Tax Court Ruling Clarifies Profits Interest

In a recent case, the Tax Court upheld the idea that receipt of a partnership’s “profits interest” is a non-taxable event as detailed in Revenue Procedure 93-27. This case provides guidance on the treatment of the receipt of a profits interest.

A “profits interest” entitles the holder to a share of the increase in a partnership’s value between the date the profits interest is issued and a future date. It is similar to a call option for a share of stock in a public company. This contrasts with the more straightforward partnership “capital interest” that entitles the holder to a share of the total value of the partnership, which is similar to a share of stock in a public company.

What Is Considered Taxable Compensation?

Under Section 1.721-1(b)(1) of the Income Tax Regulations, receipt of a partnership capital interest for services provided to or for the benefit of a partnership is considered taxable compensation. But whether receipt of a profits interest for services is taxable has been the subject of litigation.

In Campbell v. Commissioner, the Eighth Circuit in dictum suggested that the taxpayer’s receipt of a partnership profits interest was not taxable. However, other courts have determined in certain circumstances that receipt of a partnership profits interest is a taxable event under Section 83 of the Internal Revenue Code. Courts have also found that the profits interest received typically has speculative or no determinable value at the time of receipt.

According to Rev. Procedure 93-27, the IRS generally will not treat the receipt of a profits interest as a taxable event for the partner or the partnership.

Was Income Underreported?

On March 20, 2017, the IRS issued a notice to Joseph NPA Investment LLC regarding whether ES NPA Holding underreported income for 2011 and, if so, whether an accuracy-related penalty was appropriate. According to the IRS, the company received more than $16 million in unreported other income that year related to its receipt of a 50 percent capital interest in Integrated Development Solutions LLC (IDS).

ES NPA Holding argued that the Class C units of IDS it received were a profits interest as defined in Rev. Procedure 93-27 and therefore excludable from income in 2011. The IRS argued that this Rev. Procedure was not applicable because ES NPA Holding did not render services to IDS. The safe harbor in the Rev. Procedure was also inapplicable, stated the IRS.

ES NPA Holding believed that the burden of proof had shifted to the IRS because the company had credibly demonstrated its position.

Campbell Decision is Reversed

The U.S. Court of Appeals for the Eighth Circuit reversed the decision in Campbell, finding that receipt of a profits interest was not taxable because the value received was speculative. It ruled that the Class C units of IDS that ES NPA Holding received were a profits interest because, applying the fair market value of the LLC at the time of receipt, the partner would not receive any proceeds from a liquidation at that time.

A key takeaway from this ruling is the importance of drafting agreements as unambiguously as possible. In this case, the agreement was ambiguous enough for the IRS to challenge it and call the partnership interest a capital interest instead of a profits interest.