May 19, 2023
Tax Court finds for partnership in dispute over whether income is excludable as a profits interest under Revenue Procedure 93-27
In ES NPA Holding, LLC v. Commissioner (T.C. Memo 2023-55), the Tax Court (court) held that Revenue Procedure 93-27 applies to a partnership's indirect receipt of a partnership interest, which is a profits interest and thus excludable from income. As such, the partnership did not have unreported income and was not liable for accuracy-related penalties under IRC Section 6662.
NPA, Inc. formed IDS, LLC (IDS) and NPA, LLC. IDS had class B and class C units, and NPA, LLC had class A, B and C units. In 2011, NPA, Inc. contributed substantially all its business assets to NPA, LLC in exchange for all the class A, B and C units in NPA, LLC. NPA, Inc. then contributed all its units in NPA, LLC to IDS as a capital contribution to IDS. The class B and class C units in IDS tracked the class B and class C units that IDS held in NPA, LLC — the owner of the IDS class C units was entitled to 100% of the payments received by IDS because of its ownership of NPA, LLC class C units.
An entity named NPA Investors subsequently acquired from IDS the class A units in NPA, LLC. On that same day, ES NPA Holding, Inc. (ES NPA) exercised a call option granted by NPA, Inc. and acquired all the IDS class C units in exchange for ES NPA's payment to NPA, Inc. of $100,000 and specified services provided or to be provided to NPA, Inc.
At the end of the transactions, NPA Investors held the class A units in NPA, LLC, and IDS held the class B units and the class C units. EPS NPA held the class C units in IDS, which track the class C units that IDS holds in NPA, LLC. NPA, Inc held the class B units in IDS, which track the class B units that IDS holds in NPA, LLC.
In 2017, the IRS issued a notice of final partnership administrative adjustment (FPAA) to ES NPA through its tax matters partners. The IRS determined that ES NPA had over $16m of unreported income attributable to receiving a 50% capital interest in IDS. In the alternative, the IRS determined that the unreported income was attributable to ES NPA receiving a 30% indirect capital interest in NPA, LLC.
ES NPA contended that its indirect receipt of units in NPA, LLC (through ES NPA's interest in IDS) was a profits interest under Revenue Procedure 93-27 and, therefore, excludable from income for 2011.
The IRS contended that Revenue Procedure 93-27 did not apply because ES NPA did not provide services directly to IDS. The IRS also argued that the Revenue Procedure 93-27 safe harbor did not apply because ES NPA received a capital interest in IDS. Additionally, the IRS argued that the fair market value of ES NPA's interest in IDS was more than ES NPA claimed, which would change the outcome.
Under Revenue Procedure 93-27, receipt of a capital interest in exchange for services is taxable as compensation, but receipt of a profits interest is not a taxable event. A capital interest is defined as one that would "give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership." A profits interest is defined as a partnership interest other than a capital interest. A profits interest is not treated as income when it is acquired if it is received "for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner."
Revenue Procedure 93-27 applies
The court first found that ES NPA met Revenue Procedure 93-27's scope requirement that services be provided to or for the benefit of the partnership by the taxpayer as a partner or in anticipation of being a partner. In its analysis, the court said (1) ES NPA substantively provided services to NPA, Inc. in exchange for the class C units in IDS, and (2) ES NPA's interests in the class C units in IDS were identical to the interests in class C units in NPA, LLC.
The IRS argued that ES NPA received an interest in IDS in exchange for services it provided to NPA, Inc., but not to NPA, LLC. The court said the IRS's reading of the revenue procedure and views of the transaction were "unreasonably narrow."
The court found that "ES NPA directly (or through its principals), before and after formation, provided services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner." In support of its finding, the court said that the material assets of the partnership were held in NPA, LLC and the activities ES NPA performed were to and for the benefit of the future partnership. It did not matter that ES NPA's interest in NPA, LLC was held indirectly through IDS, which was a "mere conduit," because the liquidation rights in the class C units in IDS and NPA, LLC were identical. In addition, there was entrepreneurial risk and receipt of a profits interest in the capacity as a partner.
ES NPA satisfied the requirements of Revenue Procedure 93-27
The court next turned to whether ES NPA's class C units were a profits interest. This determination depended on whether ES NPA would receive a distribution upon a hypothetical liquidation of the partnerships immediately after receipt of the class C units in IDS. In this case, ES NPA contended that the class C unit holders would receive nothing in the hypothetical liquidation of the partnerships using the $30m fair market value (FMV) of the assets implied by the purchase by NPA Investors, an arm's-length transaction. The IRS contended that its expert valued NPA, LLC at over $52m, which would result in a distribution to ES NPA as a class C unit holder in the hypothetical liquidation.
The court rejected the IRS's proposed valuation of NPA, LLC, saying, "[t]he parties agree that the best evidence of fair market value is actual arm's-length sales involving that property." According to the court, the original owner of the business in the transaction had sold a 70% interest in his business for around $21m, which would result in the overall FMV of NPA, LLC being almost $30m. The court, siding with the taxpayer's valuation, determined that ES NPA would not receive a distribution upon liquidation of NPA LLC and, therefore, the class C units were properly treated as a profits interest.
Because Revenue Procedure 93-27 applied and the requirements were satisfied, the court concluded that the income was excludable. ES NPA was not, therefore, subject to an accuracy-related penalty under IRC Section 6662.
This holding raises several important issues that the court resolved in favor of the taxpayer.
Scope of "to or for the benefit of the partnership" and "in anticipation of becoming a partner"
The holding is notable because the court broadly read the language in Revenue Procedure 93-27 on providing services "to or for the benefit of the partnership" and "in anticipation of becoming a partner." In PLR 200329001, the IRS applied the "to or for the benefit of the partnership" language in a flexible but narrower manner in an umbrella partnership real estate investment trust (UPREIT) structure where a REIT was a limited partner and the sole general partner of an operating partnership. Certain employees of the REIT, the operating partnership, and affiliates of the operating partnership all received profits interests in the operating partnership despite not all of the employees providing services directly to the partnership. The IRS ruled that Revenue Procedure 93-27 applied to the profits interest issuances. The PLR reflects a commonly applied interpretation of the revenue procedure's scope.
Proposed regulations from 2005 would significantly narrow the application of the principles of Revenue Procedure 93-27 by applying them only to grants of profits interests for services provided directly to the issuing partnership (Prop. Treas. Reg. 1.721-1(b)(3) (2005) (a compensatory partnership interest is an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership (either before or after the formation of the partnership)).
Grants of profits interest that convert the entity to a partnership
It does not appear that the IRS argued that Revenue Procedure 93-27 did not apply because IDS was a disregarded entity of NPA, Inc. and sprang to life as a partnership only upon the acquisition of the profits interest by ES NPA as a result of paying $100,000 and providing services. In McDougal v. Commissioner, 62 T.C. 720 (1974), the court held that springing a partnership to life via giving a service provider equity in the business is taxable for the owner and the service provider (the owner used appreciated property in the partnership to pay an expense).
The 2005 proposed regulations addressing grants of compensatory partnership interests would not tax a partnership granting a "compensatory partnership interest" on the transfer or substantial vesting of that interest (Prop. Treas. Reg. 1.721-1(b)(1) - (3)). Citing McDougal, the Preamble states "[t]he rule providing for nonrecognition of gain or loss does not apply to the transfer or substantial vesting of an interest in an eligible entity … that becomes a partnership … as a result of the transfer or substantial vesting of the interest."
It is not clear what to make of the IRS not raising this argument in the case at hand. In general, most practitioners confirm that the granting entity is a partnership for tax purposes before granting profits interests.
The IRS challenged the valuation asserted by the parties, arguing that the class C units had a capital account value. ES NPA argued that an implied value from the parties' economics meant the class C units had no capital account value, and the court agreed. The disagreement between the taxpayer and the IRS illustrates the difficulties in establishing an implied value when there are structural differences between return of capital rights and residual sharing.1
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
1 Kristen A. Parillo, Tax Court Decision on Profits Isn't Full Story, Tax Notes Today (May 11, 2023) (quoting Clifford Warren of the IRS Associate Chief Counsel Office (Passthroughs and Special Industries) as stating that "There's more to the case than meets the eye").