What Is a Tax Receivable Agreement?

Understanding Tax Receivable Agreements

A Tax Receivable Agreement (TRA) is a contractual arrangement common in corporate transactions. It provides a mechanism for sharing future economic benefits derived from a company’s tax attributes. These agreements are prevalent in initial public offerings (IPOs) involving pass-through entities, such as partnerships or Limited Liability Companies (LLCs), and in mergers and acquisitions. The primary purpose of a TRA is to compensate original owners for tax benefits that transfer to the acquiring entity or the newly public company. This financial tool helps align the interests of various parties by monetizing tax assets that might otherwise be undervalued or lost in a transaction.

How Tax Receivable Agreements Work

A Tax Receivable Agreement (TRA) is a binding contract between a company and its former owners, outlining how future tax savings will be shared. The agreement is typically triggered when certain tax attributes, such as net operating losses (NOLs) or depreciation step-ups, are utilized by the company to reduce its taxable income. These attributes represent valuable deductions or credits that can significantly lower a company’s future tax liabilities. The company agrees to pay a percentage, commonly 85%, of the actual tax savings it realizes back to the former owners. This allows original owners to participate in the financial upside of these tax benefits as they are realized.

The specific tax attributes covered by a TRA are identified and valued at the time of the transaction. Net operating losses (NOLs) occur when deductible expenses exceed gross income, resulting in a loss for tax purposes. These losses can be carried forward indefinitely to offset future taxable income. A depreciation step-up often arises in acquisitions, adjusting the tax basis of assets to their fair market value, allowing for increased depreciation and amortization deductions.

The operational mechanics center on the calculation and timing of payments. The company calculates actual tax savings by comparing its tax liability with what it would have owed without the benefit of the covered tax attributes. This “with and without” methodology ensures payments are directly tied to real cash tax savings. For instance, if a company uses $50 million of an NOL to reduce taxable income, the tax savings are based on the tax rate applied to that reduction.

Once tax savings are determined, the company typically pays 85% of these savings to the TRA holders. The remaining 15% is retained by the company. These payments are classified as a liability on the company’s balance sheet.

Payments are contingent upon the company actually realizing tax savings. If the company does not generate sufficient taxable income, no payments are made for that period. This means payments are not fixed amounts but fluctuate with the company’s taxable income and ability to absorb the tax attributes. Payments are typically made annually, often for many years, as the tax attributes are progressively utilized. The duration can be substantial, sometimes extending beyond 15 years.

Key Terms Within Tax Receivable Agreements

Tax Receivable Agreements include several provisions beyond the basic payment calculation that govern their operation and protect involved parties’ interests. Early termination clauses are common, allowing the company to end the TRA obligations before all tax attributes are exhausted. If a company elects to terminate early, it typically pays a lump sum to the TRA holders. This payment is usually based on the present value of projected future tax savings, discounted at a specified rate, and often includes assumptions favorable to the TRA holders.

Change of control provisions are frequently incorporated, addressing how the TRA is affected if the company undergoes an acquisition or a significant shift in ownership. These clauses often stipulate that a change of control can trigger an accelerated payment of the TRA liability. The amount of this accelerated payment is typically determined by assuming full utilization of the remaining tax attributes and may involve specific valuation assumptions. Such provisions ensure that TRA holders receive their due even if the company’s ownership structure changes.

Dispute resolution mechanisms provide a framework for resolving disagreements concerning the calculation of tax savings or the interpretation of the agreement’s terms. These mechanisms can range from requiring good-faith negotiations to mandating arbitration or, in some cases, allowing for litigation. The specific method chosen depends on the preferences of the parties and the complexity of potential disputes. Effective resolution clauses help avoid prolonged and costly legal battles.

Limitations or caps on payments may be part of a TRA. These provisions can set a maximum aggregate amount to be paid under the agreement or limit the duration over which payments will be made. Such caps provide the company with predictability regarding its long-term financial commitments. Additionally, some TRAs may include provisions for adjustments in the event of changes in tax law, which could impact the value of the underlying tax attributes.

The Parties Involved in Tax Receivable Agreements

The typical parties to a Tax Receivable Agreement are former owners of a business and the acquiring entity or the newly public company. The former owners, often private equity firms, family founders, or pre-IPO shareholders, are the recipients of payments under the TRA. Their interest in entering a TRA stems from a desire to monetize future tax benefits associated with the business they are selling or taking public. These tax attributes were generated during their ownership, and the TRA allows them to capture a portion of the value of these assets as they are realized by the new entity.

For these former owners, the TRA provides an additional stream of cash flow beyond the initial sale price, which can enhance the overall value received from the transaction. This structure can be particularly appealing when the value of tax attributes is uncertain or cannot be fully reflected in the upfront purchase price. By tying payments to actual tax savings, the former owners share in the future success of the company. They also gain a mechanism to receive compensation for tax liabilities they might incur at the time of the transaction, especially in structures that create immediate taxable events for them.

The acquiring entity or the newly public company, often referred to as “PubCo” in IPO contexts, is the party that benefits from utilizing the tax attributes and is obligated to make payments under the TRA. This entity’s motivation for entering into a TRA is to gain access to valuable tax deductions and credits that reduce its future tax burden. These tax benefits can lead to improved cash flow and enhanced profitability for the company. While the company commits to sharing a portion of these savings, it retains a significant share, which contributes to its financial health.

From the company’s perspective, TRAs help bridge valuation gaps during transactions by allowing the company to acquire the tax attributes without paying their full value upfront. Instead, payments are made over time as the benefits are realized, which can make a deal more financially feasible. The agreement also ensures the company benefits from the tax attributes by reducing its tax liability, which can be reinvested into the business or used for other corporate purposes. However, the company also takes on a long-term liability and must manage the cash flow implications of these future payments.