Carvana Co. is an unmitigated Wall Street success story, as evidenced by its nearly $28 billion market capitalization. Recently, however, the company and its founders were cast in a harsh light by the Wall Street Journal in an article suggesting that said founders were operating the company largely for their personal benefit, and only secondarily for the benefit of the public owners of the company’s “low-vote” stock.
Although the article focused much of its attention on certain stock trades that the company facilitated for the benefit of said founders, another aspect of Carvana’s “governance structure"—the burdensome tax receivable agreement (TRA) with which it is saddled—also warranted some scrutiny. Under the TRA, the founders will be in line for additional payments, which could amount to over $1 billion, assuming the company can generate sufficient amounts of taxable income over the next decade or so. These TRAs have become a staple of IPOs and frequently crop up in SPAC deals. At this point it is unclear whether public investors in TRA-burdened companies are fully conversant with their ramifications.
Before rendering a value judgment regarding the “legitimacy” of TRAs, it is important to appreciate the tax rules that make them possible. When a partnership (or other unincorporated entity, such as a single-member limited liability company) transforms itself into a corporation for the purpose of facilitating a public offering of ownership stakes (or where such an entity combines with a SPAC), the newly-formed corporation becomes a partner in the so-called “operating partnership,” while the remaining interests therein continue to be held by the founders.
Thus, the newly-pubic corporation does not directly conduct business activities, but, instead, becomes a partner in the operating partnership in which the business assets and activities are lodged. Such a corporation is known as an “up-C,” a name borrowed from the real estate investment trust (REIT) community in recognition of the fact that most REITs conduct their activities through operating partnerships, of which the REIT is a member. A REIT that conducts its activities in this fashion is popularly known as an “up-REIT.”
The newly-public corporation will issue “low vote” stock to public investors in exchange for cash. Such a corporation will then deploy the cash to purchase operating partnership interests from the founders. In addition—and this is a key feature—said founders will also receive “high vote” stock in exchange for the operating partnership interests sold by them to the corporation. This high vote stock typically carries with it a majority of the total combined voting power of all classes of stock entitled to vote, leaving control of the corporation securely in the hands of the founders. Typically, this high vote stock is bereft of “economic rights,” in the sense that it is not entitled to dividends or to distributions in liquidation, should the corporation undergo a “solvent” liquidation.
The founders receive one other element of consideration for the partnership interests they sell to the corporation: an “exchange right” pursuant to which they will be entitled, at times specified in the relevant agreement, to exchange their (retained) partnership interests in return for low-vote shares issued by the corporation. These exchanges, which are undertaken when the founders choose to effect them, will be taxable to the founders because, immediately after the exchange, the founders are not “in control” of the corporation (within the meaning of tax code Section 368(c)), with the result that the exchanges do not qualify, with respect to the exchanging founders, under Section 351(a).
Under Section 754, if a partnership files the requisite election, “the basis of partnership property shall be adjusted in the case of a transfer of a partnership interest in the manner provided in section 743.” This latter section provides that “in the case of a transfer of an interest in a partnership by sale or exchange,” a partnership with respect to which the election provided for in Section 754 is in effect shall increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his or her or its interest in the partnership over his or her or its proportionate share of the adjusted basis of the partnership property. Such increase shall constitute an adjustment to the basis of partnership property with respect to the transferee partner only.
Thus, when the new public corporation purchases its initial interest in the operating partnership from the founders, or acquires such an interest in the taxable exchange that arises from the founders’ exercise of their exchange rights, the corporation will enjoy (because the partnership will have filed the election called for by section 754) a step-up in basis with respect to its proportionate share of the partnership’s assets. As a consequence of the step-up, the corporation’s taxable income derived from the partnership will be diminished (because the basis step-up increases the amount of depreciation and amortization tax deductions the purchasing partner will enjoy) and, correspondingly, its tax liabilities will be minimized.
Although the fruits of the basis step-up, as Section 743(b) expressly provides, “belong” to the corporation, the purchasing partner. After all, the corporation paid a price for the partnership interests that reflected the value of the partnership’s assets. The TRA—which as indicated, has become almost standard operating procedure in IPOs (and SPAC acquisitions) of heretofore unincorporated entities,—"shifts” said tax benefits to those persons, i.e., the founders, who transferred the partnership interests to the corporation.
A typical TRA is described by the newly formed corporation in language that makes its results plain, but no less sobering: “We will (the corporation will say) enter into a TRA with our existing owners (the founders) that will provide for the payment by us of 85% of the tax benefits that we are deemed to realize as a result of the current tax basis in the assets of the partnership and the increases in basis resulting from our purchases or exchanges of partnership units. We expect (the corporation is constrained to say) that these payments will be substantial.” (In SPAC deals, frequently, the public will be shut out entirely, since 85% of the tax savings will accrue to the benefit of the founders with the other 15% credited to the account of the SPAC’s sponsor(s).)
Financial Accounting for TRAs
The financial accounting for these arrangements is relatively unobtrusive. The corporation will record a “deferred tax asset” to reflect the fact that the tax basis of its share of the partnership’s assets will exceed the carrying amount thereof. The corporation will also record an account payable to reflect its inchoate obligation to make the “tax benefit transfer payments” to the founders. In some cases, the corporation will see fit to establish a “valuation allowance” with respect to the deferred tax asset, reflecting some uncertainty regarding its ability to generate taxable income with which to “realize” the deferred tax asset.
Any excess of the deferred tax asset over the account payable will be credited, not to earnings, but, instead, to a balance sheet account, “additional paid-in capital.” As the enhanced basis assets are depreciated and amortized, the deferred tax asset will decline proportionately with the accompanying charge reflected in the provision for income taxes. The corporation’s earnings before interest, taxes, depreciation, and amortization (EBITDA), therefore, the principal metric for valuing corporations, will be wholly unaffected by this arrangement.
These agreements, it should be noted, are fully, and sometimes quite extensively, disclosed and, presumably, are taken into consideration by a prospective purchaser of the corporation’s stock. However, notwithstanding “efficient market” theories, which espouse that all information is perfectly disseminated (and understood) by all market participants, it is not inconceivable that the full import of these TRAs might not be fully appreciated by all investors and, therefore, to the extent such TRAs are not properly taken into account by such investors, market inefficiencies might well ensue. Given the reaction to the Journal’s article about Carvana, it might be surmised that, in the case of TRAs, the efficient market theory is not operating—as its proponents would like to envision—at full capacity.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.
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