Profits Interest Safe Harbor Gets Tested and Lessons to be Learned by Operating Agreement Drafters

The US Tax Court (USTC) issued a Memorandum opinion (ES NPA Holding, LLC vs. CIR, T.C. Memo 2023-55) finding that the taxpayer (ES NPA Holding, LLC – hereafter – ES NPA or taxpayer) received a profits interest that was non-taxable at the time of receipt, even though no appraisal was on file at the time of issuance and the interest was in a lower-tier partnership that actually received the services from the taxpayer.

Quick Summary of the Case

Several tiers of partnership were formed surrounding a consumer loan business. A substantial portion of that business was sold soon after to an unrelated third party. The taxpayer received the right to purchase “Class C Units” (the ones at issue) for $100,000 in exchange for services rendered to a lower tiered partnership. The operating agreement for the upper tier partnership (the partnership that actually issued interests to the taxpayer), provided for capital accounts for the other interests in such partnership and a zero capital account for the Class C Units. The taxpayer reported these Class C Units as having no value at the time of issuance. 

The IRS challenged  the taxpayer’s return stating that the Class C Units had a value in excess of zero and Revenue Procedure 93-27 was inapplicable because the upper tier partnership was not the service recipients (the Class C Units were not issued in exchange for services to the actual issuing partnership but rather to a lower tier partnership). The USTC found in favor of the taxpayer, both on the valuation issue and that RP 93-27 applied even though the services were provided to a lower tier partnership. A sale close in time to the issuance of these Class C Units was dispositive as far as the USTC was concerned, and the IRS expert could not overcome such fair market value.

Takeaway for Non Tax Practitioners

• No “magic language” was in this partnership agreement regarding Revenue Procedure 93-27 and the intent that the profits interest safe harbor applied here – this does not mean leave out that language – it means that having the language in the agreement will not save the day if the transaction does not fit the safe harbor.
• No appraisal was completed prior to issuance – however – a sale very close in time to the issuance was made. The takeaway – if you do not advocate for an appraisal you are asking for trouble and if a sale is made close in time and the valuation or “hurdle” for the profits interest is substantially lower than such sale’s purchase price, you can expect that the court will take that sale seriously as a measure of value and a deficiency will be found.
• The issuance of an upper tier partnership interest in exchange for services (in fact, in this case, an option to purchase the interest of the upper tier partnership) rendered to a lower tiered partnership, satisfied the profits interest requirements but is not specifically blessed by the safe harbor.
• This Tax Court case took place 11 years after the transaction in question.
•  The IRS sought the accuracy related penalty of 20% in this matter.

Conclusion

The taxpayer dodged a bullet here. There was no appraisal nor indication of the use of the safe harbor in any documents to justify the capital accounts set forth in the operating agreement (at least none that were discussed in the case). The use of the upper tier partnership interest for services rendered to the lower tier partnership was a good give by the USTC (but it was unconventional and not in line with the safe harbor). This case was not free to litigate, so despite the win, the taxpayer paid a fair amount of money for the practitioner’s liberal interpretation of the safe harbor and lack of discussion in any deal documents of the safe harbor. After 10 years, with interest and penalties accruing, even a relatively small deficiency would have ballooned to a huge number - likely more than doubling the original amount of the understatement. Lack of familiarity with capital accounts and other tax issues in drafting operating agreements can be a career killer when using forms prepared by others. This case also demonstrated how a “protective” 83(b) election accomplishes little, if nothing. The service provider issue would not have been resolved since the 83(b) election would not have been with the putative service recipient and would not have helped on the valuation issue.