The growing importance of tax partnerships in startup deal structures
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For the past two decades, the standard route for a startup was to create a corporation organized in Delaware. Outside of a few niche markets, such as real estate, this structure has provided tax and organizational simplicity that readily facilitated growth and subsequent rounds of capital infusion. Now, the world is changing. In 2022, some of Utah’s largest startup deals were transactions that involved tax partnerships⎯usually entities organized as LLCs. This article discusses the cultural and tax reasons driving the shift and some fundamental deal structuring considerations.
The partnership structure: A quick history
In 1913, the first constitutional income tax was passed and recognized the existence of a tax partnership. This structure and the associated “carried interest,” also known as a promote or profits interest, originated in the 1600s in Venice maritime trade. During the 1900s, with the growing ease of chartering a corporation, the structure fell out of favor as it lacked clear liability protection for investors. With the explicit recognition of limited liability partnerships followed by the limited liability company, the partnership structure became effectively fungible with corporations.
Corporations: A tax code preference?
Tax and entity selection is complicated and seldom has an obvious “right” answer. Under the current tax code, corporations do enjoy some specific preferences. First, the ability to issue stock that qualifies for gain exclusion under Section 1202, known as Qualified Small Business Stock. If the business qualifies, and many startup endeavors do, founders and initial investors can avoid exceptional amounts of gain (at least $10 million in most cases). Second, at least until 2026, C corporations enjoy a tax preference of (very generally) 10 percentage points on income to partnership structures. Third, since tax attributes are not allocated to equity holders, phantom income or debt discharge income won’t be an issue for investors, though this may be alleviated by using a blocker corporation. Of course, investors may miss out on allocated losses.
Mergers and rollovers: Where partnerships shine
With the removal of the partnership technical termination rules in 2017, and subject to certain mandatory allocations, partnerships have unparalleled flexibility in structuring mergers, rollovers and contribution transactions on a tax-free, or at least tax-deferred basis. While mergers and divisions are certainly achievable in the corporate context, a variety of control and ownership requirements significantly limit structuring to an increasingly complex series of “triangles.” Since partnerships lack the “tax” costs associated with traditional corporate transactions, they are a powerful tool for deal design.
The culture of ‘partnership’
Especially in Utah, the relationship between capital and founders is characterized as a “partnership.” The same tax structure can reinforce this relationship in several ways. First, the partnership agreement can be drafted to precisely align incentives, including tiered distribution waterfalls and the use of profits interest. The profits interest, which can be granted tax-free to employees (though they probably become partners with the grant)can be an extraordinary low-cost and low-friction incentive for employee retention. In one common iteration, it allows for participation in the economics of the partnership after an initial value is achieved by the founders. Second, the partnership agreement, subject to certain constraints, may specifically allocate certain items, such as particular state tax incentives. Third, the culture can continue with the business’s supply chain and strategic relationships. A timely example is the dental support organization (DSO) space—one of Utah’s fastest-growing areas. The speed of DSO growth has been possible because dentists often roll a portion of their interest in the underlying dental office with the acquisition of non-clinical assets. The roll has two primary benefits: it lowers the amount of acquisition capital and creates a long-term incentive for the productivity of the acquired asset, since the “seller” continues to own equity. By tiering partnerships, startups can create nested incentive structures with strategic partners to incentivize growth.
Partnerships are not without complexity
In addition to a variety of accounting and allocation rules that are beyond the scope of this article, there are a several complications that are often encountered. First, structuring roll-up and contribution transactions is similar to hitting a target on a moving train while riding a horse—both the value of the contributed equity and the value of the receiving entity are moving. The true-up and equalization is often more complicated than a cash purchase price adjustment. Second, partnerships must allocate all tax items, which can leave partners with allocated income and no corresponding cash distribution to cover the tax liability. Third, as partnerships grow in size and complexity, there are special audit and regulatory rules that must be followed, e.g., classification as a publicly traded partnership.
Partnership structures often offer a viable alternative to the traditional corporation and can be a flexible tool for the startup community. They can be deployed throughout the business cycle, including as the early-stage form of organization or a tool to facilitate the onboarding of capital or a strategic joint venture.