C HAPTER 3: R ECEIPT OF A P ARTNERSHIP I NTEREST IN E XCHANGE FOR S ERVICES

I NTRODUCTION When someone receives an interest in partnership capital in exchange for services, he or she must recognize income equal to the FMV of the partnership interest received.

C APITAL I NTEREST R ECEIVED 1) Results to Service Partner – An interest in capital that vests in the service partner immediately is valued and treated as personal service income on the date of receipt. An interest is vested if it either is transferable or it is not subject to a substantial risk of forfeiture. – If the partnership interest does not vest immediately, but rather is contingent, and is not transferable until that date, then the service partner recognizes no income with regard to the receipt of the partnership interest until it is vested.

C APITAL I NTEREST R ECEIVED C ONT. – The service partner may elect, under Code Sec. 83(b), to ignore the contingency associated with the receipt of the partnership interest, and include the interest in income when it’s received and measured at its initial value. If this election is made, partners may not take into account the risk of forfeiture or lack of transferability, in valuing the interest. – If the interest is subsequently forfeited, no deduction for the loss will be allowed for such partners. This election is especially beneficial when the initial value of the partnership interest received is relatively low, or when the difference between that value, and the amount paid, is relatively small.

C APITAL I NTEREST R ECEIVED C ONT. Code Sec. 83(b) Election The election must be made no later than 30 days after the date that the property is transferred, and may be made prior to the transfer. Until the interest vests (if the Code Sec. 83(b) election is not made), the service partner is not considered a partner for tax purposes.

C APITAL I NTEREST R ECEIVED C ONT. There are 2 benefits of electing to be taxed in the year of receipt: 1) The recipient avoids recognizing subsequent appreciation in the partnership interest as compensation income when the interest becomes vested. 2) Any amounts received as partnership distributions are not re-characterized as compensation.

C APITAL I NTEREST R ECEIVED C ONT. 2) Results to Partnership – When the interest is vested, the partnership is treated as if it transferred a partitioned tenancy-in- common interest in its property to the service partner as compensation for his or her past or future services. It is entitled to a deduction for the value of the capital interest paid to the service partner, unless a cash payment to an independent party for such services would be nondeductible. The deduction is allocable to the continuing partners other than the service partner in proportion to their respective indirect interests in the partnership property transferred.

C APITAL I NTEREST R ECEIVED C ONT. The partnership must realize a gain or loss on the portion of its property used to pay for the services. This is allocated to the same partners who were allocated the deduction. The portion of the partnership’s property treated as paid to the service partner is stepped up or down in basis for the amount of gain or loss recognized by the partnership.

P ROFIT I NTEREST R ECEIVED Profit interest allocated to a partner, in exchange for a promise of future services (or in payment for past services), is taken into account the year the partnership realized that partner’s share of income or loss. Profits interest must be taken into account in the year in which it is created when it has a “determinable market value”.

P ROFIT I NTEREST R ECEIVED C ONT. The IRS has ruled that the receipt of the right is not taxable if: – 1) The partnership doesn’t have a substantially reliable stream of income, – 2) the interest is held 2 years, AND – 3) the partnership interest isn’t publically traded. In addition, the following 3 requirements must also be met: – 1) The partnership and the service provider treat the service provider as a partner from the date the interest is granted, and the service provider recognizes his or her distributive share of partnership income, gain, loss, deduction, and credit in computing income tax liability for the entire period during which the service provider has the interest;

P ROFIT I NTEREST R ECEIVED C ONT. 2) Neither the partnership nor any of the partners take any deductions for the value of the interest AND; 3) The other conditions stated in Rev. Proc are satisfied.

P ROPOSED R EGULATIONS When finalized, a set of proposed regulations under Code Sections 83, 704, 706, and 721 would supply some needed guidance in the situations where partnership interests are exchanged for services. – 1) Results to Service Partner If a partnership interest is transferred in connection with the performance of services, the FMV of the interest will be treated as a guaranteed payment to the recipient service partner. If the partnership interest is vested, it will be included in his or her income.

P ROPOSED R EGULATIONS C ONT. If the partnership interest isn’t vested, then the recipient of the partnership interest isn’t treated as a partner unless makes the election under section 83(b). Even if the election hasn’t been made, the holder of a nonvested interest may be allocated partnership income, gain, loss, deduction, or credit, that might later be forfeited. For this reason, allocation of partnership items that occur when the interest isn’t vested can’t have economic effect, and the partner generally won’t recognize these items.

P ROPOSED R EGULATIONS C ONT. However, these allocations WILL be deemed to have economic effect if: 1) the partnership agreement provides for “forfeiture allocations” among the partners to attempt to reverse the forfeited allocations, and 2) all other material allocations are recognized under Code Sec. 704(b).

P ROPOSED R EGULATIONS C ONT. – 2) Results to Partnership Under proposed regulations, Code Sec. 721 doesn’t apply to the transfer of a partnership interest in exchange for services. Instead, they will be considered transferred property to which Code Sec. 83 applies. Under Code Sec. 83, no gain or loss will generally be recognized by the partnership when the compensatory partnership interest is either transferred, substantially vested, or forfeited. The partnership will treat the partnership interest transferred as a guaranteed payment for services under Code Sec. 707(c).

P ROPOSED R EGULATIONS C ONT. The partnership will 1) be allowed a deduction for the value of the partnership interest transferred and 2) be required to recognize income if the partnership interest is forfeited. 3) Value of the partnership interest Under the proposed regulations, the service partner can generally use one of two alternative treatments for determining the value of the compensatory partnership interest. 1) He can use the estimated “willing-buyer-willing-seller” FMV of the partnership interest.

P ROPOSED R EGULATIONS C ONT. 2) He can elect to use the “safe harbor” liquidation value of the partnership interest as the value of the interest. This is the amount of cash that the service partner would receive if, immediately after the transfer, sold all of it’s assets for cash equal to the FMV of those assets, and then liquidated. Since the liquidation value of a profits interest is zero, any profits interest received by the service partner isn’t taxable if this election is used.

P ROPOSED R EGULATIONS C ONT. In order to be eligible for the “safe harbor” election, the partnership must not be 1) related to a substantially certain or predictable stream of income from partnership assets, 2) transferred in anticipation of a subsequent disposition, or 3) an interest in a publicly traded partnership. With respect to number 2: If the partnership interest is sold or disposed of within two years of the date of receipt of the partnership interest, it is presumed to have been transferred in anticipation of a subsequent disposition. The safe harbor value is the liquidation value of the interest less any amount paid for the interest.