MEMORANDUM
PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT
Date: February 16, 2024
To: Marcus Pellegrino, Partner, Healthcare — Ardent Capital Partners III LP Claire Ashworth, Co-Founder & Managing Partner — Ardent Capital Partners III LP
From: Leonard Cross, Partner, Tax — Calderwood & Harkness LLP Robert Jansen, Associate, Tax — Calderwood & Harkness LLP
Re: C-Corporation blocker Entity Analysis — Ardent Healthcare Intermediate Inc. — Acquisition of Pinnacle Health Services Group LLC
Matter No.: 1001-00006 Engagement No.: 1001-00006
Right-click to update Table of Contents
I. Executive Summary
The purpose of this memorandum is to analyze the interposition of a C-corporation blocker entity — Ardent Healthcare Intermediate Inc. ("Intermediate" or "AHI") — between Ardent Healthcare Holdings LLC ("Holdings") and the surviving operating subsidiary, Pinnacle Health Services Group LLC ("Pinnacle" or the "Company"), in the proposed acquisition of Pinnacle at an enterprise value of approximately $412,000,000 (the "Transaction"). This memorandum sets forth our analysis of the structural, tax, and operational considerations relevant to the decision to employ a blocker entity and provides our recommendation to the deal team.
We recommend a three-tier post-closing acquisition structure organized as follows:
Tier 1: Ardent Healthcare Holdings LLC, a Delaware limited liability company classified as a partnership for federal income tax purposes, serving as the top-level holding vehicle for investor and rollover equity.
Tier 2: Ardent Healthcare Intermediate Inc., a Delaware C-corporation, serving as the blocker entity and the sole corporate-level taxpayer in the structure.
Tier 3: Pinnacle Health Services Group LLC, a surviving Delaware limited liability company classified as a partnership for federal income tax purposes, serving as the operating entity conducting healthcare operations across five states.
The interposition of Intermediate Inc. as a blocker entity serves four principal objectives:
(a) blocking Unrelated Business Taxable Income ("UBTI") for tax-exempt limited partners of Ardent Capital Partners III LP ("Fund III"), including pension funds, endowments, and foundations, whose tax-exempt status would otherwise be jeopardized by the flow-through of operating income from Pinnacle's healthcare business;
(b) Facilitating a Potential Future IPO Exit by placing a C-corporation in the structure at inception, thereby avoiding the cost, delay, and tax friction associated with a last-minute corporate conversion or reorganization prior to an initial public offering;
(c) Isolating State Income Tax Nexus at the corporate level, such that Pinnacle's operations in Pennsylvania, Virginia, Maryland, North Carolina, and Georgia create filing obligations for Intermediate Inc. rather than for Holdings LLC, Fund III, or the individual limited partners of Fund III; and
(d) Mitigating New York Nexus Risk for Holdings LLC, whose business address is located in New York City, by ensuring that management activities are attributed to entities that are already subject to New York taxation rather than to Holdings LLC, which should function solely as a passive holding entity.
Based on our analysis, Calderwood & Harkness LLP ("Calderwood & Harkness" or "we") recommends interposing Intermediate Inc. as described herein. The benefits of the blocker structure substantially outweigh its costs, which principally consist of the incremental corporate-level federal income tax (currently 21%) and state income taxes (blended effective rate of approximately 6.42%) imposed on operating income flowing through Intermediate Inc. These costs are significantly offset by the Section 743(b) basis step-up amortization deductions of approximately $20.04 million per year, which will generate annual tax savings of approximately $5.01 million at a 25% blended federal-state rate. The structure is fully compatible with the Section 754 election, Tax Receivable Agreement ("TRA"), rollover equity mechanics, and financing arrangements contemplated for the Transaction.
II. Background
A. Transaction Overview
Ardent Capital Partners III LP. Fund III is a Delaware limited partnership with total capital commitments of approximately $3.2 billion (vintage 2022). Fund III is headquartered at 600 Lexington Avenue, 38th Floor, New York, NY 10022. The general partner of Fund III is Ardent Capital GP III LLC, a Delaware limited liability company. Fund III was co-founded by Dominic Ferrera and Claire Ashworth. The healthcare deal team for the Transaction is led by Marcus Pellegrino, Partner, Healthcare.
Target. The acquisition target is Pinnacle Health Services Group LLC, a Delaware limited liability company currently classified as a partnership for federal income tax purposes, headquartered at 2200 Renaissance Boulevard, Suite 400, King of Prussia, Pennsylvania 19406 (EIN 82-1947632). Pinnacle was founded in 2016 and currently operates thirty-four (34) urgent care clinics and eight (8) ambulatory surgery centers across five states: Pennsylvania, Virginia, Maryland, North Carolina, and Georgia. Pinnacle employs approximately 1,620 individuals, including 142 employed physicians. Pinnacle's healthcare operations constitute a trade or business regularly carried on within the meaning of IRC Section 512 and the regulations thereunder.
Valuation and Transaction Metrics. The Transaction contemplates an enterprise value of $412,000,000. The equity value is $339,400,000, calculated as the enterprise value minus net debt of $72,600,000 (consisting of $81,300,000 of funded debt less $8,700,000 of cash on hand). The working capital target is $18,200,000, subject to customary post-closing true-up. For the fiscal year ended December 31, 2023, Pinnacle reported revenue of approximately $287.4 million and adjusted EBITDA of approximately $51.8 million, resulting in an implied EV/EBITDA multiple of approximately 7.95x.
B. Proposed Acquisition Structure
Merger Mechanics. The Transaction will be structured as a reverse merger in which Ardent Healthcare Merger Sub LLC, a Delaware limited liability company (File No. 7834227) formed for the sole purpose of effectuating the merger, will merge with and into Pinnacle, with Pinnacle surviving as a wholly owned subsidiary of Intermediate Inc. (or, more precisely, as an entity in which Intermediate Inc. holds substantially all membership interests, as discussed further in Section IV.C below). The merger will be consummated pursuant to a definitive Agreement and Plan of Merger (the "Merger Agreement") among Holdings LLC, Intermediate Inc., Merger Sub, Pinnacle, and the equityholders' representative.
Equity Capital. The equity capital for the Transaction will consist of the following:
(i) Fund III Committed Equity: $198,500,000, to be contributed by Fund III to Holdings LLC in exchange for Class A Units of Holdings LLC, and subsequently contributed by Holdings LLC to Intermediate Inc. in exchange for 100% of the outstanding common stock of Intermediate Inc.
(ii) Rollover Equity: A total of $59,540,000 in rollover equity from three participants:
• Dr. Raymond Carvallo — $32,410,000
• Dr. Nadia Ostrowski — $24,180,000
• Jonathan Marsh — $2,950,000
The rollover equity represents approximately 23.08% of post-closing equity on a pre-dilution basis and approximately 22.50% on a fully diluted basis after giving effect to the 2.5% mezzanine warrants issued to Cascadia Mezzanine Fund IV LP ("Cascadia").
Rollover Equity Treatment. The rollover participants will contribute their existing Pinnacle membership interests to Holdings LLC in exchange for Class B Units of Holdings LLC. Fifty percent (50%) of the Class B Units will vest at closing, with the remaining fifty percent (50%) vesting ratably over a thirty-six (36) month period. The Class B Units are intended to be treated as profits interests under Revenue Procedure 93-27 and Revenue Procedure 2001-43. Section 83(b) elections will be filed by each rollover participant within thirty (30) days of closing. The rollover contributions are intended to qualify as tax-deferred contributions under IRC Section 721 at the Holdings LLC level. A detailed analysis of the rollover equity tax treatment is set forth in our separate Rollover Equity Tax Memorandum — Section 721 vs. Section 351 Analysis, to be delivered on February 22, 2024.
Debt Financing. The Transaction will be funded in part with the following debt facilities:
(i) Senior Secured Credit Facility: A $155,000,000 Term Loan B (SOFR + 425 basis points, seven-year maturity) and a $35,000,000 revolving credit facility (SOFR + 375 basis points, five-year maturity), arranged by Graystone National Bank, N.A., as administrative agent, with syndicate members Ridgepoint Capital Markets LLC and Thorncrest Credit Partners LP.
(ii) Mezzanine Facility: $30,000,000 in subordinated mezzanine notes (12.5% cash interest / 2.0% payment-in-kind interest, eight-year maturity) from Cascadia Mezzanine Fund IV LP, accompanied by warrants entitling Cascadia to acquire 2.5% of the fully diluted equity interests in Holdings LLC.
Section 754 Election and Basis Step-Up. Pinnacle will make an election under IRC Section 754 for the taxable year ending December 31, 2024, the year in which the Transaction closes. This election will result in a basis step-up under IRC Section 743(b) with respect to Intermediate Inc.'s share of Pinnacle's assets equal to approximately $224,400,000 (calculated as the $412,000,000 enterprise value minus $187,600,000 of Pinnacle's existing inside basis in its assets). The basis step-up and its amortization are analyzed in greater detail in the Section 338(h)(10) vs. Section 754 Election Analysis Memorandum, to be delivered on February 28, 2024.
C. Entity Details — Ardent Healthcare Intermediate Inc.
Ardent Healthcare Intermediate Inc. is a Delaware C-corporation to be formed and filed with the Delaware Secretary of State in advance of closing. The key organizational details for Intermediate Inc. are as follows:
Entity Type: Delaware C-corporation
File No.: 7834223 (reserved)
EIN: 93-2187512
Registered Agent: Pemberton Industries, 251 Little Falls Drive, Wilmington, Delaware 19808
Business Address: 600 Lexington Avenue, 38th Floor, New York, New York 10022
Sole Shareholder: Ardent Healthcare Holdings LLC (EIN 93-2187445, File No. 7834219)
Post-Closing Holdings: Intermediate Inc. will hold 100% (or substantially all) of the membership interests of Pinnacle Health Services Group LLC, the surviving entity in the merger
Intermediate Inc. will be formed as a standard Delaware C-corporation with a single class of authorized common stock. Its Certificate of Incorporation will be prepared separately and filed on or about March 5, 2024. Initial directors and officers will be appointed promptly after formation.
D. Fund III Investor Composition (Relevant to UBTI Analysis)
As a large-cap private equity fund with $3.2 billion of capital commitments, Fund III's limited partner base is comprised of a diverse group of institutional and individual investors. Consistent with industry norms for funds of this size and vintage, Fund III's limited partner base includes tax-exempt investors such as public and private pension funds, university and hospital endowments, private charitable foundations, and sovereign wealth funds. These categories of investors are, to varying degrees, subject to the unrelated business income tax under IRC Sections 511 through 514 and are accordingly sensitive to investment structures that could generate UBTI.
The limited partnership agreement of Ardent Capital Partners III LP contains provisions requiring the general partner to use commercially reasonable efforts to structure acquisitions so as to avoid the generation of UBTI for tax-exempt limited partners, or, where UBTI cannot be entirely avoided, to employ blocker corporations or other structures to shield tax-exempt investors from direct UBTI exposure. These provisions are standard in the industry and reflect the expectations of Fund III's LP advisory committee.
The specific limited partner composition details and commitment amounts are maintained by Fund III's third-party fund administrator. For purposes of this analysis, Calderwood & Harkness has been informed by Marcus Pellegrino that tax-exempt limited partners represent a material portion of Fund III's capital base, and that protection against UBTI exposure is a significant structural concern for the Transaction. We have relied on this representation without independent verification.
III. Analysis of blocker Entity Objectives
A. Objective 1: Blocking UBTI for Tax-Exempt Fund III Limited Partners
1. The UBTI Problem
Under IRC Sections 511 through 514, tax-exempt organizations — including qualified pension trusts described in IRC Section 401(a), state and local government pension plans, university and hospital endowments described in IRC Section 501(c)(3), private foundations described in IRC Section 509(a), and certain sovereign wealth funds — are subject to federal income tax on their unrelated business taxable income ("UBTI"). The purpose of the UBTI rules is to prevent tax-exempt organizations from enjoying an unfair competitive advantage over taxable businesses by ensuring that income derived from activities unrelated to the organization's exempt purpose is subject to tax.
UBTI is defined under IRC Section 512(a)(1) as the gross income derived from any unrelated trade or business (as defined in IRC Section 513) regularly carried on by the tax-exempt organization, less deductions directly connected with such trade or business. An unrelated trade or business is any trade or business the conduct of which is not substantially related to the exercise or performance of the organization's exempt purpose or function.
The UBTI rules apply not only to trades or businesses conducted directly by a tax-exempt organization, but also to trades or businesses conducted through pass-through entities. Under IRC Section 512(c) and Treasury Regulation Section 1.512(c)-1, if a tax-exempt organization is a partner in a partnership, its share of partnership gross income from an unrelated trade or business is included in the organization's UBTI. This look-through rule applies to each tier of a multi-tiered partnership structure. Accordingly, if a tax-exempt limited partner invests in Fund III (a limited partnership), which in turn holds membership interests in Holdings LLC (classified as a partnership), which in turn holds a direct interest in Pinnacle (classified as a partnership), the operating income of Pinnacle flows through each tier and is ultimately allocated to the tax-exempt limited partner as UBTI.
Pinnacle's healthcare operations — consisting of thirty-four urgent care clinics and eight ambulatory surgery centers operating across five states — clearly constitute a trade or business regularly carried on within the meaning of IRC Sections 512 and 513. The clinics and surgery centers provide medical services on a daily, ongoing basis to paying patients. There is no question that this activity constitutes a "trade or business" and that it is "regularly carried on." Consequently, in the absence of a blocker structure, all of Pinnacle's operating income flowing through to tax-exempt Fund III limited partners would constitute UBTI and would be subject to federal income tax at rates applicable to trusts (up to 37% for income exceeding $14,450 in 2024) or corporate rates (21%), depending on the organizational form of the tax-exempt entity.
In addition to the direct UBTI generated by Pinnacle's operating activities, the debt-financed income rules under IRC Section 514 present an independent source of UBTI risk. Section 514 provides that income derived from "debt-financed property" — that is, property with respect to which there is "acquisition indebtedness" — is treated as UBTI to the extent of the ratio of the average acquisition indebtedness to the average adjusted basis of the property. The $155,000,000 Term Loan B and $35,000,000 revolving credit facility that will be incurred at the operating entity level in connection with the Transaction constitute acquisition indebtedness within the meaning of IRC Section 514(c). To the extent that the income generated by assets acquired or improved with the proceeds of such indebtedness flows through to tax-exempt Fund III limited partners, such income would constitute debt-financed UBTI under Section 514, even if the underlying income would otherwise be excluded from UBTI (e.g., as investment income). The debt-financed income rules therefore provide a secondary basis for imposing UBTI on tax-exempt Fund III limited partners in the absence of a blocker.
2. How the blocker Solves the Problem
The interposition of Intermediate Inc. — a C-corporation — between Holdings LLC and Pinnacle completely severs the flow-through chain that would otherwise transmit UBTI to tax-exempt Fund III limited partners. The mechanism operates as follows:
Step 1: Pinnacle's operating income is generated by the healthcare operations conducted at the clinic and surgery center level.
Step 2: Because Pinnacle is classified as a partnership for federal income tax purposes, this operating income is allocated among Pinnacle's members on a pro rata basis (or in accordance with the Pinnacle operating agreement). Post-closing, the operating income is allocated to Intermediate Inc. as the holder of substantially all of Pinnacle's membership interests.
Step 3: Intermediate Inc. is a C-corporation and is therefore a separate taxpayer for federal income tax purposes. The operating income allocated to Intermediate Inc. from Pinnacle is reported on Intermediate Inc.'s Form 1120, United States Corporation Income Tax Return, and is subject to corporate-level federal income tax at the current rate of 21%.
Step 4: When Intermediate Inc. distributes its after-tax earnings to Holdings LLC (its sole shareholder), those distributions are characterized as dividends under IRC Section 301 (to the extent of Intermediate Inc.'s current and accumulated earnings and profits).
Step 5: Dividends are specifically excluded from UBTI under IRC Section 512(b)(1), which provides that UBTI does not include "dividends." Accordingly, when the dividend income from Intermediate Inc. flows through Holdings LLC to Fund III and then to the tax-exempt limited partners of Fund III, such income is not treated as UBTI and is not subject to the unrelated business income tax.
Furthermore, the IRC Section 514 debt-financed income rules do not apply to dividends received from a controlled C-corporation, provided that the stock of the C-corporation is not itself treated as "debt-financed property." Because Holdings LLC's stock in Intermediate Inc. is acquired with contributed equity (not with acquisition indebtedness at the Holdings LLC level), the dividend exclusion from UBTI is not overridden by the debt-financed income rules. Even though the underlying operations of Pinnacle are leveraged with the Term Loan B and revolving credit facility, those debts are incurred at the Pinnacle or Intermediate Inc. level and do not constitute acquisition indebtedness with respect to Holdings LLC's stock in Intermediate Inc.
The result is a complete blocking of UBTI for tax-exempt Fund III limited partners with respect to all operating income generated by Pinnacle's healthcare business. This is the single most important structural objective served by the blocker entity and is the primary reason that blocker corporations are employed in substantially all private equity acquisitions involving operating businesses with tax-exempt investors.
3. Cost of the blocker — Double Taxation Analysis
The UBTI blocking benefit comes at a cost: the imposition of a corporate-level income tax on operating income that would otherwise flow through directly to Fund III's limited partners on a pre-tax basis. The cost-benefit analysis differs for taxable and tax-exempt limited partners.
Tax-Exempt Limited Partners. For tax-exempt limited partners, the cost of the blocker is the 21% federal corporate income tax imposed on operating income at the Intermediate Inc. level. In the absence of the blocker, such income would be subject to UBTI tax at rates up to 37% (for trust-form tax-exempt entities) or 21% (for corporate-form tax-exempt entities), plus applicable state UBTI taxes. Accordingly, for trust-form tax-exempt limited partners (including most pension funds), the 21% corporate rate at the Intermediate Inc. level is substantially more favorable than the alternative of direct UBTI taxation. Moreover, certain tax-exempt investors may be subject to additional state-level UBTI taxes in their home jurisdictions, which the blocker structure also eliminates. For these investors, the blocker is unambiguously beneficial.
Taxable Limited Partners. For taxable limited partners (including individuals, taxable trusts, and corporate investors), the blocker introduces a layer of double taxation. Operating income earned by Pinnacle and allocated to Intermediate Inc. is first subject to the 21% federal corporate income tax. When Intermediate Inc. distributes its after-tax earnings as dividends, those dividends flow through Holdings LLC and Fund III to the taxable limited partners, who are subject to tax on the dividend income. For individual taxable limited partners, dividends from Intermediate Inc. should qualify as "qualified dividends" under IRC Section 1(h)(11), eligible for the preferential long-term capital gains rate of 20% (for taxpayers in the highest income bracket), plus the 3.8% net investment income tax under IRC Section 1411, resulting in a combined investor-level rate of 23.8% on dividends received. The combined effective tax rate on operating income flowing through the blocker to a taxable individual limited partner is therefore approximately:
21% (corporate level) + [79% × 23.8% (investor level)] = 21% + 18.8% = approximately 39.8%
By comparison, if the operating income flowed directly to the taxable limited partner without a blocker (i.e., as ordinary business income), it would be taxed at the individual's marginal ordinary income rate of up to 37%, plus the 3.8% net investment income tax, for a combined rate of up to 40.8%. The incremental cost of the blocker to taxable limited partners is therefore relatively modest on an ongoing basis, although the double taxation becomes more significant upon exit (as discussed in Section IX.B below).
Overall Cost-Benefit Assessment. The incremental corporate-level tax is the accepted and customary cost of providing UBTI protection to tax-exempt limited partners. This trade-off is standard market practice for private equity acquisitions of operating businesses in the healthcare sector (and in other operating sectors) and is expected by Fund III's LP advisory committee. The cost is further mitigated by the significant tax shield generated by the Section 743(b) basis step-up. As detailed below and in the Section 338(h)(10) vs. Section 754 Election Analysis Memorandum, the $224,400,000 basis step-up will generate annual amortization deductions of approximately $20,040,000 per year over a weighted-average useful life of approximately 11.2 years. At a blended federal-state tax rate of approximately 25%, these deductions produce annual tax savings of approximately $5,010,000, which significantly offset the corporate tax cost borne by Intermediate Inc. and are the source of the TRA payments to rollover participants.
4. Alternative Structures Considered and Rejected
In the course of our analysis, we considered the following alternative structures and determined that the recommended three-tier blocker structure is superior to each:
Alternative 1: Direct Fund III Investment Without blocker. Under this approach, Holdings LLC would directly hold the membership interests of Pinnacle without interposing a C-corporation. This structure was rejected because it would expose tax-exempt Fund III limited partners to UBTI on all of Pinnacle's operating income, in violation of the UBTI protection obligations in Fund III's limited partnership agreement and contrary to the expectations of the LP advisory committee. This alternative is structurally impermissible given Fund III's investor composition.
Alternative 2: Fund-Level blocker (Separate blocker Corporation Owned by Tax-Exempt LPs Only). Under this approach, a separate C-corporation blocker would be formed at the fund level, with only tax-exempt limited partners investing through the blocker while taxable limited partners invest directly through Fund III. This structure was rejected as administratively complex. It requires separate capital calls, separate capital accounts, and the maintenance of divergent economic streams among limited partners. It can also create complications in connection with fund-level waterfall calculations, clawback mechanics, and GP carry distributions. Moreover, this approach does not provide the IPO readiness, state nexus isolation, or NY nexus mitigation benefits that the recommended deal-level blocker provides.
Alternative 3: Offshore blocker (Cayman Islands Corporation). Under this approach, the blocker corporation would be organized as an offshore entity, typically a Cayman Islands exempted company. This structure was rejected as unnecessary and counterproductive in the context of a domestic healthcare acquisition with no foreign-source income. An offshore blocker would provide no incremental U.S. federal income tax benefit to U.S. tax-exempt investors, which are subject to the same UBTI rules regardless of whether the blocker is domestic or offshore. Furthermore, an offshore blocker could create additional complexity under the controlled foreign corporation ("CFC") and passive foreign investment company ("PFIC") regimes, potentially generating adverse tax consequences for taxable U.S. investors in Fund III. There is no foreign income or foreign operations to justify an offshore structure.
B. Objective 2: Facilitating a Potential Future IPO Exit
1. IPO Readiness Considerations
A significant secondary benefit of the blocker structure is that it positions the investment for a potential initial public offering exit without requiring a complex and time-consuming corporate reorganization immediately prior to the offering. Public equity markets overwhelmingly favor C-corporation issuers. While Up-C IPO structures (in which the operating entity remains a partnership and a newly formed C-corporation serves as the public vehicle) have become more common in recent years, they add substantial complexity to the offering process, including the negotiation and implementation of an exchange agreement, a tax receivable agreement, and dual-class governance arrangements.
By forming Intermediate Inc. at the outset of the investment, the Ardent deal team preserves maximum flexibility with respect to exit strategy. If Fund III determines that a public market exit is the most attractive liquidity path for the Pinnacle investment — whether through an IPO of Intermediate Inc. itself, an IPO of a newly formed holding company into which Intermediate Inc. contributes its assets, or an Up-C structure — the existence of an operational C-corporation within the structure eliminates several months of preparatory work and tax planning that would otherwise be required. In particular:
(i) Intermediate Inc. can serve as the direct IPO issuer (or as the predecessor entity that contributes its operations to a newly formed IPO holding company) without requiring the formation, capitalization, and tax qualification of a new corporate entity.
(ii) The corporate-level financial statements of Intermediate Inc. provide a ready basis for the audited financial statements required in the S-1 registration statement, avoiding the need to prepare corporate-level financials for the first time during the IPO process.
(iii) The existing corporate governance infrastructure of Intermediate Inc. (board of directors, officers, corporate records, bylaws) can be expanded and professionalized for public company purposes, rather than created from scratch.
We note that an Up-C IPO structure remains available even with the blocker in place. The blocker does not foreclose any exit structure; rather, it expands the range of available exit options and reduces the time and cost associated with each.
2. Tax Receivable Agreement Compatibility
The TRA negotiated in connection with the Transaction provides for the payment of 85% of the realized tax benefits attributable to the Section 743(b) basis step-up to the rollover participants and pre-closing Pinnacle members. The estimated annual TRA payment is approximately $4,260,000 per year (calculated as 85% of the estimated annual tax benefit of $5,010,000). The TRA is structured at the Holdings LLC level.
In an IPO scenario, the TRA obligations would be assumed by, or replicated at, the public company level. This is standard practice in public company TRA structures. The existing blocker structure is fully compatible with the standard TRA mechanics employed in public company contexts. Specifically, the Section 743(b) amortization deductions flow through Pinnacle (on its partnership return) and reduce the taxable income allocable to Intermediate Inc. This reduction in taxable income generates the corporate-level tax savings that fund the TRA payments. In a public offering, the public company (whether Intermediate Inc. itself or a newly formed holding company) would step into the role of the party obligated to make TRA payments, with the economic mechanics remaining substantially unchanged.
3. Accounting and Financial Reporting
The presence of a C-corporation in the ownership chain simplifies GAAP financial reporting in both the current private company context and a potential future public company context. Consolidated financial statements can be prepared at the Intermediate Inc. level, with Pinnacle's results consolidated as a wholly owned (or substantially wholly owned) subsidiary. This approach avoids the complex partnership accounting disclosures and variable interest entity analyses that would be required if the financial reporting entity were itself a partnership or if an Up-C structure were employed at the public company level.
For purposes of the current investment, the C-corporation structure also provides a clean entity for lender financial reporting under the senior secured credit facility and mezzanine facility, consistent with the expectations of Graystone National Bank, N.A. and Cascadia.
C. Objective 3: Isolating State Income Tax Nexus
1. Overview of State Tax Nexus Landscape
Pinnacle currently operates healthcare facilities in five states. The applicable state corporate income tax rates for the taxable year beginning January 1, 2024, are as follows:
Based on the allocation of Pinnacle's revenue and EBITDA across these five states (as reflected in the quality of earnings analysis prepared by Northmark Advisory Group LLC), the blended effective state income tax rate applicable to Intermediate Inc. is estimated at approximately 6.42%, weighted by the contribution of each state's operations to overall EBITDA.
In addition to the state-level corporate income taxes, Pinnacle's three clinics located within the City of Philadelphia are subject to the Philadelphia Business Income and Receipts Tax ("BIRT"), which imposes both a gross receipts tax at a rate of 0.1415 mills per dollar of gross receipts and a net income tax at a rate of 5.99% on net income allocable to Philadelphia. The BIRT is imposed at the entity level and will be borne by Intermediate Inc. as the owner of the Pinnacle operations.
State income tax apportionment methodologies vary by state. Pennsylvania, Virginia, and Georgia employ single-sales-factor apportionment, under which 100% of the apportionment fraction is determined by the ratio of in-state sales to total sales. Maryland and North Carolina employ a three-factor apportionment formula with double-weighted sales (i.e., sales factor receives 50% weight, while property and payroll factors each receive 25% weight). Calderwood & Harkness has performed preliminary apportionment calculations for each state; detailed state-by-state analysis is provided in the State & Local Tax Memorandum to be delivered on February 20, 2024.
2. Nexus Isolation Through the blocker
Without the blocker, if Holdings LLC directly held the membership interests of Pinnacle, the operating activities of Pinnacle could create income tax nexus for Holdings LLC — as a partner in an operating partnership — in each of the five states in which Pinnacle conducts business. Under the laws of most states, a partner in a partnership that conducts business within the state is itself deemed to be conducting business within the state and is subject to the state's income tax on its allocable share of partnership income. This nexus determination typically flows through each tier of a multi-tiered partnership structure. Accordingly, Holdings LLC's members — including Fund III — and Fund III's limited partners could be deemed to have nexus in each of the five states in which Pinnacle operates, potentially requiring each limited partner to file individual state income tax returns and pay state income tax on its allocable share of Pinnacle operating income in each state.
By interposing Intermediate Inc. between Holdings LLC and Pinnacle, the state income tax nexus created by Pinnacle's healthcare operations is "trapped" at the Intermediate Inc. level. Intermediate Inc., as a C-corporation, is a separate taxpayer for state income tax purposes. It will file corporate income tax returns in Pennsylvania, Virginia, Maryland, North Carolina, and Georgia, and it will pay state corporate income taxes on the income allocable to each state under the applicable apportionment formulas. Holdings LLC and its members — including Fund III and Fund III's limited partners — are shielded from multi-state filing obligations attributable to Pinnacle's operations. Holdings LLC's only nexus determination relates to its own activities, which are principally limited to its Delaware formation and its New York business address (the New York nexus implications of which are discussed separately in Section III.D below).
This nexus isolation benefit is particularly significant for Fund III's individual limited partners (both domestic and foreign), who would otherwise face the burden of filing state income tax returns in up to five states on account of their indirect interest in Pinnacle's operations. The compliance cost, administrative burden, and potential tax exposure associated with multi-state filing obligations for hundreds of limited partners are substantial and would likely generate significant LP dissatisfaction.
3. State-Specific Considerations
Pennsylvania. Intermediate Inc. will file Pennsylvania corporate net income tax returns as a corporation conducting business within the Commonwealth. The Pennsylvania corporate net income tax rate is currently 8.99% but is declining annually under Act 53 of 2022, with the rate scheduled to reach 4.99% by 2031. This declining rate trajectory benefits the blocker structure, as the effective state tax cost decreases over the anticipated hold period. The Philadelphia BIRT will apply to Intermediate Inc.'s allocable share of income and gross receipts attributable to the three Pinnacle clinics located within Philadelphia. Calderwood & Harkness notes that the BIRT net income tax (5.99%) is in addition to, and not in lieu of, the Pennsylvania corporate net income tax, creating a combined Philadelphia-area effective rate that is higher than the statewide rate.
Virginia. Intermediate Inc. will be subject to Virginia's corporate income tax at a flat rate of 6.0% on income apportioned to Virginia. Virginia imposes a nonresident withholding obligation at a rate of 5.0% on payments to nonresident members of pass-through entities conducting business in Virginia. This withholding obligation is relevant to pre-closing sellers of Pinnacle membership interests but is less relevant post-closing, as Intermediate Inc. will be the sole (or substantially sole) member of Pinnacle and is itself a domestic C-corporation that files Virginia corporate returns directly.
Maryland. Intermediate Inc. will be subject to Maryland's corporate income tax at a rate of 8.25% on income apportioned to Maryland. Maryland also offers a pass-through entity ("PTE") election that allows partnerships and S corporations to elect to pay income tax at the entity level, with a corresponding credit available to the partners or shareholders. The PTE election analysis is relevant at the Holdings LLC level and is addressed separately in the State & Local Tax Memorandum to be delivered on February 20, 2024. For purposes of the blocker analysis, the key consideration is that Intermediate Inc.'s presence in the structure prevents Maryland nexus from flowing through to Holdings LLC and Fund III.
North Carolina. Intermediate Inc. will be subject to North Carolina's corporate income tax at a rate of 2.5%, which is the lowest corporate income tax rate among Pinnacle's five operating states. North Carolina also imposes a franchise tax on corporations doing business in the state. North Carolina has enacted legislation (H.B. 334 of 2021) that provides for the phase-out of the corporate income tax to 0% by 2030, contingent on certain state revenue triggers being met. If the phase-out proceeds as scheduled, the North Carolina income tax cost of the blocker structure will decline to zero during the hold period.
Georgia. Intermediate Inc. will be subject to Georgia's corporate income tax at a rate of 5.75% on income apportioned to Georgia. Georgia imposes a nonresident withholding obligation at a rate of 5.75% on income allocable to nonresident members of pass-through entities. Similar to the Virginia analysis, this withholding obligation is principally relevant to pre-closing sellers and is mitigated post-closing by Intermediate Inc.'s status as the sole (or substantially sole) member of Pinnacle.
4. Avoidance of State-Level "Composite" Filing Requirements
Many states require partnerships with nonresident partners to file composite income tax returns on behalf of their nonresident partners or, alternatively, to withhold state income tax on income allocable to nonresident partners. These composite filing and withholding requirements create significant administrative burdens in multi-tiered partnership structures.
Without the blocker, the following cascade of composite filing obligations could arise:
(i) Pinnacle (operating in five states) would be required to file composite returns or withhold on income allocable to Holdings LLC (a nonresident partner) in each of the five states.
(ii) Holdings LLC, having received allocations of income from Pinnacle in five states, would be required to file composite returns or withhold on income allocable to Fund III (a nonresident partner) in each of those five states.
(iii) Fund III, having received allocations of income from Holdings LLC in five states, would be required to file composite returns or withhold on income allocable to each of its individual limited partners (many of whom are nonresidents of the applicable states) in each of those five states.
The result would be a multi-tiered web of composite filing and withholding obligations spanning five states and potentially hundreds of limited partners. The compliance cost, administrative complexity, and risk of errors or omissions in this process would be substantial.
With the blocker in place, Intermediate Inc. is the sole (or substantially sole) member of Pinnacle post-closing. As a C-corporation that files its own state corporate income tax returns in each operating state, Intermediate Inc. satisfies the state income tax obligations directly. There is no need for Pinnacle to file composite returns or withhold on income allocable to nonresident partners, because Intermediate Inc. is the only partner and it files its own returns. The composite filing cascade described above is entirely eliminated.
D. Objective 4: Mitigating New York Nexus Risk for Holdings LLC
1. The New York Nexus Risk
Holdings LLC's business address is 600 Lexington Avenue, 38th Floor, New York, New York 10022 — the same address as Fund III and Ardent Capital GP III LLC. New York imposes income tax on partnerships and limited liability companies that are engaged in, or that carry on, any trade, business, profession, or occupation within the state. New York Tax Law Section 631(b) provides that a nonresident individual's New York-source income includes the individual's distributive share of partnership income to the extent that such income is derived from or connected with New York sources.
The New York nexus risk arises in the following manner: if Holdings LLC were to enter into management fee agreements directly with Pinnacle or Intermediate Inc., or if management or oversight services were rendered by individuals located at Holdings LLC's New York offices on behalf of Holdings LLC, Holdings LLC could be deemed to be "carrying on" a trade or business in New York. This determination could arise from the provision of management, consulting, or advisory services to Pinnacle; the exercise of day-to-day oversight over Pinnacle's operations; or the negotiation and execution of contracts on behalf of Pinnacle, in each case, from New York.
If Holdings LLC were found to have New York nexus, the consequences would be significant. Holdings LLC's income — including its allocable share of income from Pinnacle (whether received as dividends from Intermediate Inc. or, in the absence of a blocker, as operating income from Pinnacle) — would be treated as New York-source income. This income would flow through to Fund III and then to Fund III's individual limited partners, creating New York income tax filing obligations and potential New York income tax liability for hundreds of limited partners who have no connection to New York other than their investment in Fund III. The New York State income tax rate for high-income individuals is currently 10.9%, and New York City imposes an additional income tax of up to 3.876%, resulting in a combined state and city rate of up to approximately 14.776%.
2. Recommended Mitigation Strategy
To mitigate the New York nexus risk for Holdings LLC, Calderwood & Harkness recommends the following structural and operational measures:
Management Fee Agreements. All management fee agreements and management services agreements should be entered into between Ardent Capital GP III LLC — the general partner of Fund III — and Intermediate Inc. Ardent Capital GP III LLC is already subject to New York nexus and already files New York income tax returns. By routing all management activities through Ardent Capital GP III LLC, the management fee income and the associated New York nexus are attributed to an entity that is already a New York filer, rather than to Holdings LLC.
Holdings LLC as Passive Holding Entity. Holdings LLC should be treated, in both form and substance, as a passive holding entity whose sole activity is holding the stock of Intermediate Inc. and receiving dividends therefrom. Holdings LLC should not conduct management, oversight, advisory, consulting, or operational activities. It should not enter into management agreements, consulting agreements, or services agreements with any entity. It should not employ any personnel. It should not maintain office space separate from its registered agent's office (except as necessary for the receipt of mail at the New York address, which should be minimal and administrative in nature).
Board / Manager Meetings. Board of directors meetings (if Intermediate Inc.) or manager meetings (if Holdings LLC) for Holdings LLC should be held outside New York. Suitable locations include Delaware (where Holdings LLC is formed), King of Prussia, Pennsylvania (where Pinnacle is headquartered), or such other locations as may be appropriate. Minutes of Holdings LLC manager meetings should reflect the location of such meetings.
Personnel Attribution. No employees or contractors should be attributed to Holdings LLC. All personnel conducting management, advisory, or operational functions with respect to the Pinnacle investment should be employees of Ardent Capital GP III LLC (which provides management services to Intermediate Inc. under the Management Services Agreement) or employees of Intermediate Inc. or Pinnacle. Time records, payroll records, and organizational charts should clearly reflect this delineation.
3. Documentation and Operating Protocols
To support the New York nexus mitigation strategy, Calderwood & Harkness recommends that the following documentation be prepared and maintained on an ongoing basis:
(i) Management Services Agreement between Ardent Capital GP III LLC and Intermediate Inc. (not Holdings LLC), setting forth the scope, compensation, and terms of the management services to be provided by Ardent Capital GP III LLC. This agreement should be drafted to make clear that Holdings LLC is not a party to the management services arrangement and does not provide, direct, or control the management services.
(ii) Board Resolutions of Holdings LLC confirming its passive holding company status and resolving that Holdings LLC will not engage in management, advisory, or operational activities with respect to Pinnacle or Intermediate Inc.
(iii) Records of Holdings LLC Manager Meetings reflecting that all such meetings are conducted outside New York, with minutes prepared and signed by the managers in attendance at the non-New York location.
(iv) Expense Allocation and Intercompany Agreements clearly delineating that Holdings LLC does not bear, pay for, or reimburse any costs associated with management services rendered from New York. All such costs should be borne by Ardent Capital GP III LLC and charged to Intermediate Inc. under the Management Services Agreement.
(v) Organizational Charts and Personnel Records reflecting that no employees or contractors are attributed to Holdings LLC.
Calderwood & Harkness will provide further analysis and detailed recommendations regarding the New York nexus mitigation strategy in the State Tax Structuring Recommendations Letter, to be delivered on or about March 18, 2024.
IV. Federal Tax Classification and Elections
A. Holdings LLC — Partnership Classification
Ardent Healthcare Holdings LLC is a Delaware limited liability company with more than one member. Following the closing of the Transaction, the members of Holdings LLC will include Fund III (as the holder of Class A Units) and the three rollover participants — Dr. Raymond Carvallo, Dr. Nadia Ostrowski, and Jonathan Farnsworth — as the holders of Class B Units. Cascadia Mezzanine Fund IV LP will hold warrants to acquire equity interests in Holdings LLC representing 2.5% on a fully diluted basis.
Under the default classification rules of Treasury Regulation Section 301.7701-3(b)(1)(i), a domestic eligible entity (such as a Delaware LLC) with two or more members is classified as a partnership for federal income tax purposes unless an affirmative election is made to be classified as an association taxable as a corporation. No such election will be filed for Holdings LLC. Holdings LLC will be classified as a partnership for federal income tax purposes.
Holdings LLC's Employer Identification Number is 93-2187445.
B. Intermediate Inc. — C-Corporation Classification
Ardent Healthcare Intermediate Inc. is a Delaware corporation. Under Treasury Regulation Section 301.7701-2(b)(1), a business entity organized under a federal or state statute that refers to the entity as "incorporated" or as a "corporation" is automatically classified as a corporation for federal income tax purposes. No check-the-box election is needed or appropriate; corporate status arises by default from the entity's organizational form.
No election under IRC Section 1362 to be treated as an S-corporation will be made for Intermediate Inc. Fund III, as a limited partnership with multiple classes of partners, is not an eligible shareholder of an S-corporation under IRC Section 1361(b)(1)(B) (which limits S-corporation shareholders to individuals, estates, certain trusts, and certain tax-exempt organizations and requires no more than 100 shareholders). Holdings LLC, as a partnership and the sole shareholder of Intermediate Inc., is likewise not an eligible S-corporation shareholder. The S-corporation election is therefore structurally unavailable.
Intermediate Inc.'s Employer Identification Number is 93-2187512.
C. Pinnacle — Partnership Classification Post-Closing
Pinnacle Health Services Group LLC (EIN 82-1947632) is currently classified as a partnership for federal income tax purposes, with multiple members. Following the closing of the Transaction, Pinnacle will be the surviving entity in the reverse merger, and its sole member will be Intermediate Inc. (which will hold 100% of the membership interests acquired in the merger).
A single-member LLC is treated as a "disregarded entity" for federal income tax purposes under Treasury Regulation Section 301.7701-3(b)(1)(ii), meaning that it is not recognized as a separate entity from its owner for tax purposes. If Pinnacle were to become a disregarded entity, it would not file its own partnership tax return (Form 1065), and all of its income, deductions, gains, losses, and credits would be reported directly on Intermediate Inc.'s corporate tax return (Form 1120).
This outcome would have significant implications for the Section 754 election and Section 743(b) basis step-up that are central to the tax economics of the Transaction. The Section 754 election is made by a partnership on its partnership tax return for the taxable year in which a triggering event (such as a transfer of a partnership interest) occurs. If Pinnacle is a disregarded entity, it does not file a partnership return, and the Section 754 election mechanism is unavailable. Similarly, the Section 743(b) basis adjustment is a concept that applies only to partnerships with a Section 754 election in effect. A disregarded entity does not have "partners" and cannot make or maintain a Section 754 election.
Resolution: To preserve Pinnacle's partnership classification for federal income tax purposes and to ensure the availability of the Section 754 election and Section 743(b) basis step-up, Pinnacle must have at least two members post-closing. Calderwood & Harkness recommends that a nominal membership interest in Pinnacle — for example, a 0.01% interest — be retained by Holdings LLC or another Ardent-affiliated entity (such as Ardent Capital GP III LLC) to ensure that Pinnacle has at least two members and therefore retains its partnership classification. The holder of the nominal interest would receive a de minimis allocation of Pinnacle's income and would bear negligible economic risk.
Alternatively, a check-the-box election under Treasury Regulation Section 301.7701-3 could be considered, under which Pinnacle would affirmatively elect to be classified as a corporation (or, more precisely, as an association taxable as a corporation). However, this election would sacrifice the partnership-level benefits of the structure — including the Section 754 election, the Section 743(b) basis step-up, and the flow-through of tax attributes — and is not recommended.
The Section 754 / Section 743(b) mechanics and the interaction between partnership classification and basis step-up are analyzed in greater detail in the Section 338(h)(10) vs. Section 754 Election Analysis Memorandum, to be delivered on February 28, 2024.
V. Structural Diagram
The following text-based organizational chart depicts the post-closing structure of the Transaction, including the ownership chain, debt facilities, and management services arrangement:
POST-CLOSING ORGANIZATIONAL STRUCTURE
``` ┌──────────────────────────────────────────────────────────────────┐ │ ARDENT CAPITAL PARTNERS III LP │ │ (Delaware LP, EIN 87-3491520) │ │ Fund III Equity: $198,500,000 → Class A Units │ └──────────────────────┬───────────────────────────────────────────┘ │ │ (membership interests) │ ┌─────────────┼──────────────────────────────────────────┐ │ │ │ │ ▼ │ │ ┌──────────────────────────────────────────────┐ │ │ │ ARDENT HEALTHCARE HOLDINGS LLC │ │ │ │ (Delaware LLC, Partnership Tax Status) │ ◄────┤ │ │ EIN: 93-2187445
ROLLOVER PARTICIPANTS DEBT FACILITIES ───────────────────── ─────────────── Dr. Raymond Carvallo: $32.41M ► Graystone National Bank, N.A. Dr. Nadia Ostrowski: $24.18M (Administrative Agent) Jonathan Farnsworth: $ 2.95M $155M Term Loan B (SOFR + 425 bps) ───────────────────────────── $35M Revolver (SOFR + 375 bps) Total Rollover: $59.54M ► at Intermediate Inc. / Pinnacle → Class B Units of Holdings LLC Cascadia Mezzanine Fund IV LP MANAGEMENT SERVICES $30M Mezz Notes (12.5% / 2.0% PIK) ──────────────────── + Warrants for 2.5% FD Equity Ardent Capital GP III LLC → at Intermediate Inc. / Holdings LLC → MSA with Intermediate Inc. (NOT Holdings LLC — NY nexus mitigation) ```
VI. Impact on Financing Arrangements
A. Senior Secured Credit Facility
The $155,000,000 Term Loan B and $35,000,000 revolving credit facility arranged by Graystone National Bank, N.A. (as administrative agent), with syndicate members Ridgepoint Capital Markets LLC and Thorncrest Credit Partners LP, will be incurred at the Intermediate Inc. or Pinnacle level. The exact borrower entity — whether Intermediate Inc., Pinnacle, or a co-borrower arrangement — is to be confirmed in coordination with Harcourt Shaw & DeVries LLP (Thomas Kundra, lead finance counsel to Ardent). In our experience, lenders typically prefer that the borrower entity under a senior secured credit facility be the operating entity (here, Pinnacle) or the direct parent thereof (here, Intermediate Inc.), with guarantees flowing upstream and downstream through the ownership chain.
The use of Intermediate Inc. as a C-corporation borrower (or guarantor) is consistent with lender expectations and market practice for leveraged healthcare acquisitions. C-corporation borrowers simplify the credit agreement representations regarding tax status, organizational structure, and distribution mechanics. Lenders are generally familiar and comfortable with blocker corporation structures in the private equity context.
From a tax perspective, the interest expense deductions generated by the Term Loan B and revolving credit facility will offset operating income at the Intermediate Inc. / Pinnacle level, thereby reducing the federal and state corporate income taxes owed by Intermediate Inc. These interest expense deductions, combined with the Section 743(b) amortization deductions, constitute the primary tax shields available to Intermediate Inc. and play a significant role in mitigating the incremental corporate-level tax cost of the blocker structure. The interest deduction limitations under IRC Section 163(j) (which generally limits business interest expense deductions to the sum of business interest income plus 30% of adjusted taxable income) will apply to Intermediate Inc.'s consolidated tax group and should be monitored on an annual basis. Based on our preliminary analysis, the Section 163(j) limitation is not expected to restrict interest deductions in the early years of the hold period, given the magnitude of Pinnacle's adjusted EBITDA relative to the interest expense.
B. Mezzanine Facility
The $30,000,000 subordinated mezzanine notes from Cascadia Mezzanine Fund IV LP (bearing 12.5% cash interest and 2.0% payment-in-kind interest, with an eight-year maturity) will be incurred at the Intermediate Inc. or Holdings LLC level. The specific level at which the mezzanine debt is placed in the capital structure is to be confirmed with the finance counsel, taking into account intercreditor agreement restrictions and subordination mechanics.
The mezzanine warrants entitling Cascadia to acquire 2.5% of the fully diluted equity interests in Holdings LLC will be issued at the Holdings LLC level. Because Holdings LLC is classified as a partnership for federal income tax purposes, it has the flexibility to issue multiple classes of equity interests — including warrants, options, and profits interests — without the single-class-of-stock limitations that apply to S-corporations under IRC Section 1361(b)(1)(D). The blocker structure does not impede the mezzanine warrant mechanics in any respect. The warrants will be classified as partnership interests in Holdings LLC upon exercise, and Cascadia's exercise of the warrants will be treated as an issuance of partnership interests in exchange for consideration (the warrant exercise price), subject to the applicable partnership tax rules.
The blocker structure is fully compatible with the mezzanine facility and does not create any structural impediment to the issuance of the mezzanine notes or the warrants.
VII. Impact on Tax Receivable Agreement
The Tax Receivable Agreement entered into in connection with the Transaction provides for the payment of 85% of the realized tax benefits from the Section 743(b) basis step-up to the rollover participants (Dr. Raymond Carvallo, Dr. Nadia Ostrowski, and Jonathan Farnsworth) and pre-closing Pinnacle members. The TRA mechanics operate as follows:
(i) The Section 754 election made by Pinn