Tax Court applies profits interest safe harbor through tiered partnership

The Tax Court has ruled in ES NPA Holding, LLC v. Commissioner (T.C. Memo. 2023-55) that a taxpayer was not required to recognize income upon the receipt of a partnership profits interest through the application of the administrative safe harbor provided by Rev. Proc. 93-27. Although the case appears to have largely involved a valuation dispute, and certain factual aspects of the case are unclear, the court’s opinion nevertheless provides useful guidance to taxpayers in structuring grants of compensatory partnership profits interests in tiered partnership structures.

The controversy in ES NPA arose out of the restructuring and sale of interests in a consumer loan business formerly conducted by NPA Inc. NPA Inc.’s sole shareholder entered into a letter of intent to sell a 70% interest in NPA Inc.’s business for a price of approximately $21 million. To accomplish the sale, NPA Inc.’s assets were transferred to NPA LLC, a disregarded entity wholly owned by IDS LLC (“IDS”), another disregarded entity wholly owned by NPA Inc. After this restructuring, IDS’ 100% ownership of NPA LLC was denominated in three classes of units (Class A, B and C units), while NPA Inc.’s ownership of IDS was denominated in two classes of units (Class B and C units).

IDS sold its Class A units in NPA LLC to an unrelated acquirer.

ES NPA Holding LLC (ES NPA), the petitioner in the case, then acquired and exercised an option to acquire (for a relatively nominal strike price) the Class C units in IDS from NPA Inc. After these transactions, IDS and the outside investors owned 100% of the partnership interests in NPA LLC, with the outside investors holding Class A units and IDS holding Class B and C units. NPA LLC’s partnership agreement established capital account balances for the Class A units and Class B units of approximately $21 million and $9 million, respectively (that is, the capital contribution credited to the Class A units reflected a roughly 70% interest in NPA LLC’s capital). Upon a liquidation of NPA LLC, the holders of Class A and Class B units were entitled to a priority return in an amount equal to their capital contributions (no amounts would be distributed with respect to the Class C units until such capital contributions had been repaid). Thereafter, any further distributions would be made 40% to the Class A units, 30% to the Class B units, and 30% to the Class C units. The IDS partnership agreement provided that any amounts IDS received with respect to its Class B units in NPA LLC would be distributed to NPA Inc., while amounts received with respect to its Class C units would be distributed to ES NPA.

The principal issue in the case was the tax consequence to ES NPA of its acquisition of Class C units in IDS. ES NPA asserted that the receipt of the IDS Class C units was tax free under Rev. Proc. 93-27. Under that longstanding administrative guidance, “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 not treat the receipt of such an interest as a taxable event for the partner or the partnership.” For purposes of Rev. Proc. 93-27, a partnership profits interest is one that would entitle the holder to no share of the proceeds if the partnership sold all of its assets for their fair market value and then liquidated immediately after the issuance of such interest.

The IRS objected to ES NPA’s effort to apply Rev. Proc. 93-27 on multiple grounds. First, the IRS asserted that ES NPA’s Class C units were not entitled to application of the revenue procedure as a technical matter. The option pursuant to which ES NPA acquired its IDS interest stated that such option was being issued in consideration of services being provided to NPA Inc. in connection with the sale of an interest in NPA LLC by IDS to outside investors. The facts of the case suggest that ES NPA’s principals had been responsible for assembling the investor group that acquired the NPA LLC Class A units. The IRS asserted that ES NPA did not provide services to or for the benefit of IDS and, therefore, the receipt of an interest in IDS must fall outside of the scope of the revenue procedure. The court, however, found the IRS’ reading of the revenue procedure and views of the transaction at issue to be “unreasonably narrow.” The court’s reasoning suggests that ES NPA’s services with respect to the activities of NPA LLC were sufficient to fall within the scope of Rev. Proc. 93-27, and that it was of no material consequence that ES NPA’s partnership interest was effectively held indirectly through IDS. The court did not discuss the impact, if any, that ES NPA’s acquisition of the IDS Class C units pursuant to an option agreement with NPA Inc. had on its analysis.

The IRS also challenged the roughly $30 million valuation agreed to by the parties in establishing the capital contributions attributable to the Class B and C units under the NPA LLC partnership agreement. The IRS submitted a valuation prepared by an expert witness valuing NPA LLC at more than $50 million as of the date ES NPA acquired its Class C units. If the court agreed that NPA LLC’s liquidation value actually exceeded the $30 million agreed to by the parties, it stood to reason that the ES NPA’s Class C units would have ultimately been entitled to a 30% share of such excess, throwing the Class C units out of the scope of the revenue procedure and, thus, not treated as a profits interest. The court, however, credited testimony submitted at trial that the $21 million purchase price paid by the outside investors for the Class A units represented an arm’s length transaction between unrelated parties, and, as such, provided a superior method of valuation of NPA LLC as a whole. The Tax Court held that NPA LLC had a value of $30 million at the time of the issuance of ES NPA’s interest, and that pursuant to the NPA LLC partnership agreement, ES NPA would not ultimately have received any of the proceeds if NPA LLC had liquidated at a $30 million value immediately following the issuance of its interests (and not noting any other exception to the revenue procedure applied). The Tax Court thus ultimately held that ES NPA’s interest in IDS satisfied the requirements of Revenue Procedure 93-27 such that its receipt was tax-free to ES NPA.

Although the court’s analysis in ES NPA may leave some factual questions unresolved, the court’s permissive interpretation of the scope of Rev. Proc. 93-27 in tiered partnership structures seems to be good news to taxpayers, even though the IRS may seek to challenge whether the services being provided are “to or for the benefit” of the specific partnership in the tiered structure issuing the partnership interest. The case also clearly demonstrates the need for taxpayers to be prepared to substantiate fair market values used to establish partnership profits interests intended to satisfy the Rev. Proc. 93-27 safe harbor. This case shows that the IRS may seek to challenge purported partnership liquidation values that it views as being self-serving or artificially low. This risk could be heightened for partnerships that seek to establish partnership liquidation values without the benefit of benchmarks provided by arm’s length transactions with unrelated parties.