In the recent case of ES NPA Holding LLC v. Commissioner, the IRS argued that a profits interest can only be received tax-free by a service provider when the service is rendered directly to or for the benefit of the entity issuing the interest. The facts of the case are complicated, but in short, in the ES NPA case, the person that received the profits interest had rendered services to a corporation which was a member in the LLC (taxed as a partnership) that issued the profits interest. Moreover, the profits interest in the operating LLC was held indirectly through an upper tier partnership. 

Under the relevant guidance (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 being a partner.”  The Tax Court rejected the argument of the IRS as being too narrow a reading of Rev. Proc. 93-27. The Court found that the services provided to the corporation were part of the transaction that caused the formation the LLC. It further found that it is of no material consequence that the profits interest in the LLC was held indirectly through an upper tier LLC which it said was a mere conduit since the economic rights in the profits interest units in both the upper tier and lower tier LLCs were identical.

By this holding, the Tax Court has effectively approved what has in effect become relatively common practice, i.e., the practice of issuing profits interests to a service provider in circumstance in which the services are rendered to an entity other than the partnership issuing the profits interest as long as the services benefit the issuing partnership.

Bottom Line: This decision will not likely result in a significant change in practice with respect to issuing profits interests but provides additional comfort for continued use of structures already determined to be permissible by tax practitioners.

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