treat Target as having sold all of its assets at FMV. • Consequences • Target is taxed on deemed sales of its assets subject to liabilities to Buyer Corp, followed by a deemed liquidation. Deemed liquidation generally does not result in additional tax. • Key is convincing Target Shareholders to accommodate a step-up transaction. • Main tax issues to consider: • § 1374 BIG tax • Inside/ outside basis differences • Character differences • State tax differences • Impact if not S Corp • Too much gain is triggered • Section 336(e)

  33. Alternative 3: F Reorganization and 99-5 transaction Shareholders Shareholders NewCo Stock 50% Target Units NewCo (S Corp) PE Fund Target Stock Cash Target LLC Target (S Corp) NewCo • Basic transaction • Target Shareholders form NewCo, a domestic corporation, and contribute all of the stock of Target to NewCo in exchange for all of the stock of NewCo. • Target converts into an LLC, a disregarded entity. • PE Fund buys all of the Target LLC units from NewCo. • Consequences • The first two steps should be treated as a tax-free reorganization pursuant to § 368(a)(1)(F). • NewCo does not have to make a new S election pursuant to Rev. Rul. 64-250. • Same tax consequences for PE Fund as Alternatives 2 and 3. • Perhaps different consequences to Target Shareholders (inside/outside basis differences). • If S Corp bad, trigger gain, but get step up.

  34. Alternative 4: F Reorganization and 99-5 transaction (cont'd) Shareholders PE Fund NewCo 50% 50% Target LLC • Consequences • The first two steps should be treated as a tax-free reorganization pursuant to § 368(a)(1)(F). • PE Fund’s purchase of 50% of Target shares is treated as the purchase of a 50% interest in each of the Target’s assets followed by a contribution of Target’s assets to Target LLC under Rev. Rul. 99-5, Situation 1. • Considerations • Book/tax disparity for assets deemed contributed by NewCo. • Anti-churning.

  35. Alternative 5: F Reorganization/Interest Purchase Shareholders Shareholders 3 50% Target Units 4 NewCo Stock NewCo PE Fund 1 Target Stock 1 Cash 4 Target (S Corp) NewCo Target LLC • Basic transaction • Shareholders form NewCo, a domestic corporation, and contribute all of the stock of Target to NewCo in exchange for all of the stock of NewCo. • Target converts into an LLC, a disregarded entity. • Shareholders contribute cash to Target LLC in exchange for membership interests. • PE Fund buys 50 percent of Target LLC units from NewCo. • Considerations • Purchase of interests vs. assets. • Will form be respected? • Anti-churning. • If debt at Target LLC, disguised sale?

  36. Exit from Partnership Investments: Sales

  37. Sale of Typical PE Investment in an Operating Partnership Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Partnership 1 Portfolio Company • Objective • PE wants to sell Portfolio Company.

  38. Sale of Typical PE Investment in an Operating Partnership (cont'd) Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Partnership 1 Portfolio Company • Partnership 1 liquidates and distributes its interest in Portfolio Company to HoldCo and Sponsor.

  39. Sale of Typical PE Investment in an Operating Partnership (cont'd) Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Portfolio Company • Sponsor and AIV sell their interests in Portfolio Company; AIV2 sells its shares of HoldCo (likely at a discounted purchase price).

  40. Exit from Partnership Investments: UP-C IPOs

  41. UP-C Structure – Simplified Ending Structure Unblocked Investors Blocked Investors Public AIV 1 AIV 2 TRA TRA PubCo Non-Managing Member Managing Member Blocker Non-Managing Member Portfolio Company

  42. Pre-IPO Structure Unblocked Investors Sponsor Blocked Investors AIV 1 AIV 2 LP GP GP LP HoldCo Partnership 1 Portfolio Company

  43. Pre-IPO Structure – Simplified Blocked Investors AIV 2 Unblocked Investors Blocker AIV 1 Portfolio Company

  44. PubCo – Step 1 Blocked Investors Unblocked Investors AIV 2 Blocker AIV 1 Cash PubCo Portfolio Company AIV 1 forms a corporation that will be the public registrant (“PubCo”). Portfolio Company is recapitalized. The unblocked units are exchangeable for PubCo shares. (See Rev. Rul. 69-265 regarding the exchange right.)

  45. PubCo – Step 2 Blocked Investors AIV 2 Unblocked Investors Blocker AIV 1 PubCo Portfolio Company LLC PubCo forms a limited liability company (“LLC”), a corporation for U.S. federal income tax purposes.

  46. PubCo – Step 3 Blocked Investors Unblocked Investors AIV 2 Blocker AIV 1 PubCo Portfolio Company LLC Merger LLC merges with and into Blocker. Blocker’s shareholders receive PubCo shares and an income tax receivable (“ITR”) as merger consideration.

  47. PubCo – Step 4 Blocked Investors Unblocked Investors AIV 1 Public AIV 2 Common Stock Cash PubCo Blocker Portfolio Company PubCo undertakes an IPO.

  48. PubCo – Step 5 Unblocked Investors Blocked Investors Public AIV 1 AIV 2 PubCo Blocker Units Cash Portfolio Company PubCo contributes the IPO proceeds to Portfolio Company in exchange for units. Portfolio Company will use the cash for general company purposes (e.g., repayment of existing debt, capital expenditures, acquisitions, etc.).

  49. UP-C Final Structure Unblocked Investors Blocked Investors Public AIV 1 AIV 2 TRA TRA PubCo Non-Managing Member Managing Member Blocker Non-Managing Member Portfolio Company From time to time, AIV 1 may exchange Portfolio Company units for PubCo stock and ITRs.

  50. Tax Receivable Agreements • What is a tax receivable agreement? • What attributes are covered? • "With and Without" calculation • What is needed? • § 754 election. • § 743(b) adjustment to step up basis. • Other tax attributes (e.g., NOLs, credits) • Financial statement treatment. • Liability for gross payments. • Valuation allowance needed?

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