United States: Receipt Of A Profits Interest In A Partnership By A Service Provider – Not Taxable

INTRODUCTION

In E.S. N.P.A. Holding L.L.C. v. Commr., ¹ the U.S. Tax Court decided that the indirect receipt of a profits interest in a partnership in exchange for services was not a taxable event for the recipient. The ruling was largely an application of Revenue Procedure 93-27, in which the I.R.S. provided guidance on the tax treatment of an individual who directly provides services to a partnership in exchange for the receipt of a profits interest in the partnership. The court notably held for the taxpayer even though the taxpayer provided services and received a profits interest indirectly, a situation not specifically addressed in the revenue procedure.

This article explains the applicable regulations, an important 8th Cir. Case reversing a decision of the U.S. Tax Court, the Revenue Procedure mentioned above, and finally E.S. N.P.A. Holding v. Commr., a case in which certain applicable tax rules were stretched by the court.

REGULATIONS

U.S. law generally gives tax-free treatment to contributions of property to an entity in exchange for ownership interests in the entity, provided certain requirements are met.² But this favorable treatment is typically unavailable if the item contributed is viewed to be services instead of property.³ In the partnership context, Treas. Reg. §1.721-1(b)(1) states that the "receipt of a partnership capital interest in exchange for services is taxable to the service provider." In explaining the rule, however, the regulation distinguishes between the receipt of a capital interest – viz., an immediate interest in the assets of the partnership, which can be received on termination of the partnership – from the receipt of a profits interest – meaning an interest in a share of future profit:

To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61. [Emphasis added.]

CAMPBELL V. COMMR.

Many commentators interpreted this language to mean that the receipt of a profits interest in return for the provision of services would not result in taxable income and that the result would not differ whether the services were performed before or after the partnership interest was received.⁴ However, in Campbell v. Commr.,⁵ the Tax Court determined, inter alia, that the receipt of a partnership interest for past services performed as an employee was a taxable event, stating as follows in pertinent part:

We reject petitioners [sic] argument that we should no longer follow our decision in the Diamond case and reaffirm our holding that section 721(a) and the regulations thereunder are simply inapplicable where, as in the Diamond case and the instant case, a partner receives his partnership interest in exchange for services he has rendered to the partnership. In order to invoke the benefits of nonrecognition under section 721(a), the taxpayer must contribute "property" to the partnership in exchange for his partnership interest. United States v. Stafford (11th Cir. 1984). The Stafford case makes it clear that services are not "property" for purposes of section 721(a).

The considerations which underlie section 721(a) nonrecognition treatment where a taxpayer receives a partnership interest in exchange for property are vastly different from those reasons advanced by petitioners in favor of section 721(a) nonrecognition treatment where a taxpayer receives a partnership interest in exchange for services. In the former situation, there has been no disposition of the contributed property. The partnership interest such partner receives represents a mere change in the form of an asset which the taxpayer already owns. Archbald v. Commissioner, 27 B.T.A. 837 (1933), affd. 70 F.2d 720 (2d Cir. 1934). In the latter situation, it represents compensation for services, the value of which has not previously been reported as income.

On appeal, the I.R.S. conceded that no difference in tax treatment exists merely because a partnership interest is issued before or after services are performed. In both fact patterns, Code §721(a) applies and no income is recognized. However, it argued that the taxpayer received the partnership interests in exchange for services he provided to his employer, rather than services he provided to the partnerships. According to the I.R.S., the Tax Court essentially held that Campbell received the interests as compensation from his employer. Thus, he was not a service partner; the principles of partnership taxation did not apply; and the receipt of compensation from his employer was taxable upon receipt. The 8th Circuit disagreed with the I.R.S. and reversed the U.S. Tax Court decision,⁶ stating as follows:

Contrary to the Commissioner's belief, the tax court did not hold that Campbell received his partnership interests for services he performed for his employer rather than services performed for the partnerships. In reaffirming Diamond v. Commissioner, 492 F.2d 286 (7th Cir.1974), the court held "that section 721(a) and the regulations thereunder are simply inapplicable where, as in the Diamond case and the instant case, a partner receives his partnership interest in exchange for services he has rendered to the partnership." Campbell, 59 T.C.M. at 249. [Emphasis added.] The court also noted the records of the partnerships indicate that Campbell received the partnership interests after rendering services. Id. at 249. The Commissioner tenuously relies on the tax court's statements that Campbell received his partnership interests in connection with services provided for his employer. Id. at 251-53. These statements were made in the discussion of when Campbell received his interests. We believe that the court did not specifically hold that the interests were received as payment for services provided to his employer.

In response to the Tax Court's observation that the statutory language did not distinguish between capital interests and profits interests, the 8th Circuit wrote that separate treatment was warranted because the issuance of a profits interest did not represent a transfer of assets to the partner.

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Footnotes

1. T.C. Memo. 2023-55 (2023).

2. See Code §§351, 721.

3. See Code §351(d).

4. A. Willis, Partnership Taxation, p. 125 (2d ed. 1976); Cowan, “Receipt of an Interest in Partnership Profits: The Diamond Case,” 27 Tax Law Review 161 (1972)

5. T.C. Memo. 1990-162 (1990), rev'd in pertinent part, 943 F.2d 815 (8th Cir. 1991).

6. 943 F.2d 815 (1991).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.