Tax Court Clarifies What A Profits Interest Is
The U.S. Tax Court has held in ES NPA Holding, T.C. Memo 2023–55, that an interest in a partnership granted for services was a profits interest that was not taxable to the taxpayer under Revenue Procedure 93–27.
The case helps to define what a partnership profits interest is, as compared to a capital interest. It reviews the tax history of a profits interest and how it is taxed under the Internal Revenue Code. The case analyzed the governing IRS revenue procedure, 93–27, which provides for the tax free receipt of a partnership profits interest for services “to or for the benefit” of the partnership. Under the acquisition of partnership interest option agreement in the case, the services of the recipient of the interest and holder of the option were required to be provided to the ultimate owner of the structure and not to the partnership explicitly as the service recipient. The IRS disputed the application of Rev Proc 93–27 on that basis (that the interest was not granted for services to or for the benefit of the partnership whose profits interest was granted).
The court said that the IRS was viewing the situation too narrowly. The court cited factors such as that the material assets of the business were held in the partnership whose interest was issued for services and that the services of the taxpayer were necessary for the actual existence of the partnership whose interest was granted. The court also noted that there was entrepreneurial risk in the ownership of the granted interest.
The case held for the taxpayer and is appealable to the Eighth Circuit, the appeals court that held that the profits interest for services had only speculative value in the Campbell case. The actual interest granted to the taxpayer for services was an indirect interest in the subject partnership but the court held that because the ownership of the directly held interest tracked 100% to the operations of the subject partnership, that it met the conditions of the revenue procedure.
The case is meaningful for a number of reasons:
1. First, providing services “to or for the benefit” of the partnership was not viewed literally but expansively. Many structures today use or would like to use a tiered partnership structure where an interest in a parent partnership could be granted for services rendered to the subsidiary partnership or the reverse case. There have been questions about whether those kinds of structures meet the conditions of Rev Proc 93–27 because it was not known how narrowly or broadly “to or for the benefit of” would be construed. This particular case had 100% tracking so that in substance there was a direct interest in the subject partnership. The value of one entity was tied 100% to the other entity. The case does not say whether there was any divergence of assets held or operations conducted by one entity as compared to the other but 100% tracking would indicate that there was no discomformance. It is not clear how far the concept of “to or for the benefit of” extends where there is no explicit tracking but rather there is a high degree of conformity in the value of one entity and the value of another entity. But this case opens the door to that analysis and is a welcome development.
2. The case notes in a footnote that the IRS proposed regulations in 2005 that would resolve this situation in at least some cases but those regulations remain proposed to this day. The case notes the history of a profits interest, including the Tax Court opinion in Campbell a number of years back where it was held that a profits interest was taxable upon grant. But this case was appealable to the Eighth Circuit Court of Appeals which reversed the Tax Court in Campbell and held that the profits interest there had only speculative value and was not taxable. Then the IRS issued the revenue procedure 93–27. The case today also noted in a footnote that in its view the IRS has viewed a profits interest for services as a form of deferred compensation.
3. The Tax Court case today did not say what would have happened if the case was appealable to a different circuit court of appeals than the Eighth Circuit and/or whether Rev Proc 93–27 would bind the government despite the Tax Court’s difference of opinion on the issue. The Tax Court held in Campbell that the profits interest was property issued for services and thus taxable. It would seem that the revenue procedure 93–27 would bind the IRS in Tax Court or on appeal to a circuit court of appeals (except perhaps an appeal to the Eighth Circuit), but that issue is not addressed in the case. Further, if this case is appealed to the Eighth Circuit, will the Eighth Circuit decide the case on the merits and not apply Rev Proc 93–27 because that circuit held in Campbell that the profits interest was not taxable under the circumstances or will the circuit bind the IRS to the revenue procedure as this case implicitly did? It does not appear that the IRS challenged the bona fides of its own revenue procedure in the case or at least it was not discussed.
4. There was a valuation issue of the profits interest where, despite a prior arm’s length sale in the case, the IRS argued for an expert opinion. The court rejected that assertion and relied upon the stated capital accounts which were clearly based on the sales history of a bona fide arm’s length sale. However, the argument in the case indicates the need for accurate and sustainable valuations in profits interests cases.
Relating to the “to or for the benefit of” Rev Proc 93–27 issue, the Tax Court said the two things at 1 and 2 below. It seems to be enough to meet the “to or for the benefit of” test. The services were necessary so that there would be a functioning partnership and the material assets of the business were in that partnership and strategic advice was to be rendered to enhance the performance of the overall business. Forget about the tiers of partnerships because there was stated to be 100% tracking. The real parent was the corporation up top. That does not seem too tenuous. The question in future cases will be how much benefit you can prove exists.
1. “The “Whereas” clause of the call option agreement states that ES NPA agreed to provide the following services to NPA, Inc. in exchange for the option to pay $100,000 to NPA, Inc. to acquire all of the class C units in IDS (which reflected an indirect interest in the class C units of NPA, LLC): “strategic advice for the purpose of enhancing the performance of [NPA Inc.’s] business and to assemble an investor group that would purchase 40 [sic] percent of [NPA Inc.’s] business for approximately $21 million.” The call option agreement also provides that ES NPA is hereby given “an option . . . to purchase all of the Class C Units . . . from [IDS]” and is dated October 14, 2011.”
2. “Considering the text of Revenue Procedure 93–27 §4, the evidence supports a finding 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. It is undisputed that the material assets of this partnership are held in NPA, LLC, and the activities ES NPA performed were to and for the benefit of the future partnership. It is of no material consequence that ES NPA’s interest in NPA, LLC is held indirectly through IDS, which is a mere conduit since the liquidation rights in the class C units in both IDS and NPA, LLC are identical. This partnership came about only through ES NPA and NPA, Inc.’s joint ownership of IDS and their ownership interest in NPA, LLC. Other relevant elements here evidencing that the application of Revenue Procedure 93–27 is proper are the presence of entrepreneurial risk and the receipt of a profits interest in the capacity as a partner. Thus, it is entirely reasonable to conclude that ES NPA’s receipt of the class C units meets the intended parameters of Revenue Procedure 93–27 §4.”
