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ES NPA HOLDING LLC v. Commissioner (T.C. Memo. 2021-68)

On June 3, 2021, the Tax Court issued a Memorandum Opinion in the case of ES NPA HOLDING, LLC v. Commissioner (T.C. Memo. 2021-68). The primary issue presented in ES NPA HOLDING, LLC was whether the adjustment to ES NPA’s 2011 ordinary income originates at the level of another limited liability company, IDS, in which the petitioner held an interest, which is to say that the adjustment is a partnership item of IDS and not a partnership item of the petitioner.

Background

In 2011 Joshua Landy owned all the shares in NPA, Inc., an S corporation. On September 12, 2011, NPA Holding was formed, and on September 27, 2011, NPA, Inc., formed two LLCs: IDS and NPA, LLC. On October 14, 2011, NPA Holding exercised a call option granted by NPA, Inc., and pursuant thereto acquired all of the IDS class C units.  IDS was a single member LLC and was classified as a disregarded entity for Federal income tax purposes under Treas. Reg. § 301.7701-3(b)(1)(ii).

Tax Court’s Jurisdiction

IRC § 6226 provides for judicial review of final partnership administrative adjustments (FPAAs). In general, IRC § 6226(f) gives the Tax Court jurisdiction to determine all partnership items of the partnership for the partnership’s taxable year to which the FPAA relates. However, the Tax Court’s jurisdiction does not extend to determining the partnership items of lower tier partnerships. See Sente Inv. Club P’ship of Utah v. Commissioner, 95 T.C. 243, 247-248 (1990). That means that the Tax Court may determine only the partnership items of the partnership to which the FPAA relates. Id. If the partnership items of a lower tier partnership are included in the FPAA of the partnership before the court, it is without jurisdiction to determine those lower tier partnership items. See Rawls Trading, L.P. v. Commissioner, 138 T.C. 271, 288-289 (2012); Sente Inv. Club, 95 T.C. at 247-248.

The party challenging the FPAA bears the burden of proving the IRS’s determinations in a FPAA are erroneous. See Rule 142(a)(1); Crescent Holdings, LLC v. Commissioner, 141 T.C. 477, 485 (2013); Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996). However, the party alleging the Tax Court’s jurisdiction to determine partnership items bears the burden of proving the facts establishing our jurisdiction. Jimastowlo Oil, LLC v. Commissioner, T.C. Memo. 2013-195, at *6; see also McNutt v. Gen. Motors Acceptance Corp. of Ind., 298 U.S. 178, 189 (1936); Pietanza v. Commissioner, 92 T.C. 729, 736-737 (1989), aff’d without published opinion, 935 F.2d 1282 (3d Cir. 1991).

IRC § 6231(a)(3) defines a partnership item as any item required to be taken into account for the partnership’s taxable year to the extent the regulations prescribed by the IRS provide that such an item is more appropriately determined at the partnership level than at the partner level. In general, the partnership’s aggregate and each partner’s share of items of income, gain, loss, deduction, or credit of the partnership are partnership items. Treas. Reg. § 301.6231(a)(3)-1(a)(1)(i). Taxable income of a partnership is computed in the same manner as in the case of an individual. IRC § 703(a). The tax treatment of any partnership item generally must be determined at the partnership level. IRC § 6221.

Receipt of a Partnership Interest in Exchange for Services

IRC § 721(a) provides that no gain or loss shall be recognized to a partner in the case of a contribution of property to the partnership in exchange for an interest in the partnership. For the same reason the IRS has ruled that partners generally do not recognize gain or loss upon the conversion of a disregarded entity to a partnership. See Rev. Rul. 99-5, 1999-1 C.B. 434.

By contrast, where a person receives a partnership interest in exchange for a contribution of services, nonrecognition is not always guaranteed. See Treas. Reg. § 1.721-1(b)(1). Under Treas. Reg. § 1.721-1(b)(1), the “receipt of a partnership capital interest in exchange for services is taxable to the service provider.” Crescent Holdings, 141 T.C. at 488; see also IRC § 83(a) (generally dictating the recipient’s tax treatment of property received in connection with services performed); Treas. Reg. § 1.61-2(d) (stating property received as compensation must be included in income). After Treas. Reg. § 1.721-1(b)(1), went into effect, there was confusion about how receipt of a partnership profits interest would be treated. See Rev. Proc. 93-27, § 3. In 1993 the Commissioner issued Rev. Proc. 93-27, which addresses the issue and states that if a person receives a profits 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, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. Id. at § 4.01. Therefore, under present guidance from the IRS, whether the receipt of a partnership interest in exchange for services provided to or for the benefit of the issuing partnership is a taxable event turns on whether the partnership interest is a capital interest or a profits interest. See Rev. Proc. 93-27, § 4.01.

Deduction for Compensation Paid in the Form of a Partnership Interest

IRC § 83(h) allows a deduction under IRC § 162 to the person for whom were performed the services in connection with which property was transferred. Property includes a partnership interest in or held by the service recipient. Treas. Reg. § 1.83-3(e); Treas. Reg. § 1.721-1(b); see also McDougal v. Commissioner, 62 T.C. 720, 728 (1974). The service recipient may deduct an amount equal to the payment that the service provider included in gross income under IRC § 83(a), (b), or (d)(2), to the extent the amount meets the requirements of IRC § 162 and the regulations interpreting it. IRC § 83(h); Treas. Reg. § 1.83-6(a)(1); see Venture Funding, Ltd. v. Commissioner, 110 T.C. 236 (1998) (holding that the deduction under section 83 is limited to the amount included, as opposed to includible, in gross income, subject to certain exceptions), aff’d without published opinion, 198 F.3d 248 (6th Cir. 1999). Further, IRC § 162(a) allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. See also IRC § 162(a)(1) (allowing deduction for “reasonable allowance for salaries or other compensation for personal services actually rendered”).

The Parties’ Arguments

The petitioner argues that the IRS’s proposed adjustment to NPA Holding’s income constitutes a partnership item of IDS, which the Tax Court could only adjudicate in a proceeding under TEFRA involving IDS. Specifically, the petitioner contends that if income was realized with respect to the NPA, LLC class C units in October 2011, then IDS was the source of that income because it held the class C units in NPA, LLC. Accordingly, as the petitioner argues, the income represents a partnership item of IDS and not ES NPA.

The IRS counters petitioner’s argument and directs us to the call option agreement as the most relevant transactional document, which provides that NPA Holding received IDS class C units, for the sum of $100,000 and for services provided (or to be provided) by NPA Holding. In the IRS’s view, the IDS class C units were worth more than the $100,000 paid, and consequently NPA Holding received income that it was required to recognize on its 2011 partnership income tax return.

The Tax Court’s Holding

The adjustment at issue resulted when NPA Holding obtained an interest in IDS; it is not a distributive share of IDS’ income.  Though the interest that NPA Holding received—the IDS class C units—tracks the NPA, LLC class C units held by IDS, that does not alter the analysis. The record does not show that IRS based its adjustment on underlying payments from NPA, LLC to IDS under the terms of IDS class C units in NPA, LLC. Therefore, the adjustment to the 2011 gross income made in the FPAA is properly classified as a partnership item of NPA Holding.

(T.C. Memo. 2021-67) New Capital Fire, Inc. v. Commissioner

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