ES NPA Holding, LLC v. Comm’r, T.C. Memo 2023-55

The Tax Court ruled that the Class C units 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. Any proceeds in excess of fair market value would be  speculative. No accuracy penalty was appropriate either. 

On March 20, 2017, the IRS issued a “notice of final partnership administrative adjustment” for 2011 to Joseph NPA Investment LLC (the petitioner), the Tax Matters Partner for ES NPA Holding LLC. The issues were: (1) whether ES NPA Holding underreported its income  for 2011; and (2) whether an accuracy-related penalty was appropriate. The Tax Court found  for the petitioner. 

ES NPA Holding and its Tax Matters Partner and its final partnership administrative  adjustment. ES NPA Holding was formed on Sept. 12, 2011. The IRS determined that ES  NPA Holding had received $16,106,250 of unreported other income for 2011. The income  was related to ES NPA Holding’s receipt of a 50% capital interest in Integrated Development  Solutions LLC, or, in the alternative, receipt of an indirect 30% capital interest in National  Performance Agency LLC (NPA, LLC). 

Restructuring of NPA LLC. Before Oct. 14, 2011, Joshus Landy owned 100% of the shares  or membership units in NPA Inc. and other consumer loan business entities and desired to  dispose of a portion of them. Monu Joseph and Amit Raizada contacted Landy and, on June  25, 2011, offered to purchase 70% of Landy’s businesses for $20.59 million through a Joseph company, Emerald Crest Capital. The term sheet specified certain contingencies including those relative to the final structure of the transaction and that other purchasers  might be brought into the deal. 

Landy engaged the law firm of Bryan Cave LLP for the transaction. Through a 60-page  acquisition due diligence memorandum, Emerald Crest Capital proposed a structure for the purchase, as explained in the opinion as follows: 

The sale of Mr. Landy’s businesses was arranged through the following transactions,  which took place on September 27, October 13, and October 14, 2011. On  September 27, 2011, NPA Inc. formed two LLCs: IDS and NPA, LLC. IDS had two  classes of membership units: class B and class C. NPA, LLC had three classes of  units: class A, class B, and class C. Per Articles 9.2 and 13.3 of the IDS first amended  and restated limited liability company agreement, the class B and class C units in IDS  track 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. 

On Oct. 13, 2011, NPA contributed its assets to NPA, LLC in exchange for all three classes  of units: A, B, and C. “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.” NPA Investors LP purchased all of  the Class A shares for $14,502,436. ES NPA Holding acquired all of the Class C shares of  IDS for $100,000 and “services to be provided.” 

“At the end of the day on October 14, 2011, (i) the class A units held by NPA Investors had  a capital contribution of $20,985,509, (ii) the class B units held by IDS had a capital  contribution of $8,993,790, and (iii) the class C units held by IDS had a capital contribution  of zero.” (Editor’s note: The opinion provides two charts outlining the structure of the entities  following the multiple transactions.) 

Opinion. 

Summary of parties arguments. 

Petitioner. ES NPA Holding argued its receipt of Class C units of IDS was the receipt of a  profits interest as defined in Rev. Proc. 93-27, excludable from income for 2011. 

Respondent. Respondent argued that Rev. Proc. 93-27 was not applicable because ES  NPA Holding did not render services to IDS. Alternatively, the safe harbor in Rev. Proc. 93- 27 was inapplicable because ES NPA Holding received a taxable capital interest in IDS and  argued that the fair market value of the class C units of IDS was $12,169,000 as of Oct. 14,  2011. 

Burden of proof. Petitioner argued the burden of proof had shifted to the respondent since  the petitioner had credibly demonstrated its position. The court’s opinions were based on  the preponderance of the evidence, so the burden of proof was not material. 

Receipt of a partnership interest in exchange for services. Nonrecognition of gain where a  partnership interest was received in exchange for services was not always guaranteed. “The  U.S. Court of Appeals for the Eighth Circuit … reversed our decision in Campbell, finding  that the receipt of a profits interest was not taxable since the value received was  speculative.” The IRS, in Rev. Proc. 93-27, acknowledged it would not treat the receipt of a  profits interest as a taxable event. 

Analysis. 

Definition of a profits interest. A profits interest in a partnership was other than a capital  interest. (Rev. Proc. 93-27) A capital interest was 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 of the partnership” (Rev. Proc. 93-27)  as of immediately after the transaction, i.e., the receipt of the partnership interest. It was not  treated as income if a person received the interest “for the provision of services to or for the  benefit of a partnership in a partner capacity or in anticipation of being a partner.” 

Whether the class C units in NPA LLC that ES NPA received constituted a profits  interest. 

Was Revenue Procedure 93-27 applicable? It was incontrovertible that ES NPA Holding did provide services to NPA Inc. in exchange for the class C units in IDS, which are identical to  class C units in NPA LLC. Respondent took too narrow a view as to the application of Rev.  Proc. 93-27, which should be viewed as administrative guidance on the treatment of receipt  of a profits interest for services. Thus, Rev. Proc 93-27 supported a finding that ES NPA  Holding “either directly or through its principals, before and after formation, provided  services to or for the benefit of the partnership in a partner capacity or in anticipation of  being a partner.” It was not material that ES NPA Holding’s interest in NPA LLC was held  through IDS, which was a mere conduit. 

Had ES NPA satisfied the requirements of Revenue Procedure 93-27? The court concluded that ES NPA Holding’s receipt of the class C units qualified under Rev. Proc. 93-27 but did it meet the requirements upon a hypothetical liquidation as of the date of the transaction?  Under the operating agreement, the proceeds in liquidation were to be distributed 30% to class B holders and 40% to class A holders with the remaining 30% to class C holders  provided the class A and B capital accounts have been satisfied in full. The parties agreed that, if the fair market value of NPA LLC was $29,979,299, the amount in the capital account  as of Oct. 14, 2011, there would be no distributions to the class C units. 

Therefore, the subjective determination of the fair market value of NPA LLC must be made. The respondent offered the opinion of its expert witness that the fair market value was  $52,463,722 and disputed that Landy knew the value of his businesses and that the  transaction was, therefore, not at arm’s length and should not be relied on to determine fair  market value. 

The petitioner contended that the actual terms of the sale was the best evidence of the fair  market value of $29,979,299 and that the sale was arm’s length and, thus, the best evidence  of that value being the sale of a 70% interest in the businesses. Alternatively, the petitioner  argued that, on the basis of its expert testimony, the fair market value was, as stated above,  based on a “direct capitalization of earnings.” Further, the petitioner’s expert’s rebuttal report  disputed the respondent’s expert’s report, saying he erroneously assumed that Landy was  selling 40% of his interest for $21 million.  

The parties agreed that the best evidence of fair market value was an actual arm’s-length sale of the property on or close to the valuation date. The court agreed with that position. Here, there was an actual sale that showed that the sale of a 70% interest implied a value  of $29,979,299. Petitioner believed that an appraisal was required in this case, but the court  believed otherwise and believed an actual sale was more persuasive. (Casey v. Commr.  and Gaggero v. Commr.) The respondent replied that the sale was not arm’s length since “Mr. Landy was pressured to sell, failed to obtain a formal appraisal, and lacked  sophistication and education.” The court noted there was no evidence he was under duress.  Landry also testified he was not under any financial strain since the businesses were profitable.  

Also the respondent’s expert did not perform any analysis of the actual transaction and was  not aware that Landy had sold 70% of his businesses for approximately $21 million.35 In his  rebuttal report, the respondent’s expert determined a value of $48.5 million using a 4.7x multiple of EBITDA. The court rejected the respondent’s expert’s value and adopted the  arm’s-length bona fide transaction value of $21 million plus the direct capital for the class B  units, for a value of approximately $30 million. The court determined that there would not be  any distribution to the class C units at that value and that no accuracy penalty was appropriate.