Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Tax Receivable Agreements
Transcript
- Lucas: So you've probably heard of a tax receivable agreement — TRA for short — if you've followed any large SPAC merger in the last few years. They're showing up in almost every deal where a private company goes public through a SPAC, and they're quietly allowing ultra-wealthy families to defer and sometimes reduce huge tax bills. Luna: Right, I've seen those clauses in SEC filings but never fully understood how they work. Is it basically the company paying the founders' taxes for them? Lucas: Close, but it's a bit more elegant than that. Here's the core mechanism: when a company goes public via a traditional IPO, the founders and early investors — often family offices — hold shares with a very low tax basis. If they sell those shares, they owe capital gains tax on the difference. But if they hold, they're locked up. Luna: With a SPAC merger, the structure is different, and that's where the TRA comes in. Lucas: Exactly. In a SPAC merger, the private company merges into the SPAC, and the founders' shares get converted into public company shares. But the IRS allows the public company to step up the tax basis of the assets acquired in the merger. That step-up creates a tax benefit — essentially future deductions — that the public company can use to reduce its own tax liability. Lucas: The TRA is an agreement between the public company and the pre ipo shareholders. The company promises to pay those shareholders 85 or 90 percent of the cash tax savings it actually realizes from those step-up deductions. So the founders get a stream of payments over time, tied to the company's future tax savings. Luna: So instead of paying tax now on their low-basis shares, they get paid later by the company for letting the company use their tax attributes. That's a pretty sweet deal. Lucas: It is. And the size can be enormous. Take the Pershing Square Tontine Holdings deal with Universal Music Group. Bill Ackman structured that as a SPAC merger, and the TRA agreement created a deferred tax asset worth roughly 1.4 billion dollars — most of which would flow back to the selling shareholders over time. Luna: Wait, Universal Music Group is already public in Europe, right? How did that SPAC structure apply? Lucas: It was the acquisition of a 10 percent stake in UMG by Pershing Square, but the principle is the same. The TRA in that deal allowed Ackman's fund and other investors to defer taxes on the gain from the transaction. The company — UMG — got the step-up, and the TRA payments were tied to that. Luna: So who are the typical beneficiaries? Family offices that invested early in a SPAC sponsor or private companies that merge into SPACs? Lucas: Both. The sponsor itself — often a team of high-net-worth individuals or a family office — holds founder shares with a near-zero basis. When the merger closes, those shares convert, and the sponsor enters into a TRA. Also, the pre-merger shareholders of the target company, including any family offices that invested in that private company, can be party to the TRA. Lucas: The TRA effectively lets them monetize a future tax benefit today — but without triggering an immediate taxable event. That's the key: they don't sell shares; they transfer a tax attribute. Luna: And the payments from the company are taxed as ordinary income to the recipients, not capital gains. So the family office ends up paying a lower rate on the deferred gain, because the TRA payments are deductible to the company, and the family office pays income tax on those payments at a rate that's often lower than the capital gains rate they would have paid on a direct sale. Lucas: You've got it. And that's the clever part. The TRA converts what would be a capital gain into ordinary income, but over a much longer period — often 15 to 20 years. So the net present value of the tax burden is significantly lower, especially if the family office can invest the deferred tax money in the meantime. Luna: I've heard some critics call this a loophole. Are there any risks? The IRS has been looking at these arrangements more closely. Lucas: Absolutely. The IRS has issued guidance and there have been proposals in Congress to limit or eliminate TRA benefits for certain structures. The main risk is that if the company never generates enough taxable income to use the step-up deductions, the TRA payments never materialize. So the family office is betting on the company's future profitability. Lucas: There's also the risk that the company goes bankrupt or restructures. In that case, the TRA could become worthless. And some TRA agreements have provisions that accelerate payments if the company undergoes a change of control, which can create liquidity demands. Luna: So it's not a free lunch. You need a profitable company and a long time horizon. But for a family office with a concentrated position in a successful company going public, it's a powerful deferral tool. Lucas: Exactly. And that's why they're ubiquitous in SPAC deals now. According to data from the NYU Stern School of Business, over 80 percent of SPAC mergers in 2020 and 2021 included a TRA. And they're not just for SPACs — traditional IPOs can also include tra like structures, though they're less common. Luna: Let's talk about a concrete example. You mentioned Universal Music. Can you walk through the numbers? Lucas: Sure. In the Pershing Square Tontine deal, the SPAC acquired a roughly 10 percent stake in UMG for around 4 billion dollars. The TRA was created based on the step-up in tax basis of the acquired assets. The estimated tax savings for UMG over time were projected at about 1.4 billion. Under the TRA, 85 percent of those savings — around 1.2 billion — would be paid to the selling shareholders, primarily Pershing Square's investors. Lucas: Those payments would be made over roughly 15 years, tied to UMG's actual tax savings each year. So Ackman's fund effectively deferred tax on a large portion of the gain and will receive a stream of income that's taxable at ordinary rates, but with a long deferral. Luna: And what about the family offices that invested in the SPAC sponsor itself? Do they benefit separately? Lucas: Yes. The sponsor typically enters into its own TRA with the SPAC, separate from the target company's TRA. The sponsor's TRA covers the tax benefits from the sponsor's founder shares, which are often converted into public shares. So a family office that invested in the sponsor gets two layers of TRA — one from the sponsor and one from the target. Luna: That's significant. So a family office with 50 million dollars in a SPAC sponsor could see tens of millions in deferred tax liability over the life of the TRA. Lucas: Exactly. And because the TRA payments are contingent on future tax savings, they don't appear as a liability on the balance sheet at closing. They're disclosed in the footnotes, but they don't affect the company's reported earnings or cash flow until the payments actually occur. Luna: That's one reason some investors criticize TRA structures — they can obscure the true cost of the deal. The company might report strong earnings, but a portion of those earnings is effectively owed to pre ipo shareholders through the TRA. Lucas: Right. And that's why institutional investors are starting to push back. A few large pension funds have voted against SPAC mergers that include overly generous TRA terms. They argue that the TRA transfers value from future public shareholders to the pre ipo group. Luna: But from the family office perspective, it's a way to unlock liquidity without selling shares. If you're a family with a concentrated position in a private company that's going public, you might not want to sell — you believe in the long-term value. The TRA gives you a path to monetize some of that value without triggering a tax event. Lucas: And it also aligns with the company's incentives: the company gets a lower effective tax rate, which boosts after-tax earnings. So both sides benefit, as long as the company is profitable. Luna: Are there any alternatives to TRA? Like using an installment sale or a deferred sales trust? Lucas: Those are different tools for different situations. Installment sales and deferred sales trusts are typically used when a family sells an entire business. The TRA is specifically for IPOs and SPAC mergers where the family retains an equity stake in the public company. There's also the option of using a charitable remainder trust, but that involves a charitable component. Lucas: What makes the TRA unique is that it's a contractual arrangement with the public company itself, not a separate trust or installment note. It's embedded in the merger agreement. Luna: So for a family office evaluating whether to participate in a SPAC deal, what should they look for in the TRA terms? Lucas: Key terms include the percentage of tax savings paid — typically 85 to 90 percent — the duration of the payment stream, whether there's a cap on total payments, and any acceleration provisions. Also, pay attention to whether the TRA payments are subordinated to other debt or have any credit enhancements. Luna: And the taxability of the payments: they're ordinary income to the recipient, but the company gets a deduction. So the effective tax rate on the deferred gain is the family's ordinary income rate, which for many ultra-wealthy families is around 37 percent plus state taxes, versus the 23.8 percent long-term capital gains rate. Lucas: Right. So mathematically, if the family's ordinary rate is higher than the capital gains rate, they're actually paying more tax in total — but the deferral can make it worthwhile. For example, if they can invest the deferred tax money at a 10 percent return for 15 years, the compounding can more than offset the higher rate. Luna: That's the classic tax deferral math. And it's especially powerful for families that have access to high-return alternative investments. Lucas: Exactly. So while the TRA isn't for every situation, for families with a long time horizon and a belief in the company's future, it's a sophisticated tool that sits alongside strategies like exchange funds and charitable trusts. Luna: And one more thing — I know we've touched on this, but the IRS is paying attention. In 2023, the IRS issued a notice targeting certain TRA structures that it viewed as abusive, specifically where the step-up was based on inflated asset values. So families need to make sure the valuations are defensible. Lucas: Absolutely. And we should also note that the current administration has proposed limiting the step-up on SPAC mergers in the budget, but it hasn't passed yet. So the landscape could change. Luna: Before we wrap up, I want to mention something that's been on my mind. The reason we can dig into these niche strategies is that this show is listener-supported. No ads, no sponsors. A small group of listeners contribute monthly at buymeacoffee.com/fexingo, and that's what funds the research and production. If you find these episodes useful, that's where to go. Lucas: Yeah, it's a good reminder. We don't have a big corporate backer — it's just the community. And it allows us to go deep on topics like TRA structures without worrying about advertiser conflicts. Luna: Exactly. So back to the tax receivable agreement. Looking ahead, do you think we'll see more regulation, or will these structures remain a staple for wealthy families? Lucas: I think they'll persist, but with more documentation requirements. The benefits are too large for families to ignore, and the SPAC market, while down from its peak, is still active. I'd advise any family office considering a SPAC deal to have a tax specialist model the TRA under different profitability scenarios. It's not a set-it-and-forget-it strategy. Luna: Great advice. That's all for this episode. Thanks for listening. Lucas: And remember, if you want to support the show, head over to buymeacoffee.com/fexingo. We'll be back next week with another deep dive.