Partnership profits interest granted for services provided to lower-tier partnership passes muster in Tax Court

Introduction

Receiving partnership equity as compensation without getting taxed on receipt is a good result. Getting that result is possible if the partnership equity meets the IRS’ definition of a “profits interest.” Over the IRS’ objection, the Tax Court recently decided in the ES NPA Holding, LLC case the partnership equity compensation received was a profits interest qualifying for that favorable result. 

Key takeaways

• The Tax Court’s opinion authorized favorable profits interest treatment for a partnership interest granted by an upper-tier partnership for services provided to a lower-tier partnership.  
• The IRS unsuccessfully argued that this favorable treatment should not be available because the services were not provided to the same partnership that granted the equity interest.
• The court’s opinion is a reminder that accurate valuations are critical in profits interest cases. The court sustained the taxpayer’s valuation, which was based on a recent arm’s-length transaction, rejecting the higher valuation the IRS had asserted. 

Background

Profits interests represent interest in a partnership’s future profits and appreciation in value. Federal income tax is not imposed on a service provider’s receipt of a profits interest in a partnership if the conditions of Revenue Procedures 93-27 and 2001-43 are met.

To qualify, the profits interest must not be a capital interest in the partnership. That is, at the time the partnership interest is granted, it must not give the holder a share of the proceeds if the partnership’s assets were sold at fair market value immediately after the grant, with proceeds distributed in a complete liquidation of the partnership. Also, the recipient of the profits interest must receive it 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 recent ES NPA Holding, LLC case involved a partnership (an upper-tier partnership or UTP) that held an interest in another partnership (a lower-tier partnership or LTP). LTP conducted a consumer loans business and held various assets used in that business. UTP held only an interest in LTP.