The Tax Court’s May 3, 2023, decision in ES NPA Holding, LLC v. Commissioner (T.C. Memo 2023‑55), upholding a taxpayer’s position to characterize a partnership interest as a profits interest under the “safe harbor” of IRS Revenue Procedure 93-27 (as clarified by IRS Revenue Procedure 2001-43), provides helpful guidance to issuers of profits interests, including private equity funds and other investment partnerships and their portfolio companies.

As background, Revenue Procedure 93‑27 provides a “safe harbor” definition of a profits interest. Specifically, it defines a “profits interest” as a partnership interest other than a “capital interest,” meaning “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” at the time of receipt of the partnership interest. It further provides that the receipt of a profits interest in exchange for services “to or for the benefit of” a partnership in the recipient’s capacity of a partner or in anticipation of becoming a partner is not a taxable event to the recipient so long as the profits interest (1) does not relate to a “substantially certain and predictable stream of income,” (2) is held for at least two years prior to disposition, and (3) and is not granted by a “publicly traded partnership.”

In this case, the IRS took the position that (a) the partnership interest received by the taxpayer did not qualify for the Revenue Procedure 93‑27 “safe harbor” and further did not qualify as a “profits interest” because the taxpayer did not directly provide services to the issuing partnership of the partnership interest and (b) the partnership interest was a capital interest rather than a profits interest because the taxpayer would be entitled to a share of the partnership’s proceeds in a hypothetical liquidation on the day the taxpayer received the partnership interest.

In its decision, the Tax Court—interpreting Revenue Procedure 93‑27 expansively rather than literally—held in favor of the taxpayer with respect to both of the IRS’s positions and provided that (1) a taxpayer who receives a profits interest issued out of one partnership in consideration of services that were, among other things, to or for the benefit of another related partnership—may, under the appropriate facts, qualify for the “safe harbor” and (2) a contemporaneous arm’s-length transaction was acceptable evidence of value for purposes of determining that the profits interest entitled the taxpayer to distributions out of post-grant profits only, and the partnership interest was therefore a profits interest rather than a capital interest. The Tax Court further stated that “[it does] not view Revenue Procedure 93‑27 in such a restricted manner, but rather view[s] [Revenue Procedure 93‑27] as administrative guidance on the treatment of the receipt of a partnership profits interest for services.”

While the Tax Court’s decision can be interpreted as being generally consistent with market practice, there are meaningful nuances to the Tax Court’s decision. In light of these nuances, and the general lack of interpretive guidance regarding profits interests, it remains important for issuers of profits interests to discuss their specific circumstances with their legal and tax advisors.

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Photo of Michael Album Michael Album

Michael J. Album is a partner in the Employee Benefits & Executive Compensation Group, and represents companies and compensation committees, private equity firms and hedge funds, and CEOs, senior executives (in numerous business sectors) and portfolio managers on a full range of executive…

Michael J. Album is a partner in the Employee Benefits & Executive Compensation Group, and represents companies and compensation committees, private equity firms and hedge funds, and CEOs, senior executives (in numerous business sectors) and portfolio managers on a full range of executive compensation matters. As part of his practice he has represented management teams in numerous management buy-outs (including in the health care, retail and asset management sectors) and has represented “founders” and partners in a variety of businesses on restructuring and “business divorce” matters.

Michael also is a member of the Restrictive Covenants, Trade Secrets & Unfair Competition, which is an interdisciplinary group at Proskauer that represents clients on non-compete, trade secret and intellectual property matters.

Michael has written and spoken extensively in the area of executive compensation. He has contributed to the NCEO publication Selected Issues in Equity Compensation (2019 Edition) and Dow Jones Private Equity Analyst – Global Compensation Study, and his articles on MBO compensation have been featured in two publications (Private Equity Mathematics and Human Capital in Private Equity).

His other articles have appeared in The Business LawyerBloombergNew York Law JournalEmployment Relations Today, and Venture Capital Review and he has been a featured speaker on executive compensation developments at ALI-ABA, Dow Jones Private Equity and other webinars and seminars.

In addition, Michael has served on the Board of Directors of the Yale Law School Fund, and as co-Chairman of his Reunion Class Campaign for the Yale Law School Fund.

Photo of Tyler Forni Tyler Forni

Tyler Forni is an associate in the Tax Department and a member of the Employee Benefits & Executive Compensation Group.

Photo of Nicholas LaSpina Nicholas LaSpina

Nicholas LaSpina is a senior counsel in the Tax Department and a member of the employee Benefits & Executive Compensation Group.

Photo of David Teigman David Teigman

David Teigman is a partner in the Tax Department and a member of the Employee Benefits & Executive Compensation Group. David focuses his practice on executive compensation and benefit matters, principally in connection with mergers and acquisitions, securities offerings and senior executive employment…

David Teigman is a partner in the Tax Department and a member of the Employee Benefits & Executive Compensation Group. David focuses his practice on executive compensation and benefit matters, principally in connection with mergers and acquisitions, securities offerings and senior executive employment relationships.

David regularly counsels public and private companies on compensatory and benefit arrangements, such as equity-based incentives, cash-based incentives and employment, change-in-control, retention, separation and consulting agreements. He also advises on corporate governance, tax law and securities law related to employment matters.

A frequent author, David has published the following articles:

  • “Share Reserve and Other Limits in Public Company Equity Plans” (Practical Law)
  • “Roadmap to Providing Appropriate Incentives to Employees When Your Company is Going to be Sold” (The M&A Lawyer)
  • “Taxation of an Option Exercise When the Shares are Subject to a Substantial Risk of Forfeiture” (Practical Law)

David is often called upon by leading industry publications, including Agenda/Financial Times, Law360 and Modern Healthcare, for his perspective on executive compensation and benefit issues.

David received his J.D., cum laude, from the University of Buffalo, where he was the Editor-in-Chief of the Buffalo Law Review and the Executive Editor of the Public Interest Law Journal, and his B.S. from Cornell University.