Article | Tax alert

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

May 19, 2023 · Authored by Christine Faris

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.

The taxpayer in ES NPA Holding received an interest in UTP, which it claimed was a profits interest. The IRS contended that interest was a capital interest, so the taxpayer’s receipt of it was taxable.

Upper-tier partnership profits interests  

The IRS argued that the partnership interest in UTP could not meet the Rev. Proc. 93-27 profits interest definition because the recipient did not provide services to UTP. The Tax Court, however, noted that the taxpayer received the UTP partnership interest for services provided to LTP.

The UTP liquidation rights the taxpayer held by virtue of its UTP interest were identical to the LTP liquidation rights UTP held by virtue of its LTP interest. In the view of the Tax Court, the UTP acted as a mere conduit in this situation, and the taxpayer’s services provided to LTP were provided to or for the benefit of UTP.

Many investment funds (and other taxpayers) provide compensation to key personnel via upper-tier partnership profits interests. Real estate, private equity and hedge funds generally will be pleased with the court’s decision in this case.

Valuation  

The taxpayer’s reliance on the Rev. Proc. 93-27 safe harbor from immediate taxation also depended on demonstrating that the partnership interest it received did not have liquidation value on the date it was granted. The taxpayer applied the agreed-on valuation of LTP, as expressed in legal documents governing an arm’s-length transaction that closed days prior to the taxpayer’s receipt of the UTP interests in question. Applying that asset value, liquidations of LTP and UTP would result in no liquidation proceeds for the taxpayer.

The IRS disagreed with that valuation and hired a valuation expert whose report reflected a much higher liquidation value. The court concluded that the recent arm’s-length transaction provided the better measure of value, rejecting the higher valuation the IRS argued for.

The result: The court agreed with the taxpayer. The taxpayer received a profits interest, not a capital interest, and thus was not taxed on its receipt of the UTP partnership interest in exchange for services provided to LTP.   

Questions?

Please reach out to your Baker Tilly advisor if you have questions or would like to discuss how the partnership profits interest rules may affect you.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.