Tax Court Dispenses Favorable Guidance on Profits Interest Safe Harbor

The Tax Court recently held in a memorandum opinion, ES NPA Holding, LLC v. Commissioner, that partnership interests in an upper-tier partnership issued to a service provider of a lower-tier partnership qualified as nontaxable profits interests. ^[1] The decision sheds light on when services will be considered to be provided “to or for the benefit of the partnership” and whether the value of the interests on the date of issuance is best determined by looking to the contemporaneous arm’s-length sale of the underlying business of the issuing partnership to an unrelated third party or some other valuation method. As discussed below, while the Tax Court’s approach is sound in this regard, its application to the facts at hand appears flawed.

Background

Section 721(a) generally provides for nonrecognition treatment to a person who contributes property to a partnership in exchange for an interest therein. However, services are not considered “property” for this purpose. Regulations promulgated under section 721 deny nonrecognition treatment to interests in partnership capital issued in exchange for services, but they distinguish such interests from interests in a share of partnership profits. ^[2] This distinction has led some courts to exempt from current taxation the issuance of profits interests in exchange for services, though judicial approaches have not been uniform in this regard.^[3]

To address this uncertainty, the IRS issued Revenue Procedure 93-27, ^[4] which provides that while the receipt of a partnership capital interest for services is taxable, a profits interest meeting certain requirements issued in exchange for services provided “to or for the benefit of the partnership” is not generally treated as a taxable event. The Revenue Procedure defines a “capital interest” as “an interest 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 complete liquidation of the partnership.” This determination generally is made at the time of receipt of the partnership interest. ^[5] The term “profits interest” means simply “a partnership interest other than a capital interest.” ^[6] The Revenue Procedure states that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will generally not treat the receipt of such an interest as a taxable event for the partner or the partnership.^[7]

The Transaction

The case arose from the partial sale of a consumer loan business. Mr. J. Landy (Landy) owned all of the outstanding equity interests in several entities conducting such business, including NPA, Inc. (NPA). In October 2011, prospective investors offered to purchase 70% of the business from Landy for approximately $21 million, which amount was based on an EBITDA multiple.

The sale occurred by means of several integrated transactions.  NPA formed two Delaware limited liability companies: Integrated Development Solutions, LLC (the Upper Tier Partnership) and National Performance Agency, LLC (the “Lower Tier Partnership”). The Upper Tier Partnership had two classes of membership units: Class B and Class C. The Lower Tier Partnership had three classes of units: Class A, Class B, and Class C. The Upper Tier Partnership’s operating agreement provided that its Class B and Class C units fully tracked payments on the Class B and Class C units in the Lower Tier Partnership, respectively.

NPA contributed “substantially all” of its business assets to the Lower Tier Partnership in exchange for all three classes of units in the Lower Tier Partnership. NPA then contributed all such Lower Tier Partnership units to the capital of the Upper Tier Partnership.

On the following day, NPA Investors, LP (NPA Investors) purchased all of the Lower Tier Partnership’s Class A units for $21 million. ^[8] On that same day, ES NPA acquired all of the Upper Tier Partnership’s Class C units in exchange for ES NPA’s payment to NPA of $100,000 and services provided or to be provided to NPA.  Specifically, ES NPA agreed to provide “strategic advice for the purpose of enhancing the performance of [NPA’s] business and to assemble an investor group that would purchase 40 percent of [NPA’s] business for approximately $21 million.” 

When the dust settled, Landy (through NPA) owned 100% of the Class B units of the Upper Tier Partnership. ES NPA owned 100% of the Class C units of the Upper Tier Partnership. The Upper Tier Partnership owned 100% of each of the Class B and Class C units of the Lower Tier Partnership. NPA Investors owned 100% of the Class A units of the Lower Tier Partnership. The Class A units of the Lower Tier Partnership held by NPA Investors had a capital account of $21 million, ^[9] the Class B units of the Lower Tier Partnership held by the Upper Tier Partnership had a capital account of $9 million, and the Class C units of the Lower Tier Partnership held by the Upper Tier Partnership had a capital account of zero. 

The Lower Tier Partnership’s operating agreement provided that after the payment of liabilities, liquidation proceeds (and presumably operating distributions) were to be distributed 30% to Class B unitholders, 40% to Class A unitholders, and 30% to Class C unitholders. However, the Class A unitholders were entitled to a liquidation preference over the Class C unitholders equal to their capital contributions (i.e., its $21 million initial capital account). More specifically, if the sum of all distributions made to the Class A unitholders was less than their total capital contributions, the liquidating distributions to the Class C unitholders were to be reduced, but not below zero, and the distributions to the Class A unitholders were to be increased, by the amount of such deficiency.

The Case

In 2017, the IRS issued a notice of final partnership administrative adjustment to the partners of ES NPA for the 2011 tax year. The IRS determined that ES NPA had underreported “other income” of $16 million attributable to either the receipt of a capital interest in the Upper Tier Partnership or the receipt of an indirect capital interest in the Lower Tier Partnership. ES NPA thereafter filed its petition with the Tax Court.

ES NPA argued that its indirect receipt of the Class C units of the Lower Tier Partnership (through its receipt of the Class C units of the Upper Tier Partnership that fully tracked such units) was a profits interest, rather than a capital interest, and was therefore excludable from income. The IRS’ principal argument was that the Revenue Procedure did not apply inasmuch as “ES NPA received an interest in [the Upper Tier Partnership] in exchange for services it provided to NPA, Inc.—not NPA, LLC.” The IRS argued in the alternative that Revenue Procedure 93-27 was inapplicable because ES NPA had in fact received a taxable capital interest in the Upper Tier Partnership.

The Tax Court disagreed with the IRS on both points. First, the Tax Court found the IRS’ view of the transaction and reading of Revenue Procedure 93-27 to be “unreasonably narrow” based on the guidelines expressed therein that the income exclusion would apply where the services are provided “to or for the benefit of a partnership.” Thus, rather than viewing Revenue Procedure 93-27 merely as a “safe harbor” with “limited application,” the Tax Court characterized it more broadly as “administrative guidance on the treatment of the receipt of a partnership profits interest for services.” 

Notwithstanding the fact that, in form, ES NPA’s services were to be provided to NPA, the Tax Court recognized that in substance such services were rendered “to or for the benefit of” the Lower Tier Partnership to which NPA had previously contributed its consumer loan business. ^[10] Moreover, the court did not hesitate to conflate the Class C units of the Upper Tier Partnership actually issued to ES NPA with the Lower Tier Partnership’s Class C units on the basis of the complete identity of interest in the Class C units of the two partnerships. That ES NPA provided its services in anticipation of being a partner (indirectly) of the Lower Tier Partnership was amply demonstrated to the Tax Court’s satisfaction by the entrepreneurial risk in that partnership taken by ES NPA in the form of the equity issued to it in exchange for its services; no other form of consideration was provided to ES NPA for its services.

Second, the Tax Court concluded that the Class C units of the Upper Tier Partnership constituted a profits interest within the ambit of Revenue Procedure 93-27 and not an interest in partnership capital. The Tax Court explained that this determination hinged on whether ES NPA would receive a distribution upon a hypothetical liquidation of the Upper Tier Partnership at the time of receipt of the Class C units, and noted in that connection that the Class C units of the Lower Tier Partnership had a capital account of zero as of October 14, 2011. The Tax Court also considered the above-referenced liquidation provision of the Lower Tier Partnership’s operating agreement, describing that provision as conferring a preferred return on the capital of the Class A and B unitholders, with the Class C units receiving distributions in a hypothetical liquidation only after all capital contributions were first returned in full. Thus—assuming the fair market value of the Lower Tier Partnership was $29,979,299, as reflected in the partners’ capital accounts—the Tax Court agreed with both parties that there would be no distribution to the Class C unitholders upon a hypothetical liquidation.

The Tax Court next considered whether the fair market value of the Lower Tier Partnership on the date of issuance of the Class C units in fact matched the amount reflected in the partners’ capital accounts. The IRS disputed that Landy’s partial sale of his consumer loan business was at arm’s length, and it relied on the opinion of its expert as to the fair market value of the Lower Tier Partnership. ES NPA contended that the actual terms of the acquisition of the Lower Tier Partnership’s Class A units by NPA Investors offered the best evidence of the partnership’s overall fair market value, that such sale was a bona fide arm’s-length transaction, and that the IRS’ expert witness’s valuation was flawed.

Referring to the familiar “hypothetical willing buyer and willing seller” definition of fair market value, the Tax Court averred that actual arm’s-length sales occurring sufficiently close to the valuation date are the best evidence of value, and typically dispositive, over other valuation methods and that “[h]ere, there was an actual sale of the subject property—that is, Mr. Landy’s internet-based consumer lending businesses—immediately before the hypothetical liquidation of [the Lower Tier Partnership].” The Tax Court noted that such sale implied an overall fair market value of $30 million and that no formal appraisal is required in such a circumstance. ^[11] In relying on the “arm’s-length and bona fide transaction,” the Tax Court rejected the valuation report of the IRS’ expert, which had employed an income approach and a different EBITDA multiple to “test” the actual sale price and concluded that the Lower Tier Partnership had a fair market value well in excess of its partners’ capital accounts.

The Tax Court thus concluded that the Upper Tier Partnership Class C units issued to ES NPA are a profits interest as defined under Revenue Procedure 93-27 since, applying a fair market value of $29,979,299 to the Lower Tier Partnership at the time of receipt of such units, ES NPA would not have shared in any proceeds upon a hypothetical liquidation. The Tax Court further concluded that on the basis of the conflicting expert witness testimony, any fair market value in excess of $30 million was “speculative.”^[12]

It is worth noting that the Tax Court’s analysis of value seems flawed given the distribution waterfall. If the overall value of the Lower Tier Partnership were truly $30 million, it is not logical that NPA Investors would pay $21 million in exchange for only 40% of distributions, subject to a liquidation preference on its capital. ^[13] The arrangement in fact suggests a total value significantly higher than $30 million and closer to but, due to the liquidation preference, less than $52.5 million ($21 million divided by 40%). Thirty percent of any such value in excess of $30 million would inure to the benefit of the Class C unitholders and would constitute a capital interest. Thus, while the IRS’ valuation of the Class C units of $16.5 million at issuance was excessive based on the price paid by NPA Investors, such units likely had a value in excess of zero and closer to $7 million.

Implications and Considerations

The key takeaway of ES NPA Holding is the expansive reading the Tax Court gave to the requirement of Revenue Procedure 93-27 that the service provider supply services “to or for the benefit of the partnership,” embracing the substance of the parties’ commercial arrangement rather than fixating on entity-focused technicalities. This flexibility should come as welcome news to private equity firms, which often issue profits interests in upper-tier flow-through vehicles to retained management in exchange for services that management has provided, and will continue to provide, to lower-tier target portfolio companies, including those operating through or as subsidiaries of C corporations. Given the favorable fact of NPA’s contribution of substantially all of its business assets to the Lower Tier Partnership, however, it remains to be seen whether such flexibility will be extended to profits interests issued as part of a tiered partnership structure where the entity to which the services are ostensibly provided retains a meaningful portion of the underlying business outside of the tiered structure. Another noteworthy aspect of the case is the willingness by the Tax Court—at least on the facts before it—to rely on the price obtained upon the contemporaneous sale of partnership capital interests, rather than a formal appraisal, as the best evidence of the fair market value of the partnership. While reliance on third-party arm’s-length transactions is in most instances the best indicator of value, as discussed above, on these facts such third-party transactions actually point to taxable capital interest treatment for the Class C unitholders. 

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If you have any questions about the issues addressed in this alert or if you would like a copy of any of the materials mentioned, please contact any of the authors.

^[1] _{T.C. Memo. 2023-55.  Tax Court memorandum opinions may be relied upon as precedent. They are generally issued in cases that do not involve a novel legal issue. See https://ustaxcourt.gov/petitioners_after.html.}

_{All section references are to sections of the Internal Revenue Code of 1986, as amended (the “Code”) and to Treasury Regulations promulgated thereunder, unless otherwise indicated.} 

^[2] _{Treas. Reg. § 1.721-1(b)(1) states in relevant part that “[t]o the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61.”} 

^[3] _{Compare Diamond v. Comm’r, 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974) (holding that the receipt of a partnership profits interest in exchange for services was taxable) and St. John v. United States, No. 82-1134, 1983 WL 1715 (C.D. Ill. Nov. 16, 1983) (same) with Campbell v. Comm’r, 943 F.2d 815 (8th Cir. 1991) (the receipt of the profits interest was not taxable where its value on the date of issuance was “speculative”).} 

^[4] _{1993-2 C.B. 343, clarified by Rev. Proc. 2001-43, 2001-2 C.B. 191.  Treas. Reg. § 601.601(d)(2)(B) provides that a revenue procedure “is a statement of procedure that affects the rights or duties of taxpayers or other members of the public under the Code and related statutes or information that, although not necessarily affecting the rights and duties of the public, should be a matter of public knowledge.”} 

_{In 2005, Treasury issued proposed regulations addressing the receipt of a partnership interest in connection with services.  Notice of Proposed Rulemaking, REG-105346-03, 70 Fed. Reg. 29675 (May 24, 2005). In connection with the issuance of those proposed regulations, in Notice 2005-43, 2005-1 C.B. 1221, the IRS stated that Revenue Procedures 93-27 and 2001-43 will become obsolete upon the finalization of such proposed regulations but that until then, taxpayers are permitted to rely on those revenue procedures. The regulations remain in proposed form.} 

^[5]  _Id. 

^[6] _Id. 

^[7] _{Revenue Procedure 93-27 does not apply in the following circumstances: (i) if the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; (ii) if, within two years of receipt, the partner disposes of the profits interest; or (iii) if the profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of section 7704(b).  Rev. Proc. 93-27, § 4.02, 1993-2 C.B. 343.} 

^[8] _{All amounts are approximate. Of the $21 million, $14.5 million was acquired for cash from the Upper Tier Partnership and $6.5 million reflected the contribution by NPA Investors of certain notes that had been previously issued by the Lower Tier Partnership and acquired by NPA Investors as part of the overall transaction.} 

^[9] _{This amount represented 70% of total partnership capital of $30 million.} 

^[10] _{That ES NPA was also to provide the service of assembling an investor group that would purchase a portion of NPA’s business for approximately $21 million, which service at least arguably was rendered to and benefited NPA rather than the Lower Tier Partnership, was not addressed by the Tax Court. Perhaps this assemblage service (to the extent it entailed prospective efforts) may be disregarded as not having anything more than de minimis value inasmuch as the sale occurred contemporaneously with the entry into the call option agreement. Moreover, arguably such services indirectly benefited the Lower Tier Partnership. It is worth noting that profits interests are often issued in connection with services relating to a sale of partnership interests, whether as a primary issuance or a secondary sale.} 

^[11] _{The Tax Court also noted that nothing in the record indicated Landy was under any duress or compulsion to sell, and the Tax Court found Landy’s testimony with respect to the issuance of the profits interest (as to which he was indifferent) to be credible and unbiased.} 

^[12] _{The Tax Court indicated that the case was appealable to the Court of Appeals for the Eighth Circuit and that it would thus follow the latter’s precedent (i.e., Campbell, discussed in n.4 above), which held that any value in excess of liquidation value was speculative. Presumably, the Tax Court sought to mitigate the possibility of a reversal or remand by the appeals court on the ground that Revenue Procedure 93-27 was either not applicable or not binding on the IRS.} 

^[13] _{The very agreement pursuant to which the Class C units were acquired stated that $21 million represented 40% of the value of the business.}