Solace in the Mundane?
At war with Russia in eastern Europe, a nascent competing world order, mass shootings and bank failures at home, questionable audit practices by the Big 4 . . . everywhere, debt ceilings and the risk of default, inflation, tighter credit, recession, crypto-nonsense, recreational cannabis, legalized gambling, men competing in women’s sports, a nation divided over all too many things, the Knicks down to the Heat 3 games to 2,[i] the prospect of Biden vs Trump II,[ii]. . . , the list goes on.[iii]
Under these circumstances, how do you spell relief?[iv] T-A-X, perhaps? Me too![v]
We often find comfort in the familiar, including the performance of our sometimes-mundane jobs.[vi]
Which brings us to a relatively mundane topic that has actually sparked some debate, at least among politicians – the profits interest.
The Profits Interest
In general, partners receive partnership interests in exchange for contributions of money or other property to the partnership. Other partners may receive partnership interests in exchange for services rendered or to be rendered to the partnership.
As you know, a partnership is not subject to Federal income tax.[vii] Instead, an item of income or loss of the partnership retains its character and flows through to the partners,[viii] who must include such item on their own tax returns.[ix]
Capital Gain
For example, if and to the extent a partnership recognizes long-term capital gain from the sale of property, the partners, including partners who provide services to the partnership, will reflect their shares of such gain on their tax returns as long-term capital gain regardless, generally speaking, of the partners’ holding periods for their respective partnership interests. If a partner is an individual, such gain would be taxed at the reduced rates for long-term capital gains.[x]
Gain recognized on the sale of a partnership interest, whether such interest was received in exchange for property, cash, or services, is generally treated as gain from the sale of a capital asset,[xi] except to the extent the fair market value of the interest sold is attributable to so-called “hot assets.”[xii]
Future Profits
If the terms of the partnership interest issued to a partner in exchange for their services limit the partner’s participation to a share of future partnership profits and future appreciation in the value of its assets, the interest is referred to as a “profits interest.”
When such an interest is issued, the partnership should probably adjust the capital accounts of the existing partners to ensure that the newly admitted service partner will not share in the existing value of the partnership. The adjustment accomplishes this goal by reflecting the manner in which the unrealized income, gain, loss, or deduction inherent in the partnership’s property (tangible and intangible) would be allocated among the partners if there were a taxable disposition of such property for its fair market value on the date of admission.[xiii] As a result, the holder of the profits interest would not receive anything of value on the immediate liquidation of the partnership.[xiv]
Notwithstanding what appears to be the relatively straightforward formulation of what constitutes a profits interest, the U.S. Tax Court recently considered the IRS’s argument that the partnership interest issued to Taxpayer did not qualify as a profits interest and, thus, the value of such interest should have been included in Taxpayer’s gross income for the taxable year in which it was granted and vested.[xv]
Sale of Controlling Interest
Prior to the Closing Date, Principal owned 100 percent of the outstanding shares and membership units of three corporations and one limited liability company that, together, were engaged in the consumer loan business.
The persons who would eventually organize Partnership became aware that Principal desired to dispose of a portion of his consumer loan businesses. They contacted Principal and, after several weeks of discussions, one of their affiliates (Buyer) sent a term sheet to Principal in which it offered to purchase 70 percent of Principal’s consumer loan businesses for $20.59 million.
The term sheet specified certain contingencies, and also stated that Buyer might bring in various parties as part of its investment group to fund the purchase of Principal’s interest.
Thereafter, Principal retained Law Firm to represent him with respect to the preparation of the transaction documents that would effect the sale of his businesses. Meanwhile, Buyer provided an acquisition due diligence memorandum to prospective investors to facilitate the purchase of a controlling interest in Principal’s businesses.
Taxpayer was formed shortly thereafter.
Capital Structure
Partnership’s operating agreement provided that each Member had made an initial Capital Contribution to the Partnership as a condition to the issuance of membership Units to the Member. The initial Capital Contribution with respect to each Member and their Class of Units was set forth in an exhibit to the agreement.
Partnership’s operating agreement further provided that, after the payment of liabilities, the liquidation proceeds of Partnership were to be distributed 30 percent to its class B unit holders, 40 percent to its class A unit holders, and
“30 percent to the Members who hold Class C Units; provided however, that, if the sum of all distributions made to the Members who hold Class A Units . . . is less than the total Capital Contributions of such Members, the distributions to the Members who hold Class C Units shall be reduced and the distribution to the Members who hold Class A Units shall be increased, by an amount equal to the lesser of (i) the distribution to the Members who hold Class C Units . . . , and (ii) the difference between the total Capital Contributions of the Members who hold Class A Units and the sum of all distributions previously made to the Members who hold Class A Units . . . and the distribution that would be made to the Class A Members pursuant to [a liquidation of Partnership].”[xvi]
The Transaction
The sale of Principal’s businesses was arranged through the following transactions:
- Around the time Taxpayer was formed, one of Principal’s business entity’s – Corp – formed two limited liability companies: LLC and Partnership. LLC had two classes of membership units: class B and class C. Partnership had three classes of units: class A, class B, and class C. According to LLC’s operating agreement, its class B and class C units tracked the class B and class C units in Partnership, respectively, in that the owner of LLC class B units was entitled to 100 percent of the payments received by LLC because of its ownership of Partnership class B units, and the owner of LLC class C units was entitled to 100 percent of the payments received by LLC because of its ownership of Partnership class C units.
- Two weeks later, Corp contributed substantially all of its business assets to Partnership in exchange for all three classes of units (A, B, and C) in Partnership. Corp then contributed all of these Partnership Class A, B, and C units to LLC as a capital contribution. Immediately thereafter, Principal owned all of Corp, which owned all of LLC, which owned all of Partnership.
- The next day (the Closing Date), Partnership entered into revenue-sharing agreements with Principal’s other consumer loan business entities. A newly formed business entity, Investors, purchased all of Partnership’s class A units from LLC in exchange for $20.98 million.[xvii] The same day, Taxpayer exercised a call option granted by Corp and, pursuant thereto, acquired all of the LLC’s class C units from Corp in exchange for Taxpayer’s payment of $100,000 and services provided or to be provided to Corp.
Capitalization
The recitals to the call option agreement stated that Taxpayer agreed to provide the following services to Corp in exchange for the option to pay $100,000 to Corp to acquire all of the class C units in LLC (which reflected an indirect interest in the class C units of Partnership): “strategic advice for the purpose of enhancing the performance of [Corp’s] business and to assemble an investor group that would purchase [70 percent] of [Corp’s] business for approximately $21 million.”[xviii]
Thus, at the end of the Closing Date,
- the Partnership class A units held by Investors had a capital contribution of more than $20.98 million,
- the Partnership class B units held by LLC had a capital contribution in excess of $8.99 million,
- the Partnership class C units held by LLC had a capital contribution of zero,
- Taxpayer owned all the LLC’s class C units (which it acquired for services), and
- Corp owned all the LLC’s class B units.
Tax Return
Taxpayer timely filed its Form 1065, U.S. Return of Partnership Income, for Tax Year.
Almost two years later, the IRS issued a final partnership administrative adjustment (FPAA) for the Tax Year to Taxpayer. The IRS determined that Taxpayer had received, but failed to report, “other income” of more than $16 million, that was attributable to Taxpayer’s receipt of a capital interest in LLC.
In the alternative, the IRS claimed that Taxpayer’s unreported income was attributable to Taxpayer’s receipt of an indirect capital interest in Partnership.
Taxpayer’s Position
Taxpayer petitioned the U.S. Tax Court. The issue for decision before the Court was whether Taxpayer had underreported its income for the Tax Year.
Taxpayer contended that its indirect receipt of the class C units in Partnership (through Taxpayer’s receipt of the class C units in LLC) represented the receipt of a profits interest within the meaning of Rev. Proc. 93-27 that was “excludable” from its income for the Tax Year.
According to Taxpayer, it acquired the class C units in LLC and thereby, indirectly, the class C units in Partnership pursuant to the call option exercised at Closing.
IRS Position
The IRS argued that Rev. Proc. 93-27 was inapplicable because Taxpayer did not provide services to LLC.
In the alternative, the IRS asserted that the safe harbor in Revenue Procedure in 93-27 was inapplicable because Taxpayer received a taxable capital interest in LLC. Further, the IRS argued that the fair market value of Taxpayer’s class C units in LLC as of the option exercise date.
The class A units in Partnership were held by Investors; the class B and class C units were held by LLC. Taxpayer held Class C units in LLC.
Court’s Observations
The Code provides that no gain or loss will be recognized to a partner in the case of a contribution of property to the partnership in exchange for an interest in the partnership.[xix] However, where a person receives a partnership interest in exchange for a contribution of services, nonrecognition “is not always guaranteed.”
Under IRS regulation, the “receipt of a partnership capital interest in exchange for services is taxable to the service provider.”[xx] In fact, under longstanding tax principles services are not “property” the contribution of which to a partnership in exchange for a partnership interest is generally not taxable; in other words, the receipt of a partnership capital interest in exchange for services does not receive tax-deferred treatment.[xxi]
According to this regulation, to the extent that any of the partners gives up any part of its right to be repaid his contributions (as distinguished from a share in partnership profits[xxii]) in favor of another partner as compensation for services, section 721 does not apply.[xxiii] The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner.[xxiv]
The Court explained how it had previously held that the receipt of a profits interest in a partnership in exchange for the performance of services was a taxable event, regardless of whether the transferee partner would receive anything upon a theoretical liquidation.[xxv]
The Court of Appeals for the Eighth Circuit, however, reversed the Court, finding that the receipt of a profits interest was not taxable since the value received was speculative.[xxvi]
Analysis of Rev. Proc. 93-27
Ultimately, the IRS published guidance on the tax treatment of the receipt of a profits interest for services provided to or for the benefit of the partnership.[xxvii] In this guidance, the IRS acknowledged that the receipt of a capital interest for services was taxable as compensation,[xxviii] while on the other hand, it would not treat the receipt of a profits interest as a taxable event.
The IRS defined a profits interest as a partnership interest “other than a capital interest,” and a capital interest, in turn, 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.” This theoretical liquidation would be deemed to occur “at the time of receipt of the partnership interest” (immediately after the transaction). Such a profits interest would not be treated as income upon its acquisition if a person receives it “for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner.”[xxix]
The Court then considered whether the Class C units in Partnership that Taxpayer received constituted a profits interest. To answer this question, the Court had to address the IRS’s claim that Rev. Proc. 93-27 did not apply to Taxpayer’s situation.
As a threshold matter, the Court pointed out that it was uncontroverted that Taxpayer provided services to Corp in exchange for the class C units in LLC. It was also undisputed that Taxpayer’s interests in LLC’s class C units were identical in all respects to the interests in the class C units in Partnership.
Still, the IRS contended that Revenue Procedure 93-27 had no application to Taxpayer because it applied only when “a partnership profits interest for services provided to or for the benefit of the partnership.” In this case, the IRS argued, Taxpayer received an interest in LLC in exchange for services it provided to Corp – not to Partnership.
Too Narrow a Reading
The Court disagreed with the IRS and found its reading of the revenue procedure, and its views of the transaction at issue, to be unreasonably narrow.[xxx]
While the IRS accurately stated the purpose set out in Rev. Proc. 93-27, the Court pointed out that the revenue procedure also explained that “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.”
The Court then described the circumstances under which Rev. Proc. 93-27 does not apply:
(1) if the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
(2) if within two years of receipt, the partner disposes of the profits interest; or
(3) if the profits interest is a limited partnership interest in a “publicly traded partnership.”[xxxi]
The Court noted that the IRS did not assert that Taxpayer triggered any of these three elements. Therefore, the Court did not consider the issue and deemed it waived.
The Court also observed that the IRS had implied that Rev. Proc. 93-27 was a “safe harbor” with limited application. Again, the Court disagreed, stating that it did not view Rev. Proc. 93-27 in such a restricted manner, but rather viewed it as administrative guidance on the treatment of the receipt of a partnership profits interest for services.
Considering the text of Rev. Proc. 93-27, the Court found that the evidence supported a finding that Taxpayer directly (or through its principals), before and after formation, provided services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner.
It was undisputed, the Court stated, that the material assets of this partnership were held in Partnership, and the activities Taxpayer performed were to and for the benefit of the future partnership. It was of no material consequence that Taxpayer’s interest in Partnership was held indirectly through LLC, which was a mere conduit since the liquidation rights in the class C units in both LLC and Partnership were identical. This partnership came about only through Taxpayer and Corp’s joint ownership of LLC and their ownership interest in Partnership.
The Court added that other relevant elements here that evidenced the application of Rev. Proc. 93-27 was proper were the presence of entrepreneurial risk – there was no “substantially certain and predictable stream of income from partnership assets” – and the receipt of a profits interest in the capacity as a partner.
Thus, it was entirely reasonable to conclude that Taxpayer’s receipt of the class C units satisfied the parameters of Rev. Proc. 93-27.
Hypothetical Liquidation
Having concluded that Taxpayer’s receipt of the class C units qualified under Rev. Proc. 93-27, the Court turned to the question whether Taxpayer had satisfied the underlying requirements of the revenue procedure; namely, whether the received class C units were a profits interest. To answer this question, the Court had to determine whether Taxpayer would receive a distribution upon a hypothetical liquidation at the time of receipt.
On the Closing Date, the class A units held by Investors had a capital account of almost $21 million, the class B units held by LLC had a capital account of almost $9 million, and the class C units held by LLC had a capital account of zero.
Partnership’s operating agreement provided that after the payment of liabilities, Partnership’s liquidation proceeds were to be distributed 30 percent to class B unit holders and 40 percent to class A unit holders, with the remaining 30 percent to the members who held class C units, provided, however, that the sum of all distributions made to the members who held class A units had first been satisfied. In other words, the class A and B unit holders had a preferred return of their capital, and the class C units would receive anything in a hypothetical liquidation only after all capital accounts were first satisfied in full.
The parties and their respective experts agreed, under the terms of the operating agreement, that if the fair market value of Partnership was approximately $29.98 million,[xxxii] as reflected in Partnership’s capital account, there would be no distribution to the class C unit holders upon a hypothetical liquidation.
However, to answer the question regarding the hypothetical liquidation of Partnership, the Court first addressed “the largely subjective question of fair market value.” Fair market value, it continued, was defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
IRS Expert
The IRS contended that in the opinion of its expert witness the fair market value of Partnership as of the transaction date was more than $52 million. The IRS asserted that Principal lacked knowledge of the value of his business, performed minimal due diligence, and did not understand the terms of the transaction. Essentially, the IRS disputed that the transaction was an arm’s-length transaction and contended that it should not be relied upon to determine the fair market value of Partnership.
Taxpayer’s Position
Taxpayer contended that the actual terms of the sale, namely the acquisition of the class A units by Investors for $20,985,509, was the best evidence of the overall fair market value of $29,979,299. Taxpayer further claimed that the sale was a bona fide arm’s-length transaction reflecting the sale of a 70 percent interest in Partnership.
Still, the parties agreed that the best evidence of a property’s fair market value was an actual arm’s-length sale involving that property occurring sufficiently close to the valuation date.[xxxiii] Here, there was an actual sale of the subject property – that is, Principal’s consumer lending businesses – immediately before the hypothetical liquidation of Partnership. That sale of a 70 percent interest implied an overall fair market value of $29.98 million.
Not Arm’s Length?
The IRS argued that the transaction was not for fair market value and should be disregarded since Principal was pressured to sell, failed to obtain a formal appraisal, and lacked sophistication and education.
The Court found, however, that there was nothing in the record indicating that Principal was under any duress or compulsion to sell, and in fact his trial testimony reflected the contrary.[xxxiv]
The IRS retained an expert witness to provide a retrospective opinion of Partnership’s fair market value. This expert acknowledged that the sale transaction provided the best indicator of Partnership’s value; however, he conducted additional analysis using an income approach to test the reasonableness of the transaction. In his rebuttal report, the IRS’s expert opined that Partnership had an overall fair market value of almost $48.5 million, resulting in Taxpayer’s receiving a distribution upon a hypothetical liquidation.
Notwithstanding the expert’s opinion, the Court found nothing in the record to dispute a finding that the transaction was arm’s-length and bona fide. Thus, it declined to adopt the IRS expert’s opinion of value. Rather, it relied upon the arm’s-length and bona fide transaction in which Principal sold a 70 percent interest in his businesses for approximately $21 million, resulting in an overall fair market value in Partnership of approximately $29.98 million.
Therefore, the Court determined that Taxpayer’s class C units were a profits interest as defined under Rev. Proc. 93-27 because, applying a fair market value of $29.98 million to Partnership at the time of receipt, Taxpayer would not have received a share of the proceeds upon a hypothetical liquidation of Partnership.
Parting Thoughts
The Court’s analysis and conclusion regarding the treatment of Taxpayer’s profits interest were on the mark, at least under current law and under the circumstances in which the intermediate entity – LLC, above – is a true conduit.
Of course, there are still many in Congress who are determined to amend the Code to provide that partnership income allocable to a profits interest should be taxed as ordinary income and subject to self-employment tax; the same treatment would apply to the gain recognized on the sale of such an interest.
For the moment, these legislative efforts are in limbo, though their proponents must feel as though they’re in purgatory.
That said, the regulations proposed by the IRS in 2005 remain in play,[xxxv] although the agency’s authority to finalize them may become suspect depending upon whether the U.S. Supreme Court decides to overturn the Chevron doctrine.[xxxvi]
Stay tuned.
[i] Another loss for New York in what has turned out to be its never-ending contest with Florida?
[ii] Ali beat Frazier in Super Fight II, Rocky beat Apollo in Rocky II, Rocky beat Clubber Lang in their rematch (sans Mick), Rocky beat Drago after the latter beat Apollo, Adonis beat Drago’s son in their second match. Who knows?
[iii] Remember this exchange from Ghostbusters:
Peter Venkman: Well, you can believe Mr. Pecker…
Walter Peck: My name is “Peck.”
Venkman: Or you can accept the fact that this city is headed for a disaster of biblical proportions.
Mayor: What do you mean, “biblical”?
Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath-of-God type stuff!
Venkman: Exactly.
Stantz: Fire and brimstone coming down from the sky! Rivers and seas boiling!
Spengler: Forty years of darkness! Earthquakes, volcanoes!
Winston Zeddemore: The dead rising from the grave!
Venkman: Human sacrifice! Dogs and cats, living together! Mass hysteria!
Mayor: Enough, I get the point!
[iv] Remember Billy Martin’s commercial for Rolaids?
[v] Forget that last year researchers from the University of Essex, in England, ranked tax work as the third most boring job on the planet.https://www.cnbc.com/2022/03/22/these-are-the-top-5-most-boring-jobs-according-to-researchers.html. After all, they’re English – they still have “royalty” and drink warm beer.
[vi] And don’t forget what the most famous of Long Island poets (Billy Joel) once said, “We didn’t start the fire, it was always burning since the world’s been turning.” (Sorry Walt.)
[vii] IRC Sec. 701.
[viii] IRC Sec. 702.
[ix] IRC Sec. 704.
[x] IRC Sec. 1(h).
[xi] IRC Sec. 741.
[xii] IRC Sec. 751(a).
[xiii] Reg. Sec. 1.704-1(b)(2)(iv)(f) and (g).
[xiv] Although profits interests are structured as partnership interests, the income allocable to such interests is received in connection with the performance of services. For that reason, many in Congress believe that a service provider’s share of the income of a partnership attributable to profits interest should be taxed as ordinary income and be subject to self-employment tax because such income is derived from the performance of services.
In response, the Tax Cut and Jobs Act of 2017 enacted IRC Sec. 1061, which extended the long-term holding period requirement for certain capital gains resulting from partnership property dispositions and from partnership interest sales, from one year to three years, effective for taxable years beginning after December 31, 2017.
[xv] T.C. Memo. 2023-55 ES NPA Holding, LLC, v. Comm’r, No. 13471-17; filed May 3, 2023.
[xvi] The so-called “distribution threshold.”
[xvii] Thereby converting Partnership into a partnership for tax purposes. Rev. Rul. 99-5.
According to the term sheet, Investors paid $14,502,436 for “good will” and $6,483,073 for the existing book of loans for a total price of $20,985,509.
[xviii] The call option agreement also provided that Taxpayer was given “an option . . . to purchase all of the Class C Units . . . from [LLC].”
[xix] IRC Sec. 721(a).
[xx] See IRC Sec. 83(a) (generally dictating the recipient’s tax treatment of property received in connection with services performed); Reg. Sec. 1.61-2(d) (stating property received as compensation must be included in income).
[xxi] Reg. Sec. 1.721-1(b)(1).
[xxii] The Court observed that the foregoing parenthetical reference to a profits interest in the above regulation has been read as intending to exempt the receipt of a profits interest for services from taxation. This same view, it stated, has been acknowledged by the Tax Court.
[xxiii] Treasury Regulation § 1.721-1(b)(1).
[xxiv] Under IRC Sec. 61.
[xxv] Diamond v. Comm’r 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974; in Campbell v. Comm’r, T.C. Memo. 1990- 162, aff’d in part, rev’d in part, 943 F.2d 815 (8th Cir. 1991)
[xxvi] Campbell v. Comm’r, 943 F.2d 815.
[xxvii] Rev. Proc. 93-27.
[xxviii] Citing Reg. Sec. 1.721-1(b)(1).
[xxix] Rev. Proc. 2001-43 clarified Rev. Proc. 93-27 by providing that the determination of whether the interest granted is a profits interest is tested at the time of grant. Under the revenue procedure, if a partnership profits interest is transferred in connection with the performance of services, then the holder of the partnership interest may be treated as a partner even if no IRC Sec. 83(b) election is made, provided that certain conditions are met.
Compare this to IRC Sec. 83, which would not recognize the holder of an unvested interest as a partner in the absence of an election under IRC Sec. 83(b).
[xxx] The Court acknowledged that Proposed Treasury Regulations rejected the concept that the receipt of a partnership interest in connection with services was not a realization event. In conjunction with the issuance of these proposed regulations, the IRS explained in Notice 2005-43 that Rev. Proc. 93-27 and 2001-43 would become obsolete upon the finalization of these proposed regulations, but that until then taxpayers were permitted to rely upon Rev. Proc. 93-27.
[xxxi] Within the meaning of IRC Sec. 7704(b).
[xxxii] This $29 million figure would be the book value of Partnership at its formation. Reg. Serc. 1.704-3(a)(3). The IRS essentially disputed the book value assigned to the partnership’s assets and the partners’ capital accounts, and contended that the market value of the newly formed partnership was substantially greater, upon a hypothetical liquidation the class C units would be worth in excess of $12 million, and therefore that the receipt of these units was in fact a capital interest in Partnership, rather than a future profits interest as Taxpayer contended.
[xxxiii] In fact, this was usually dispositive.
[xxxiv] At trial, Principal testified how he wanted a “liquidity event” and he understood that he would retain 30% of his businesses. He also testified that he was under no financial compulsion or other need to sell, as his businesses were in fact profitable.
The parties to the transaction entered into a letter of intent whereby Principal agreed to effect the sale of 70% of his consumer loan businesses for a 2.3× multiple of EBITDA. Principal was represented by legal counsel, and after months of due diligence, the sale occurred with investors paying $14,502,436 for “good will” and $6,483,073 for the existing book of loans for a total price of $20,985,509.
Principal (through Corp) contributed substantially all of his interests in his consumer loan businesses to Partnership before the sale; so to say Principal sold 70% of his consumer loan businesses, compared to what third-party investors paid to acquire class A units in Partnership, is referring to the same transaction.
[xxxv] REG-105346-03.
[xxxvi] Last week, the Court agreed to hear a case that explicitly asks that the doctrine be overturned.
In brief, under the doctrine, an agency’s interpretation of a statute is granted deference when the statute, as enacted by Congress, is ambiguous.
