Taxpayer Prevails in Dispute Involving Receipt of Partnership Units for Services

(Parker Tax Publishing May 2023)

The Tax Court held that a taxpayer did not have unreported income under Reg. Sec. 1.721-1(b) on its receipt of class C units in a partnership in exchange for cash and the performance of services because the taxpayer received a profits interest, rather than a capital interest, in the partnership, which is not treated as income under Rev. Proc. 93-27. The court concluded that the class C units were a profits interest after finding, based on its determination of the fair market value of the partnership, that there would be no distribution to the holders of the class C units on a hypothetical liquidation of the partnership after all capital accounts were first satisfied in full in accordance with the partnership agreement. ES NPA Holding, LLC v. Comm'r, T.C. Memo. 2023-55.

Background

ES NPA Holding, LLC (ES NPA) is a Delaware partnership that was treated as a TEFRA partnership for federal income tax purposes. ES NPA timely filed its 2011 Form 1065, U.S. Return of Partnership Income, on April 15, 2012. On March 20, 2017, the IRS issued a final partnership administrative adjustment (FPAA) to ES NPA's partners for the 2011 tax year. The IRS determined in the FPAA that ES NPA had received, but failed to report, income of $16,106,250 for the 2011 tax year. According to the IRS the unreported income was attributable to ES NPA's receipt of a 50 percent capital interest in Integrated Development Solutions, LLC (IDS). Alternatively, the IRS determined that the unreported income was attributable to ES NPA's receipt of a 30 percent indirect capital interest in National Performance Agency, LLC (NPA, LLC).

Before October 14, 2011, Joshus Landy owned 100 percent of NPA, Inc., Community Credit Services, Inc. (CCS), National Opportunities Unlimited, Inc. (NOU), and American Consumer Credit, LLC (ACC). Those entities conducted consumer loan businesses. Landy desired to dispose of a portion of his consumer loan businesses (NPA, Inc., CCS, NOU, and ACC) in 2011. Monu Joseph and Amit Raizada, who would later become ES NPA's principals, became aware of an opportunity to acquire an interest in an existing online consumer finance business that was fully licensed in Delaware. Joseph and Raizada contacted Landy with regard to his desire to dispose of a portion of his consumer loan businesses.

On October 13, 2011, NPA, Inc. contributed substantially all of its business assets to NPA, LLC in exchange for three classes of units (classes A, B, and C) in NPA, LLC. NPA, Inc. then contributed all three classes of units (classes A, B, and C) in NPA, LLC to IDS as a capital contribution to IDS. On October 14, 2011, NPA, LLC entered into revenue-sharing agreements with the other consumer loan businesses, CCS, NOU, and ACC, respectively. An entity named NPA Investors, LP (NPA Investors), purchased all of NPA, LLC's class A units from IDS in exchange for $14,502,436.

Also on October 14, 2011, ES NPA exercised a call option granted by NPA, Inc., and acquired all of the IDS class C units in exchange for ES NPA's payment to NPA, Inc. of $100,000 and services provided or to be provided. ES NPA agreed to provide the following services to NPA, Inc. in exchange for the option to pay $100,000 to NPA, Inc. to acquire all of the class C units in IDS (which reflected an indirect interest in the class C units of NPA, LLC): "strategic advice for the purpose of enhancing the performance of [NPA Inc.'s] business and to assemble an investor group that would purchase 40 percent of [NPA Inc.'s] business for approximately $21 million."

At the end of the day on October 14, 2011, (1) the class A units held by NPA Investors had a capital contribution of $20,985,509, (2) the class B units held by IDS had a capital contribution of $8,993,790, and (3) the class C units held by IDS had a capital contribution of zero.

Receipt of a Partnership Interest in Exchange for Services

Under Code Sec. 721(a), no gain or loss is recognized to a partner in the case of a contribution of property to the partnership in exchange for an interest in the partnership. However, where a person receives a partnership interest in exchange for a contribution of services, nonrecognition is not always guaranteed. Reg. Sec. 1.721-1(b)(1) provides that the receipt of a partnership capital interest in exchange for services is taxable to the service provider as income under Code Sec. 61.

In Rev. Proc. 93-27, the IRS addressed the receipt of a profits interest, rather than a capital interest, in a partnership in exchange for the performance of services. In the procedure, the IRS cited Reg. Sec. 1.721-1(b)(1) and acknowledged that the receipt of a capital interest for services is taxable as compensation. On the other hand, the IRS stated that it will not treat the receipt of a profits interest as a taxable event. Rev. Proc. 93-27 defines a profits interest as a partnership interest "other than a capital interest." A capital interest is, in turn, 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 occurring immediately after the transaction. Under Rev. Proc. 93-27, a profits interest is not 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 becoming a partner.

In the Tax Court, ES NPA contended that its indirect receipt of the class C units in NPA, LLC (through ES NPA's receipt of the class C units in IDS) was a profits interest, as defined in Rev. Proc. 93-27, that was excludable from income for the 2011 tax year. The IRS's primary argument was that Rev. Proc. 93-27 was inapplicable because ES NPA did not provide services to IDS. According to the IRS, ES NPA received an interest in IDS in exchange for services it provided to NPA, Inc. - not NPA, LLC.

Analysis

The Tax Court held that (1) Rev. Proc. 93-27 applied to the transaction at issue and (2) ES NPA's class C units were a profits interest as defined in Rev. Proc. 93-27. Therefore, the court concluded that ES NPA had no unreported income for 2011 as a result of the transaction.

In the court's view, the IRS's reading of Rev. Proc. 93-27 and the transaction at issue were unreasonably narrow. The court disagreed with the IRS's characterization of the procedure as a "safe harbor" with limited application. Rather, the court 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 said that the evidence supported a finding that ES NPA 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. According to the court, it was undisputed that the material assets of this partnership were held in NPA, LLC, and the activities ES NPA performed were to and for the benefit of the future partnership. It was of no material consequence, the court found, that ES NPA's interest in NPA, LLC was held indirectly through IDS, which the court said was a mere conduit since the liquidation rights in the class C units in both IDS and NPA, LLC were identical. The court further reasoned that this partnership came about only through ES NPA and NPA, Inc.'s joint ownership of IDS and their ownership interest in NPA, LLC. Other relevant elements evidencing that the application of Rev. Proc. 93-27 was proper were the presence of entrepreneurial risk and the receipt of a profits interest in the capacity as a partner. Thus, the court concluded that it was entirely reasonable to conclude that ES NPA's receipt of the class C units meets the intended parameters of Revenue Procedure 93-27.

The next question for the court was whether ES NPA satisfied the underlying requirements of Rev. Proc. 93-27 - namely, whether the received class C units were a profits interest. To answer that question, the court had to determine whether ES NPA would receive a distribution upon a hypothetical liquidation at the time of the receipt, and the court found that ES NPA would not be entitled to receive such a distribution. The court noted that the NPA, LLC operating agreement gave the class A and B unit holders a preferred return on their capital, and the class C units would receive anything in a hypothetical liquidation only after all capital accounts were satisfied in full. The court also noted the parties' agreement that if fair market value of NPA, LLC was $29,979,299 (its book value at its formation), then there would be no distribution to the class C unit holders upon a hypothetical liquidation.

In arriving at the fair market value of NPA, LLC, the court relied upon the arm's length and bona fide transaction in which Landy sold a 70 percent interest in his consumer loan businesses for approximately $21 million, resulting in an overall fair market value in NPA, LLC of $29,979,299. Therefore, the court determined that ES NPA's class C units were a profits interest as defined under Rev. Proc. 93-27 since, based on the fair market value of NPA, LLC at the time of receipt, ES NPA would not receive a share of the proceeds in a hypothetical liquidation of the partnership.

For a discussion of the rules involving the transfer of a partnership interest in exchange for services, see Parker Tax ¶22,715.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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