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Tax Court Adopts Broad Reading of Profits Interests Safe Harbor

Thirty years after the IRS first acknowledged that taxpayers could receive profits interests for services without immediate tax, the Tax Court has confirmed our long-held belief that the same protection is available for a broad range of profit interest grants.

In Revenue Procedure 93-27, the IRS announced that a taxpayer’s receipt of a “profits interest” in a partnership “for the provision of services to or for the benefit of a partnership in a partner capacity” would not be treated as a taxable event. In the last three decades this safe harbor has gained increased importance as LLCs have proliferated, and with them the use of profits interests as a tax-efficient form of equity compensation.

Earlier this month, the Tax Court held that the receipt of a profits interest in an upper-tier partnership in respect of advisory services provided to a lower-tier partnership was eligible for tax-free treatment under Rev. Proc 93-27 (ES NPA Holding, LLC v. Commissioner, T.C. Memo 2023-55). The IRS argued that the safe harbor did not apply because the recipient provided services only to a lower-tier partnership affiliated with the partnership issuing the partnership interest, an argument that the Tax Court rejected as an unreasonably narrow reading of the Revenue Procedure. The Tax Court also confirmed that the profits interest in question had no immediate (liquidation) value. More generally, the court helpfully described the Revenue Procedure as a “broad, taxpayer-friendly safe harbor subject only to tightly defined exceptions".

The benefits of the Tax Court’s ruling will be broad-reaching, as LLCs and partnerships commonly grant profits interests in respect of services provided to subsidiaries or other entities in which the partnership holds equity. Even relatively simple operating partnerships that want to issue profits units as part of a management incentive plan will often adopt a “MIP LLC” structure under which employees and contractors receive profits interests in a passive upper-tier partnership that, in turn, holds a corresponding profits interest in the underlying operating partnership. These two-tier structures are typically adopted for reasons relating to governance or administrative convenience, or to grant profits interests to workers who would otherwise prefer to remain W-2 employees of the operating partnership.

The ruling will also provide important clarity for individuals working for private equity and hedge fund management companies who frequently receive profits interests in an entity that may be part of an elaborate structure of limited partnerships and LLCs that place many layers of equity ownership between the managers and the underlying funds they manage. The decision does not directly address other variants of this fact pattern, such as the case (seen frequently in the private equity context) where a partnership established to hold stock of a C corporation (rather than equity of a lower-tier partnership) grants profits interests to executives of the C corporation. The Tax Court’s explicit adoption of a broad reading of Rev. Proc. 93-27, however, suggests that it may view such a grant as likewise being “for the benefit of” the holding partnership, and thus similarly eligible for tax-free treatment.

Although the Tax Court’s decision was released as a memorandum opinion rather than a formally published division opinion that would constitute binding precedent, Tax Court Memorandum decisions are, not surprisingly, frequently cited to and accepted by the Tax Court as persuasive authority.

Key Contacts

 

Adam Blakemore
Partner
T. +44 (0) 20 7170 8697
adam.blakemore@cwt.com

Linda Z. Swartz
Partner
T. +1 212 504 6062
linda.swartz@cwt.com

Jon Brose
Partner
T. +1 212 504 6376
jon.brose@cwt.com

Andrew Carlon
Partner
T. +1 212 504 6378
andrew.carlon@cwt.com

Mark P. Howe
Partner
T. +1 202 862 2236
mark.howe@cwt.com

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