A recent US Tax Court case upholds profits interest treatment for a taxpayer’s receipt of a partnership interest granted in exchange for services. The case highlights how properly structuring and documenting the grant of a partnership profits interest in exchange for services can support non-taxable treatment at grant.
WHAT IS A PROFITS INTEREST?
Under IRS Revenue Procedure 93-27  (Rev. Proc.), a profits interest is a type of interest in a partnership (or LLC taxed as a partnership) that entitles the holder to a share of the partnership’s prospective profits as of the date of grant in exchange for providing services “to or for the benefit of” the partnership. Per the Rev. Proc., the grantee may treat the liquidation value of the profits interest as the fair market value—thus, if the profits interest has no value on a hypothetical liquidation of the partnership, the fair market value is zero.
When structured in accordance with the Rev. Proc., the grant of a profits interest is generally not a taxable event to the grantee. In contrast, a capital interest granted in exchange for services gives the grantee a right to a share of the partnership’s equity as of the grant date, and thus, a share of the proceeds upon liquidation. Such a capital interest grant is taxable to the grantee as compensation under the Rev. Proc.
PROPER DRAFTING AS A DEFENSE AGAINST IRS CHALLENGES
A recent case in the US Tax Court clarifies requirements under the Rev. Proc. for treating a profits interest grant as non-taxable to the recipient at the grant date.
In ES NPA Holding LLC v. Commissioner, T.C. Memo. 2023-55 (2023), the taxpayer paid $100,000 to acquire an interest in a previously disregarded entity (now an upper-tier partnership (UTP)). As part of the transaction, the taxpayer also provided advice on: (1) improving the performance of the business assets held by a lower-tier disregarded entity (now a lower-tier partnership (LTP)); and (2) finding buyers for part of UTP’s interest in LTP. The taxpayer took the position that its interest in UTP was a profits interest—the receipt of which was tax free.
However, the IRS argued that the interest was a capital interest as defined in the Rev. Proc., in part because the taxpayer did not provide services directly to UTP, but instead provided them to the owner of UTP (while it was a disregarded entity).
The Tax Court rejected the IRS’s “unreasonably narrow” reading of the Rev. Proc., stating that UTP was a “mere conduit” through which the taxpayer provided services “to or for the benefit of” LTP. Critical to this decision was the drafting of the operating agreements: the taxpayer’s legal rights in UTP were “identical in all respects”—but particularly with respect to liquidation rights—to UTP’s interest in LTP.
It is common market practice for a service provider to receive a profits interest grant in an upper-tier partnership in exchange for services provided to a lower-tier partnership. There is often a question as to whether such a structure falls within the parameters of the Rev. Proc.  This case provides comfort that structures of this nature are not necessarily outside the scope of the Rev. Proc. Readers considering a profits interest grant will want to discuss whether their particular facts are encompassed by the Rev. Proc. with their tax counsel.
THE IMPORTANCE OF VALUATION AT A PROFITS INTEREST GRANT
Having established that the profits interest fell within the parameters of the Rev. Proc., the Tax Court next reviewed whether the interest had value to the taxpayer at the time of grant. This is relevant because, as noted above, one key distinction between a profits versus capital interest is whether the service provider is entitled to any value upon a hypothetical liquidation of the partnership at the grant date—that is, whether the interest has a “zero-dollar liquidation value.”
In ES NPA Holding LLC, the IRS argued that the taxpayer was entitled to a share of hypothetical liquidation proceeds upon a grant of the taxpayer’s interest. The IRS based its conclusion on a valuation that the IRS conducted and that it supported with experts. However, the Tax Court rejected the IRS’s approach and instead relied on an implied valuation derived from the recent sale of 70% of the business to a third-party investor, reasoning that the best evidence of fair market value is an actual arm’s length sale involving that property, occurring sufficiently close to the valuation date.
Based on the recent sale’s implied valuation of the business, the Tax Court held that the taxpayer had no entitlement to liquidation proceeds at the grant date. In making this determination, the Tax Court focused on UTP’s operating agreement language, which provided that the profits interest only entitled the taxpayer to distributions after all other partners received a return of capital.
The Tax Court’s conclusions are helpful confirmation to market participants, who as a practical matter often rely on arm’s length transaction pricing as sufficient evidence of value for tax purposes. Obtaining an appraisal contemporaneous with the grant date that substantiates the zero-dollar liquidation value of a profits interest, while best advised, is not always realistic from a commercial perspective.
To support a valuation position, taxpayers should also consider a revaluation (i.e., a “book up”) at the time of granting a profits interest for services. During a recent tax industry conference, one IRS official suggested that the valuation dispute in this case arose because UTP did not conduct a proper book up of its assets.  A book up can strengthen the argument that the grantee has not received any value at the date of grant. Similarly, a properly filed Section 83(b) election showing a zero-dollar liquidation value at the time of grant can support the same.
Investment fund sponsors and other pass-through businesses that grant profits interests in exchange for services should consult with tax counsel to ensure proper drafting of the relevant operating agreements in the context of the business’s entity structure.
Additionally, partnerships should consider obtaining an independent valuation of partnership assets contemporaneous with the profits interest grant (if no comparable third-party transaction is available) and should conduct a book up of partnership assets at the time of the grant.
These prophylactic measures are especially important in the context of the IRS and current administration’s emphasis on increased audits of partnerships and high net worth individuals, as well as persistent legislation targeting carried interest recipients.