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When is a LLC Profits Interest not a Profits Interest? U.S. Tax Court: “When it is a Capital Interest”*

On December 2, 2013, the United States Tax Court issued its opinion in Crescent Holdings, LLC et al vs. Commissioner, 141 T.C. No. 15 (12/2/13) wherein it examined the tax rules applicable to transfers of partnership interests as compensation.

Crescent Holdings, LLC (“Holdings”) was a limited liability company and the parent company of Crescent Resources, LLC (“Resources”).  Holdings was a partnership for federal tax purposes.  In 2006, Resources entered into an employment agreement with Arthur Fields, its president and CEO, which included an incentive provision that included the transfer of a 2% member interest in Holdings for serving as president and CEO of the subsidiary. The 2% interest was subject to a substantial risk of forfeiture if he were to leave before three years and was not transferable.

From the facts in the case, it is not clear whether Fields,  Holdings and Resources considered the 2% interest to be a “profits interest” or a “capital interest” in Holdings.  Fields did not make an election under I.R.C. (“Code”) Section 83(b) to treat the interest as substantially vested for federal income tax purposes, and he did not regard himself as a partner during the 3 year vesting period.  Pursuant to Rev. Proc. 93-27, 1993-2 C.B. 343 and Rev. Proc. 2001-43, 2001-2 C.B. 191, the IRS will not treat the grant of a vested or unvested profits interest as a taxable event if certain requirements are met.  Neither revenue procedure takes a position as to whether a profits interest is “property” for purposes of Section 83; the safe harbors simply state that the IRS will not treat a qualifying grant as a taxable event.  Rev. Proc. 93-27, supra,  defines “capital interest” as one which entitles the recipient partner to share immediately in the proceeds of liquidation, and then defines “profits interest” as one which is not a capital interest – i.e., only future earnings and profits attributable to such an interest are recognized by the recipient.

 During the years involved, Holdings issued Schedule K-1s to the president allocating his 2% share of Holdings’ earnings and profits for each year.  However, the president did not believe he was a partner because his interest was not vested and objected to the allocation.  However, at Resources’ request, so that Holdings would not have to file amended K-1s, he reported the K-1 income in his tax return  for 2006.  Nonetheless, Holdings again allocated him a 2% share of partnership income for 2007 and 2008.   To cushion the effect of these large allocations of income, Fields was paid over $2.4 million as “tax advance payments” over the affected three years.  These payments were not treated by Holdings as partnership distributions.   

In 2009, the financial condition of Resources, the operating real estate company, deteriorated and bankruptcy became imminent.  Fields resigned from Resources on May 29, 2009, prior to the date on which his interest would have vested, September 7, 2009.  In June 2010, Holdings and Resources filed a petition under chapter 11 for bankruptcy.  Holdings and Resources filed a complaint with the Bankruptcy Court against Fields to recover the $2.4 million in tax advance payments.  After creditors of Holdings intervened in the bankruptcy proceeding and claimed the right to recover the $2.4 million, Fields reached an agreement with them to file amended tax returns for a refund of taxes paid in respect to the allocations, paid them a $600,000 deposit, and agreed to pay the remainder when he received the refunds. 

The Commissioner of Internal Revenue meanwhile was engaged in a unified partnership audit of Holdings for its taxable years 2006 and 2007, and issued final administrative partnership adjustments (FPAAs) both assessing additional ordinary income against Holdings and its partners and determining that Fields should be treated as a partner for purposes of allocating partnership income items.  Fields and his wife filed a petition in Tax Court challenging this determination, and the tax matters partner of Holdings, Duke Ventures, LLC, intervened in the Tax Court proceeding.  The ultimate issue to be decided was whether Fields or Duke Ventures and the other partners should “recognize the undistributed partnership income allocations attributable to the 2% interest” for 2006 and 2007.  At this point, the IRS as Respondent did an about turn on its prior position.  The Respondent supported Fields in his argument that he had never owned the membership interest and should not be allocated the income attributable to it, a position inconsistent with its FPAAs for 2006 and 2007.  Duke Ventures, as Intervener for Holdings, insisted that the income was allocable to Fields either because (i) it was a profits interest and properly subject to Revenue Procedures 93-27 and 2001-43, which provided for allocations of income to the holder of an unvested profits interest, or (ii) if a capital interest, because it was subject to Treasury Regulation §1.721-1(b)(1), which conflicts with Section 83 requires the holder of the capital interest to be allocated the income attributable to the interest. 

The Tax Court’s decision on the ultimate issue turned on the resolution of three key sub-issues:  (1) was the unvested membership interest granted to Fields a profits interest or a capital interest? (2) does Section 83 apply to the transfer of an unvested partnership capital interest in exchange for the performance of services? if so, (3) are allocations of income with respect to the unvested capital interest allocable to the unvested transferee or the transferor? 

Subissue #1:  The Tax Court looked to the distribution provisions of the LLC agreement of Holdings to determine whether Fields had a right to share in the proceeds of liquidation.  An earlier case, Mark IV Pictures, Inc. v. Commissioner, T.C. memo 1990-571, aff’d, 969 F.2d 669 (8th Cir. 1992), had determined that, despite the apparent attempt to create a profits interest for the recipient, the interest was a capital interest: in the event of a liquidation, the partnership agreement provided that proceeds would be distributed to partners in accordance with their percentage interests.  If the distributions had instead been only in accordance with positive capital account balances, the recipient would not have received any of the proceeds in a hypothetical liquidation at the time the interest was created, and it would have been a profits interest.  Similarly, the Tax Court determined in Crescent Holdings that the partnership interest granted to Fields entitled him to distributions under the Holdings limited liability company agreement, “the same as all other holders of the issued and outstanding membership interests.”  Under the agreement, upon a liquidation of the company, he was entitled to receive a distribution of the net assets in proportion to his then 2% percentage interest at the time of such distribution.  This is liquidation analysis consistent with Rev. Proc. 93-27 and Rev. Proc. 2001-43 for purposes of determining at the time of the grant whether either a vested or unvested interest is a profits interest. 

Subissue #2:  Having found that Fields had received a capital interest under the hypothetical liquidation test adopted by in case law and in the IRS’s revenue procedures, the Court held that Code Section 83 (Transfers of Property for Services) applied to the transfer. Under Section 83 rules, absent an election under Section 83(b) to treat unvested property as substantially vested, the recipient of property does not recognize any income related to that interest until  the interest vests (i.e., it becomes transferable or no longer subject to a  substantial risk of forfeiture).

Subissue #3:  Describing this as an “issue of first impression,” the Tax Court concluded that because Fields had never become the owner of the membership interest, for income tax purposes, any allocated but undistributed income of Holdings with respect to Fields’ 2% interest must be allocated to the transferor, because Treasury Regulations §1.83-1(a)(1) treats the transferor as the owner of the property until it becomes substantially vested.  It then found that Holdings was the transferor, and the income with respect to Fields’ 2% interest must be allocated to the other members of Holdings, stating specifically that, despite the Intervenor’s argument, on this issue there was no conflict between Section 83 and Treasury Regulation §1.721-1(b)(1). 

Limited liability companies (LLCs) have become a favored form of business structure in recent years due to their flexibility with respect to equity owners.  Both individuals and entities can be investors whereas with S corporations, shareholders must be individuals or certain grantor trusts. Boards of limited liability companies wanting to issue profits interests to key executives should become familiar with the Crescent Holdings case to make certain that they don’t inadvertently create a capital interest when one is not intended, particularly if the transferred interest is fully vested. This could create significant tax liability and penalties.

* Thanks to David Haynes, Esq., Stinson Leonard Street LLP, Minneapolis for his assistance with the writing of this article