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VideoIs Your Company Considering an Up-C? Prepare for ASC 740 Complexity
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Over the years, a number of companies have achieved public company (PubCo) status through an umbrella partnership C-corporation (Up-C) transaction. An Up-C generally involves an operating company organized as a limited liability company (LLC) or other pass-through entity. A newly formed C-corporation, referred to as a PubCo, raises capital through an initial public offering and uses the proceeds to acquire an interest in the operating company (OpCo).
This structure allows the pre-initial public offering (IPO) owners to retain a significant economic interest in OpCo while generally preserving their ability to exchange their OpCo units for shares of PubCo in the future. Those future exchanges can create additional tax basis in OpCo’s underlying assets, which can have important implications for PubCo’s financial reporting and income tax provision under ASC 740.
What Happens When an Owner Exchanges OpCo Units?
When a pre-IPO owner exchanges OpCo units for PubCo shares, the owner generally recognizes taxable gain. If the appropriate tax elections are in place, the exchange may also create additional tax basis in OpCo’s underlying assets with respect to PubCo.
This additional tax basis can generate future tax benefits for PubCo through specially allocated depreciation and amortization deductions. Absent another contractual arrangement, PubCo would retain the benefit of those deductions even though the exchanging owner recognized the corresponding taxable gain.
That is where a tax receivable agreement (TRA) comes into play.
Under a typical TRA, PubCo agrees to pay the exchanging owner a percentage of the cash-tax savings PubCo realizes from the additional tax basis. The TRA provides a significant benefit to the exchanging owner, but it also creates some unique financial-reporting and income-tax-provision issues for PubCo. Understanding how the TRA interacts with the related deferred tax asset is an important part of evaluating the financial reporting implications of an Up-C.
Recording the Deferred Tax Asset and TRA Liability
The basis step-up exists for tax purposes but does not generally result in a corresponding step-up in the carrying amount of the underlying assets for financial-reporting purposes. As a result, PubCo may recognize a deferred tax asset under ASC 740 for the future tax deductions associated with the basis step-up.
Assume an exchange creates a $100 tax-basis step-up that will be deductible over five years. At an assumed 25% tax rate, the related deferred tax asset is $25. If the TRA requires PubCo to pay the exchanging owner 85% of the resulting cash-tax savings, the initial TRA liability is $21.25 ($25 x 85%).
Assuming the exchange is accounted for as an equity transaction, the initial entry would be:
| Account | Debit | Credit |
|---|---|---|
| Deferred tax asset | $25.00 | |
| TRA liability | $21.25 | |
| Additional paid-in capital | $3.75 |
PubCo has therefore recognized the full $25 deferred tax asset, a $21.25 contractual obligation to the exchanging owner and a net $3.75 increase to equity representing PubCo’s expected 15% share of the tax benefit.
The precise accounting can depend on the terms of the exchange and TRA, including whether PubCo retains control of OpCo and whether the transaction is treated as an equity transaction under the applicable accounting guidance.
The Subsequent Provision Accounting
After the initial deferred tax asset and TRA liability are recorded, PubCo must account for the ongoing effects of the basis step-up as the related tax benefits are realized over time.
Assume the $100 basis step-up is amortized evenly over five years. PubCo would receive a $20 annual tax deduction, producing a $5 annual reduction in current income taxes at a 25% rate.
The deferred tax asset would reverse as follows:
| Account | Debit | Credit |
|---|---|---|
| Deferred tax expense | $5.00 | |
| Deferred tax asset | $5.00 |
The $5 deferred tax expense is generally offset by a corresponding $5 reduction in current tax expense. As a result, the reversal itself ordinarily has no net effect on total income tax expense although it changes the composition between current and deferred tax expense.
PubCo would then pay 85% of the $5 realized tax benefit, or $4.25, to the exchanging owner:
| Account | Debit | Credit |
|---|---|---|
| TRA liability | $4.25 | |
| Cash | $4.25 |
The TRA payment is accounted for outside the income tax provision. Economically, PubCo retains only $0.75 of the annual $5 cash-tax savings, even though its current tax provision reflects the entire $5 benefit generated by the additional deduction. In other words, the tax provision reflects the full tax benefit, while the TRA determines how much of that benefit PubCo ultimately retains after making the contractual payment to the exchanging owner.
Why the Financial Statements Can Be Confusing
The accounting outcome can differ from the underlying economics of the transaction, which can make the financial statements challenging to interpret. The income tax provision reflects the tax effect of the additional deductions, while the obligation to share those benefits with the former owner is reported separately through the TRA liability and related cash payments.
Several factors can affect the deferred tax asset, TRA liability or both over time, creating additional complexity:
- Changes in expected future taxable income
- Valuation allowances against the deferred tax asset
- Changes in enacted tax rates
- State and local tax considerations
- Additional exchanges of OpCo units
- Differences between estimated and realized tax savings
- TRA acceleration or early-termination provisions
- Changes in the expected timing or amount of TRA payments
Importantly, the ASC 740 deferred tax asset and the TRA liability are governed by different accounting models. They therefore may not move together when assumptions or circumstances change.
Companies using an Up-C structure should maintain detailed tax-basis, deferred-tax and TRA schedules and provide clear disclosures explaining the relationship among the deferred tax asset, income tax provision, TRA liability and expected cash payments.
Key Considerations Before Implementing an Up-C Structure
The tax and financial reporting implications of an Up-C can continue long after the initial transaction. Companies that understand how the deferred tax asset, income tax provision and TRA interact can be better prepared to evaluate the ongoing effects of the structure on their financial statements.
Weaver assists companies in assessing the deferred tax asset, tax receivable agreement and tax provision considerations associated with an Up-C structure. Contact us to learn more.
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