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The result of this case should be further proof that the grant of a profits interest to a lower-tier partnership, including those issued on a back-to-back basis, falls within Rev. Proc. 93-27. Again, the applicable profits interest would be based on the profits of the lower-tier partnership only.

In a finding that benefits partnerships, the U.S. Tax Court recently examined the definition of a “profits interest” in ES NPA Holdings, LLC v. Commissioner (TC Memo 2023-55), a memorandum opinion. Involving partnership profits interest in tiered structures, the decision provides support to issuers of profits interest – an equity-like form of compensation granted by a partnership or limited liability company (LLC) – including those in the real estate industry. Serving as an incentive for partners to pursue profitability, the value of profits interest is based on the growing value of the LLC.

ES NPA Holdings involved a commercial loan business. The parties formed several new entities as a part of a restructuring. ES NPA received Class C units in IDS, an intermediate LLC that held units in a lower tier entity,    PA Investors. The IRS asserted that ES NPA had received a capital interest in IDS or a capital interest in NPA. Capital interests, unlike profits interests, are taxable on receipt.

IRS Revenue Procedure 93-27 provides a safe harbor rule for the definition of a profits interest. It defines a profits interest as a partnership interest rather than a capital interest that would give the holder a share of the proceeds if the partnership assets were sold at fair market value, and the proceeds were then distributed in complete liquidation. In addition, a profits interest can be provided for services to or for the benefit of a partnership and the individual’s capacity as a partner in anticipation of becoming a partner. Generally, profits interests are not taxable on receipt, provided they do not (1) relate to “substantially certain and predictable streams of income;”(2) are held for at least two years prior to disposition; and (3) are not granted by a publicly traded partnership. Profits interests held for less than three years may have long-term capital gains reserved as short-term capital gains.

The IRS has taken the position that the taxpayer in ES NPA Holdings, LLC, could not benefit from the safe harbor of Rev. Proc. 93-27 because the taxpayer did not provide services to the issuing partnership but rather to a lower-tier partnership.

The Tax Court reading Rev. Proc. 93-27 expansively held in favor of the taxpayer, provided that the taxpayer receives a profits interest issued out of the partnership in consideration of the services that were, among other things, for the benefit of another partnership that may have qualified for the safe harbor. The Court also looked to a contemporaneous arms-length transaction that was acceptable evidence of value for determining that the profits interest only entitled the taxpayer to a share of post-grant profits. Thus, it qualified as a profits interest rather than a capital interest. The result of this case should be further proof that the grant of a profits interest to a lower-tier partnership, including those issued on a back-to-back basis, falls within Rev. Proc. 93-27. Again, the applicable profits interest would be based on the profits of the lower-tier partnership only. We recommend taxpayers consider filing Section 83(b) election for the grant of the profits interests if it is subject to a substantial risk of forfeiture.

The use of Class C and D units for lower-tier entities is a relatively commonplace structure. Typically, the operating business or property is held in a lower-tier entity, and service providers may hold indirect interests in the operating business or property. A typical structure has the service providers holding subordinate interests called Class C or D units which are behind the capital providers and management interests (Class A and B units). In some respects, this case reinforces the use of profits interests to compensate service providers that share in the speculative upside of a business. Profits investments can be valuable, and if properly structured can be non-taxable on issuance. The benefits of this recent ruling will be far reaching since profits interests are commonly granted.

Phil is chair of the tax practice team at CGS3. He is recognized as a leading joint venture and tax attorney, with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations and international tax planning. The article was published in The Daily Journal (subscriber only).