Rev. Proc. 93-27

Rev. Proc. 93-27 generally provides 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 becoming a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. The revenue procedure distinguishes between a capital interest (i.e., a partnership 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) and a profits interest (i.e., a partnership interest other than a capital interest). This determination generally is made at the time of receipt of the partnership interest.

Background

The taxpayer in ES NPA, Mr. Landy, owned and conducted a consumer loan business through four entities: National Processing of America, Inc. (NPA, Inc.); Community Credit Services, Inc. (CCS); National Opportunities Unlimited, Inc. (NOU); and American Consumer Credit, LLC (ACC). Mr. Landy desired to dispose of a portion of his business in 2011, and two individuals contacted Mr. Landy in this regard. The sale of Mr. Landy’s businesses was ultimately arranged through a double-tier partnership structure that was set up through the following steps.

1. On 27 September 2011, NPA, Inc. formed Integrated Development Solutions, LLC (IDS) and National Performance Agency, LLC (NPA, LLC).
2. On 13 October 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.
3. 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 in exchange for two classes of units (classes B and C).
4. On 14 October 2011, NPA, LLC entered into revenue-sharing agreements with the other consumer loan businesses − CCS, NOU, and ACC, respectively.
5. NPA Investors, LP (NPA Investors) purchased all of NPA, LLC’s class A units from IDS in exchange for USD 14,502,436.
6. Also on 14 October 2011, ES NPA Holding, LLC (ES NPA) exercised a call option granted by NPA, Inc., and pursuant thereto acquired all of the IDS class C units in exchange for ES NPA’s payment to NPA, Inc. of USD 100,000 and services provided or to be provided. 

The class B and class C units in IDS tracked the class B and class C units in NPA, LLC, respectively, in that the owner of IDS class B units was entitled to 100% of the payments received by IDS because of its ownership of NPA, LLC class B units and the owner of IDS class C units was entitled to 100% of the payments received by IDS because of its ownership of NPA, LLC class C units.

The NPA, LLC operating agreement provided that, after the payment of liabilities, the liquidation proceeds of NPA, LLC were to be distributed 30% to class B unit holders, 40% to class A unit holders, and 30% to the class C unit holders; provided however, that, if the sum of all distributions made to the members who held class A units was less than the total capital contributions of such members, the distributions to the members who held class C units were to be reduced and the distribution to the members who held class A units were to be increased accordingly. At the end of the day on 14 October 2011, (i) the class A units in NPA, LLC held by NPA Investors had a capital contribution of USD 20,985,509, (ii) the class B units held by IDS in NPA, LLC had a capital contribution of USD 8,993,790, and (iii) the class C units held by IDS in NPA, LLC had a capital contribution of zero.

Tax Court’s opinion

The IRS’s primary argument was that Rev. Proc. 93 27 was inapplicable because ES NPA did not provide services to IDS. The IRS’s first alternative argument was that the safe harbor in Rev. Proc. 93-27 was inapplicable because ES NPA received a taxable capital interest in IDS. Further, the IRS argued that the fair market value of ES NPA’s class C units in IDS was $12,169,000 as of 14 October 2011.

Is Rev. Proc. 93-27 applicable?

The IRS contended that Rev. Proc. 93-27 had no application because it applies only upon receipt of “a partnership profits interest for services provided to or for the benefit of the partnership,” and in this case, ES NPA received an interest in IDS in exchange for services it provided to NPA, Inc.—not NPA, LLC. The Tax Court disagreed, finding the IRS’s reading of the revenue procedure and views of the transaction at issue to be “unreasonably narrow.” The court found it to be of no material consequence that ES NPA’s interest in NPA, LLC was held indirectly through IDS, given IDS was “a mere conduit,” as the liquidation rights in the class C units in both IDS and NPA, LLC were identical.

Has ES NPA satisfied the requirements of Rev. Proc. 93-27?

Having concluded that ES NPA’s receipt of the class C units qualified under Rev. Proc. 93-27, the court turned next to the question of whether ES NPA satisfied the underlying requirements of the revenue procedure; namely, whether the received class C units were a profits interest. To answer that question, the court focused on whether the partnership interest would entitle its holder to receive a distribution upon a hypothetical liquidation at the time of receipt.

The IRS essentially disputed the book value assigned to the partnership assets and partners’ capital accounts and contended that the market value of the newly formed partnership was substantially greater, i.e., upon a hypothetical liquidation, the class C units would be worth in excess of USD 12 million, and therefore the receipt of the units was in fact a capital interest in NPA, LLC (rather than a future profits interest). In the opinion of the IRS’s retained expert witness, the fair market value of NPA, LLC as of the transaction date was USD 52,463,722.

The Tax Court declined to adopt the IRS’s expert’s opinion of value, relying instead upon the arm’s-length and bona fide transaction in which Mr. Landy sold a 70% interest in his consumer loan businesses for approximately USD 21 million (resulting in an overall fair market value in NPA, LLC of USD 29,979,299). Therefore, the Tax Court determined that ES NPA’s class C units were a profits interest as defined under Rev. Proc. 93-27 because, applying a fair market value of USD 29,979,299 to NPA, LLC at the time of receipt, ES NPA would not have received a share of the proceeds upon a hypothetical liquidation of the partnership.

Takeaways

The Tax Court’s decision in ES NPA was rightly decided. The profits interest at issue complied with all of the requirements of Rev. Proc. 93-27, administrative guidance on which taxpayers and practitioners have been relying for the past thirty years. This decision gives added comfort that services do not need to be provided directly to the partnership issuing the profits interest, as long as the issuing partnership benefits from the services being provided by the profits interest holder. ES NPA also affirms the long-standing principle that fair market value is best determined by an actual arm’s-length sale occurring sufficiently close to the valuation date, if available.

For a more in-depth analysis of this case, please see R. Lipton’s and L. Gruen’s upcoming article in the Journal of Taxation, ES NPA Holding, LLC: Tax Court Upholds Properly Structured Profits Interest under Rev. Proc. 93-27.