May 18, 2023
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On May 3, 2023, the Tax Court released a memorandum opinion in ES NPA Holding LLC v. Commissioner[1] holding that the taxpayer’s indirect receipt of a profits interest in a lower-tier partnership qualified as a non-taxable event under the safe harbor provided in Rev. Proc. 93-27.[2] The opinion provides a well-reasoned application of the profits interest safe harbor that puts to rest certain unsettled tax issues relating to the use of such structures. The court stops short of holding that a profits interest held in a tiered partnership structure will be respected in all cases, and limits analysis to the facts and arguments presented in this specific case, including that the decision seems to turn on the court’s findings about valuation with the result that the application of Rev. Proc. 93-27 in this instance is less important than it may be in other contexts.
Rev. Proc. 93-27 defines a “profits interest” as a partnership interest other than a capital interest and defines a “capital interest” as a partnership 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 a complete liquidation of the partnership.” Under Rev. Proc. 93-27, receipt of a profits interest is not treated as an income event if a person receives 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.”
For various business purposes, it is regularly necessary for a lower-tier partnership to issue a profits interest to an upper-tier partnership, following which the upper-tier partnership will issue a reciprocal profits interest to an individual service provider (i.e., using a tiered partnership structure). One common business purpose for this structure is to resolve concerns regarding the so-called “dual status” issue, whereby an individual service provider holding a direct profits interest in a lower-tier partnership would not be eligible to be classified as an employee by such partnership or any of its subsidiaries classified as disregarded entities.[3]
The transaction involved a commercial loan business conducted by Mr. Joshus Landy through his wholly owned corporation, NPA, Inc. In 2011, two individuals, Messrs. Joseph and Raizada, contacted Mr. Landy about acquiring a portion of the commercial loan business. In June 2011, one of Mr. Joseph’s businesses, Emerald Crest Capital (ECC), offered to purchase 70% of Mr. Landy’s commercial loan business for approximately $21 million. The parties agreed to engage in a pre-closing restructuring to facilitate the transaction:
At the closing, NPA Investors and IDS entered into an operating agreement for NPA, LLC. Under the terms of that agreement and using the value of total NPA, LLC capital agreed to by the parties, if NPA, LLC were to have sold all of its assets and liquidated immediately after formation, the Class C units would not have been entitled to a share of the liquidation proceeds.
The post-closing ownership reflecting the results of the pre-closing restructuring and closing of the transaction is depicted below:
In March 2017, the U.S. Internal Revenue Service (IRS) issued a notice of final partnership administrative adjustment (FPAA) to ES NPA relating to ES NPA’s receipt of the Class C units in IDS on the closing date. The IRS asserted in the FPAA that ES NPA failed to report substantial income attributable to receipt of a 50% capital interest in IDS, or in the alternative, attributable to receipt of a 30% indirect capital interest in NPA, LLC.
In support of these assertions, the IRS argued that the Class C units in IDS did not qualify as “profits interests” within the meaning of Rev. Proc. 93-27 because ES NPA did not provide services to IDS, or alternatively, because ES NPA received a taxable capital interest in IDS attributable to ES NPA’s Class C units in IDS having a fair market value of approximately $12 million at the time of receipt.[4] ES NPA took the position that the Class C units in IDS that it received were “profits interests” as defined in Rev. Proc. 93-27 and qualified for the safe harbor thereunder.
The court analyzed the IRS’s arguments and ultimately disagreed. The court instead determined that the Class C units granted to ES NPA constituted profits interests properly governed by Rev. Proc. 93 27 and structured without the right to participate in a hypothetical liquidation of NPA, LLC as of the time of grant. As such, the court held that ES NPA’s receipt of its Class C units was not a taxable event.
“To or for the Benefit” of the Partnership. The court first considered whether the tax consequences of ES NPA’s receipt of the Class C units in IDS (which tracked the economics of the Class C units in NPA, LLC) were governed by Rev. Proc. 93-27 in light of the IRS’s primary argument that ES NPA provided services to NPA, Inc. and not “the partnership” as required by Rev. Proc. 93-27. The court noted the recital in the call option agreement that specifies consideration for the Class C units in the form of “services provided or to be provided” to NPA, Inc., but also observed that the “material assets” were held in NPA, LLC as of the closing date, and that the services performed by ES NPA were to and for the benefit of the future partnership, NPA, LLC, formed as of the date of closing. Based on this review of the evidence, the court determined that the IRS’s argument was an “unreasonably narrow” reading of the “to or for the benefit” requirement and that the facts and circumstances of the issuance of the Class C units supported the conclusion that Rev. Proc. 93-27 applied based on the facts of this particular case.
The court also rejected the IRS’s assertion that Rev. Proc. 93-27 is a “safe harbor” with limited application, and instead did not view Rev. Proc. 93-27 in such a restricted manner, but rather as administrative guidance on the treatment of the receipt of a partnership profits interest for services. The court found that ES NPA’s services ultimately benefited the lower-tier operating partnership, NPA, LLC, notwithstanding that the transaction documents indicated that the services were to be provided to NPA, Inc. The court also determined that it was “of no material consequence” that ES NPA owned its Class C units in the lower-tier operating partnership indirectly through the upper-tier holding partnership, because the interests effectively provided ES NPA with 100% of the economic entitlements attributable to the Class C units in the lower-tier operating partnership. The court found it “entirely reasonable to conclude” that ES NPA’s receipt of the Class C units satisfied Rev. Proc. 93-27 but stopped short of holding that a profits interest held in a tiered partnership structure will be respected in all cases.
“Profits Interest” and Hypothetical Liquidation. Having determined that the Class C units in IDS received by ES NPA were governed by Rev. Proc. 93-27, the court considered whether the Class C units were “profits interests” within the meaning of Rev. Proc. 93-27. That is, whether, at the time of grant, the Class C units in IDS (which tracked IDS’s Class C units in NPA, LLC) would have been entitled to a share of the proceeds if NPA, LLC sold its assets for fair market value and liquidated.
The IRS disputed the fair market values assigned by ES NPA to the assets of NPA, LLC (which, if applied, would have resulted in participation in a hypothetical liquidation at the time of grant), claiming the transaction was not at arm’s length and that formal appraisal was required. The court found the argument unconvincing and rejected the IRS’s argument that a formal appraisal is required to support a taxpayer’s claim regarding the fair market value of property: “this Court and others have frequently adopted the proposition that an actual sale is more persuasive evidence of fair market value than an appraisal, so the proposition that an appraisal is necessary to validate a sale clearly cannot be correct.”[5] Because the transaction resulted in a sale of 70% of the business to the third-party taxpayer and other investors, the court determined that the transaction was at arm’s-length and supported ES NPA’s use of its fair market values, which did not provide the Class C units in IDS with a share of the liquidation proceeds at the time of grant.
We expect practitioners will highlight the decision in ES NPA Holding LLC to support the position that the profits interest safe harbor described in Rev. Proc. 93-27 should apply when a profits interest is issued on a back-to-back basis using a tiered partnership structure. Care should be taken to ensure the profits interests at each tier properly track each other and, of course, that the underlying agreement is drafted in a manner that would not result in the profits interest holder receiving a share of hypothetical liquidation proceeds as of the date of transfer. Practitioners likely will continue to recommend service providers timely file Section 83(b) elections for profits interests subject to substantial risks of forfeiture.[6]
The profits interest structure in ES NPA Holding LLC is a relatively common structure, and the Tax Court’s holding that the tax consequences of such structure are governed by the profits interest safe harbor is a positive and reassuring outcome for taxpayers, as is the court’s discussion regarding the support for ES NPA’s determination of the fair market value of the assets of NPA, LLC.
[1] ES NPA Holding LLC. V. Commissioner; T.C. Memo 2023-55.
[2] Revenue Procedure 93-27, 1993-2 C.B. 343. Revenue Procedure 93-27 is clarified by Revenue Procedure 2001-43, 2001-2 C.B. 191.
[3] For example, the tiered structure is commonly used to address the “dual status” issue—that, for U.S. federal income tax purposes, a person cannot be both a partner and an employee of the same partnership—by providing a profits interest to an employee in a partnership separate from the partnership by which that employee is not employed. The tiered structure may also serve non-tax purposes, such as simplifying an entity’s capitalization table.
[4] The opinion states in a footnote that the IRS did not assert that ES NPA triggered an exception to Rev. Proc. 93-27, such as by disposing of the profits interest within two years of receipt. The court indicated it did not consider this issue and deemed it to be waived. Perhaps this issue, among others, will be clarified if the IRS chooses to file an appeal.
[5] ES NPA Holding LLC v. Commissioner, T.C. Memo 2023-55, at *15 (emphasis in original).
[6] For the recipient of a purported profits interest that is unvested at the time of issuance, prudence may require filing a “protective” election under section 83(b) notwithstanding IRS guidance providing that no such election is required. The section 83(b) election is intended to ensure that if the purported profits interest turns out to have been a capital interest (for example, due to an understatement of the values of the partnership’s assets or an unintended consequence of how the partnership’s liquidating distribution provision is drafted), or if the conditions of Rev. Proc. 93-27 are not satisfied, the recipient’s taxable income upon receipt of the interest will be based on the fair market value of such interest at the time of receipt, which presumably would be lower than the value at the time of subsequent vesting (even if not zero at the time of grant).
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