Granting a profits interests in an entity taxed as a partnership presents complicated issues for business owners and their professionals. When properly issued, a profits interest will provide the recipient with an equity interest in the partnership without triggering a taxable event. A grant that fails to meet the necessary requirements will likely generate taxable income to the recipient and create headaches for the partnership and its other owners. A recent Tax Court decision provides a reminder of the complexity of these issues and the profits interests safe harbor under Rev. Proc. 93-27 (See ES NPA Holding LLC v. Commissioner, T.C. Memo 2023-55 (May 3, 2023)).

The case involved a taxpayer who received a partnership interest in exchange for a contribution of services which the parties intended to be a non-taxable profits interest grant. Rev. Proc. 93-27 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 a complete liquidation of the partnership." Profits interests, on the other hand, are defined as a partnership interest "other than a capital interest."

The taxpayer in ES NPA Holding LLC received a partnership interest in an upper-tier partnership ("UTP") in exchange for services the taxpayer provided to a lower-tier partnership ("LTP"). The taxpayer took the position that its indirect receipt of an interest in LTP (through its receipt of a direct interest in UTP) was a profits interest, and therefore excludable from income. The IRS argued, among other things, that that Rev. Proc. 93 27 safe harbor was inapplicable, as the taxpayer provided services to LTP, not UTP. Therefore, the IRS claimed the taxpayer’s UTP partnership interests were a taxable capital interest, implying that Rev. Proc. 93-27 is a "safe harbor with only limited application."

The Tax Court rejected the IRS’ "unreasonably narrow" interpretation, noting that Rev. Proc. 93 27 has been referred to as a "‘broad, taxpayer-friendly safe harbor’ subject only to tightly defined exceptions." Instead, the court held that UTP was "a mere conduit," and that the taxpayer’s indirect ownership of LTP through its ownership of UTP was "of no material consequence." Central to this holding was the undisputed fact that the interest in UTP and LTP were "identical in all respects," including, most importantly, the applicable partnership interests’ liquidation rights. As the taxpayer would have received nothing upon a hypothetical liquidation of UTP at the time of receipt, the Tax Court held the UTP partnership interests were profits interests.

Although the Tax Court found in favor of the taxpayer in this case, there are meaningful nuances to its decision. Crucial to the Tax Court’s decision was how the operating agreements of both LTP and UTP were drafted, and specifically the liquidation provisions. It is essential for any entity seeking to grant profits interests in exchange for services to consult with tax and corporate counsel to ensure the transaction is properly structured and the relevant operating agreements are correctly drafted.

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