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Blake D. RubinAndrea Macintosh WhitewayEY Copyright 2005 Blake D. Rubin and Andrea Macintosh Whiteway. All Rights Reserved. Reprinted from the PLI Course Handbook, 18th Annual Real Estate Tax Forum (Order #144587) If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written. |
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| Introduction |
On May 20, 2005, the Internal Revenue Service (“Service”) issued proposed regulations addressing the consequences of the issuance by a partnership of interests in partnership capital or profits in exchange for services provided to the partnership (hereinafter “Compensatory Partnership Interests”). The new regulations are proposed to be effective for Compensatory Partnership Interests issued by a partnership on or after the date the regulations are published as final regulations in the Federal Register.
The proposed regulations extend Code Sec. 83 treatment to the receipt of a partnership interest. Previously, the Service had avoided applying Code Sec. 83 to the issuance of partnership interests for services. In an unusual move, the proposed regulations were issued with a companion Notice 2005-43, 2005-24 I.R.B. 1, setting forth a proposed revenue procedure establishing certain exceptions to the rules set forth in the proposed regulations.1 After a brief discussion of the key features of the Proposed Regulations, this column will focus on some practical problems and opportunities that will arise if the Proposed Regulations are finalized in their current form.
| Application of Code Sec. 83 |
Code Sec. 83(a) generally provides that, if in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier (referred to herein as becoming “substantially vested”), over (2) the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the year in which the rights of such person in such property are substantially vested.
Code Sec. 83(b), however, provides that a service provider may elect to include the excess of the fair market value of property (determined without regard to any restriction other than a restriction which by its terms will never lapse) received in exchange for the performance of services over the amount paid for such property in income in the year such property is transferred. Code Sec. 83(b)(2) provides that an election under
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| Current Tax Treatment of Partnership Profits Interests |
Rev. Proc. 93-27, 1993-2 C.B. 343, generally provides that if a person receives a profits interest in a partnership in exchange for services provided to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the transfer of the profits interest will not be taxable to the service provider or the partnership. The Revenue Procedure does not apply to the extent that (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, (2) within two years of receipt, the partner disposes of the profits interest, or (3) the profits interest is a limited partnership interest in a publicly traded partnership within the meaning of Code Sec. 7704(b). Rev. Proc. 93-27 defines a “profits interest” as an interest that is not a “capital interest.” The term “capital interest,” in turn, is defined as “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.” This determination is generally made at the time of receipt of the partnership interest.
Rev. Proc. 2001-43, 2001-2 C.B. 191, provides that, for purposes of Rev. Proc. 93-27, if a partnership grants a substantially nonvested partnership profits interest to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that (1) the partnership and service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest, (2) upon the grant of the interest or at the time the interest becomes substantially
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Neither Rev. Proc. 93-27 nor Rev. Proc. 2001-43 applies the rules of Code Sec. 83 to the issuance of a partnership profits interest in exchange for services. As a result, the recipient of such a profits interest is not currently required to make a Code Sec. 83(b) election to ensure that no income is recognized in connection with the grant of the interest or at the time it becomes substantially vested.
| Proposed Regulations and Notice 2005-43 |
On May 24, 2005, the Service issued proposed regulations regarding the taxation of transfers by a partnership of Compensatory Partnership Interests. The proposed regulations provide that Code Sec. 83 applies to the issuance of Compensatory Partnership Interests because such interests constitute “property” within the meaning of Code Sec. 83(a). Prop. Reg. § 1.83-3(e).3 At the same time, the Service issued Notice 2005-43, 2005-24 I.R.B. 1, which contains a draft revenue procedure. When finalized, the draft revenue procedure will supersede Rev. Proc. 93-27 and Rev. Proc. 2001-43.
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Although the Notice provides a mechanism for electing to utilize the “liquidation value” approach with respect to Safe Harbor Partnership Interests, the default rule is that the service provider takes into account income equal to the fair market value of the capital or profits interest received. Under the proposed regulation, the service provider’s capital account is increased by the amount the service provider takes into income under Code Sec. 83 as a result of receiving the interest, plus any amounts paid for the interest. Prop. Reg. § 1.704-1(b)(2)(iv)(b)(1). The preamble to the Proposed Regulations acknowledges that, [s]ome commentators suggested that the amount included in the service provider’s income under Code Sec. 83, plus the amount paid for the interest, may differ from the amount of capital that the partnership has agreed to assign to the service provider. These commentators contend that the substantial economic effect safe harbor in the Code Sec. 704(b) regulations should be amended to allow partnerships to reallocate capital between the historic partners and the service provider to accord with the economic agreement of the parties. The Service rejected this comment, concluding with little explanation that the reallocation of partnership capital as suggested by the commentators is not consistent with the policies underlying the substantial economic effect safe harbor and the capital account maintenance rules whose purpose is to ensure that, to the extent that there is an economic benefit or burden associated with a partnership allocation, the partner to whom the allocation is made receives the economic benefit or bears the economic burden. The proposed regulations provide that a partnership does not recognize gain or loss upon the transfer or substantial vesting of a Compensatory Partnership Interest. Prop. Reg. § 1.721-1(b)(1). The Service rejected the approach of treating the partnership as satisfying its compensation obligation by delivering a fractional interest in each asset of the partnership in a taxable transaction, followed by a tax-free capital contribution of the same by the service provider to the partnership. Under this approach, the partnership would recognize gain or loss equal to the excess of the fair market value of each partial asset deemed transferred over the partnership’s adjusted basis in such partial asset. This approach has been criticized on numerous grounds, including that a partnership should not recognize gain or loss on the transfer of a compensatory partnership interest because no property owned by the partnership has changed hands. ====== 2-780 ====== The Service concludes that, partnerships should not be required to recognize gain on the transfer of a compensatory partnership interest. Such a rule is more consistent with the policies underlying Code Sec. 721 — to defer recognition of gain and loss when persons join together to conduct a business — than would be a rule requiring the partnership to recognize gain on the transfer of these types of interests. Therefore, the proposed regulations provide that partnerships are not taxed on the transfer or substantial vesting of a compensatory partnership interest. Under § 1.704-1(b)(4)(i) (reverse Code Sec. 704(c) principles), the historic partners generally will be required to recognize any income or loss attributable to the partnership’s assets as those assets are sold, depreciated, or amortized. The Proposed Regulations provide that partnerships may book-up and restate the value of partnership assets and capital accounts upon the transfer or vesting of a compensatory partnership interest provided that the transfer or vesting results in the service provider recognizing income under Code Sec. 83 (or would result in such recognition if the interest had a fair market value other than zero).4 If a Code Sec. 83(b) election is made with respect to a Compensatory Partnership Interest that is not substantially vested, allocations of partnership items will be deemed to have economic effect if (a) the partnership agreement requires that the partnership make forfeiture allocations if the partnership interest is later forfeited, and (b) all material allocations and capital account adjustments under the partnership agreement not pertaining to Compensatory Partnership Interests for which a Code Sec. 83(b) election has been made are recognized under Code Sec. 704(b). Forfeiture allocations are allocations to the service provider of partnership gross income and gain or gross deduction and loss (to the extent such items are available) that offset prior distributions and allocations of partnership items with respect to the forfeited interest. Prop. Reg. § 1.704-1(b)(4)(xii)(c). |
The proposed regulations will be effective for transfers of property on or after the date final regulations are published in the Federal Register. The Service intends to finalize Rev. Proc. 2005-43 in conjunction with finalizing the Proposed Regulations. |
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| Observations and Comments |
As described above, there are several very mechanical requirements contained in the Proposed Regulations and Revenue Procedure that must be met to allow a partnership to elect the Liquidation Value Safe Harbor. The most troubling of these requirements is that the partnership agreement must contain provisions that are legally binding on all partners stating that the partnership is authorized and directed to file the election, and the partnership and each partner agrees to comply with all requirements of the safe harbor. If the partnership agreement does not contain these provisions, or the provisions are not legally binding on all of the partners, then each partner must execute a document containing provisions that are legally binding on that partner stating that (a) the partnership is authorized and directed to elect the safe harbor, and (b) the partner agrees to comply with all requirements of the safe harbor with respect to all Compensatory Partnership Interests transferred while the election remains effective. As a practical matter, because of these requirements, many partnerships formed before the issuance of the Proposed Regulations will be unable to adopt the Liquidation Value Safe Harbor. It is typical for partnership agreements to authorize the general partner to make elections on behalf of the partnership, and in some cases, the partnership agreement may specifically identify certain elections that the partnership is making (e.g., Code Sec. 704(c) method with respect to contributed property). However, the requirement in the Proposed Revenue Procedure goes beyond these typical provisions relating to elections. Based on the language of the Proposed Regulations and informal comments by government officials involved in drafting them, it appears that in order to qualify for the Safe Harbor Liquidation Election, it is not sufficient to rely on a general grant of authority to the general partner to make elections for the partnership. Rather, the partnership agreement must contain specific language not only authorizing but also directing that the partnership make the Safe Harbor Liquidation Value Election. The Service apparently was concerned that, absent an agreement executed by all partners, the Service could be “whipsawed” by the partnership or particular partners claiming a compensation deduction greater than the amount of income included by the service provider.5 ====== 2-782 ====== For partnerships that do not have agreements containing the “magic language” required by the Proposed Regulations, each partner must execute a document containing similar provisions that are legally binding on that partner. In existing partnerships with more than a handful of partners, it is difficult to imagine many situations in which the partners will be able to reach unanimity on any issue. While tax practitioners may agree that making the Safe Harbor Liquidation Value Election makes sense, locating all partners and convincing them all to sign the required document may prove difficult if not impossible. Another mechanical requirement that may result in inadvertent failures to make a valid Safe Harbor Liquidation Value Election is the requirement that the election be filed with the partnership return, but that it may not be effective prior to the date it is executed. As a practical matter, elections required to be filed with a tax return are typically executed at the time the tax return is executed, shortly prior to filing. In the case of an election made with respect to the issuance of a Compensatory Partnership Interest during the tax year for which the return is being filed, execution at the time the return is filed will result in any invalid election. |
| Rev. Rul. 99-5/ McDougal Trap |
As noted above, the Proposed Regulations rejected the approach of treating the partnership as satisfying its compensation obligation by delivering a fractional interest in each asset of the partnership in a taxable transaction, followed by a tax-free capital contribution of the same by the service provider to the partnership. However, the preamble to the Proposed Regulations provides that the nonrecognition of gain or loss upon issuance of a compensatory interest by a partnership does not apply to the transfer or substantial vesting of an interest in an eligible entity, as defined in Reg. § 301.7701-3(a), that becomes a partnership for Federal income tax purposes as a result of the transfer or substantial vesting of the interest, citing McDougal v. Commissioner, 62 T.C. 720 (1974). In McDougal, the McDougals gave McClanahan a 50 percent interest in the capital and profits of a newly formed joint venture between the McDougals and the McClanahans as compensation for services rendered in connection with the training of their race horse. The Tax Court held that the McDougals recognized gain to the extent that the value of a half interest in the horse exceeded the McDougals’ adjusted basis in the half interest. The Tax Court also held that in determining the joint venture’s basis in the contributed property, the McDougals were deemed to have transferred a half interest in the horse to McClanahan and thereafter, in concert with him, to have contributed the entire horse to the joint venture. The conclusion in
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As illustrated in Example 1, based upon the preamble, the McDougal case and Rev. Rul. 99-5, if a service provider is granted an interest in a disregarded entity, the service recipient may recognize gain on any appreciated property owned in the disregarded entity.
A owns 100% of the interests in a limited liability company (“ALLC”), which is disregarded as an entity separate from A. A grants a service provider (“SP”) a 10% interest in ALLC in exchange for services to ALLC. A must recognize gain, presumably equal to 10% of the excess of value over basis in the assets of ALLC. A would also receive a compensation deduction for the value of the transferred interest, subject to the possibility that the compensation expense would have to be capitalized under Code Sec. 263 or 263A. Less clear is what the treatment of A and SP would be if the 10% interest is a profits only interest. The Proposed Regulations would not, by their terms, apply to allow a Safe Harbor Liquidation Value Election to be made (because the transfer would be treated as a transfer of assets, rather than of a Compensatory Partnership Interest). From a planning perspective, it appears that the transaction could be structured in a manner to avoid application of the McDougal case by having A first transfer a 1% interest to an affiliate that is not a disregarded entity, and then having ALLC, which at that point would be a partnership for federal income tax purposes, issue the 10% interest to SP. |
The Proposed Regulations provide that in a partnership where the Liquidation Value Safe Harbor Election is not made, the service provider must receive a capital account equal to the fair market value of the interest that it receives. If the service provider is granted a profits interest in a partnership, from the parties’ perspective, this is intended to create a right to share in future appreciation in the value of the partnership’s assets. In contrast, a capital interest granted to the service provider would create a right to receive a distribution if the partnership sold its assets at their value at the time of grant and liquidated. In order to effectuate the parties’ intention to create a profits interest rather than a capital interest, the service provider must receive a capital account balance of zero following a book-up of the partnership. As illustrated in Example 2, notwithstanding the business deal between the service provider who is issued a profits interest and the partnership, where the partnership does not make the Liquidation ====== 2-784 ====== |
A through Z form a partnership, each contributing $100, for total capital contributions of $2,600. Thereafter, the partnership admits a service provider (“SP”) for a profits interest. The partnership is unable to get all 27 partners (including SP) to execute a legally binding document meeting the requirements to make a Liquidation Value Safe Harbor election. The value of the partnership interest is determined to be $100 using the Black-Scholes theory or other appropriate valuation methodology. Under the Proposed Regulations, SP would recognize taxable income of $100 and would be required to receive a $100 capital account. The partnership would be entitled to a $100 compensation deduction which would be allocated to A through Z, thereby reducing their capital accounts to $2,500. If the partnership sold its assets for their fair market value and liquidated in accordance with positive capital account balances immediately following SP’s admission, SP would receive $100. Thus, SP’s profits interest has been transmuted by the Proposed Regulations into a $100 capital interest, contrary to the intention of the parties and the intended business deal. |
Upon the issuance of a profits interest in exchange for the performance of services, the parties will frequently find it convenient to book-up under Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii) in order to ensure that the interest granted to the service provider is a profits interest rather than a capital interest. Alternatively, instead of actually booking up, the partners may reach a similar result by providing that any built-in gain or loss inherent in the partnership’s assets at the time of the service provider’s admission will be specially allocated under Code Sec. 704(b) to the historic partners of the partnership.6 Either approach should suffice to ensure that the partnership interest granted to the service provider qualifies as a profits interest. An actual book-up, however, will require the application of Code Sec. 704(c) principles with respect to any depreciable property owned by the partnership; the special allocation approach under Code Sec. 704(b) will not. Most practitioners presumably are familiar with the need to book-up or specially allocate built-in gains and losses under the Code Sec. 704(b) ====== 2-785 ====== |
A and B are equal partners in Partnership AB, which owns assets with a basis of $30 and a fair market value of $100. AB’s partnership agreement complies with the substantial economic effect safe harbor in the Code Sec. 704(b) regulations. A and B each have a $15 capital account. Partnership AB issues SP a 10 percent interest in capital and profits. A, B and SP expect and intend that a 10 percent interest in the partnership is worth $10. In connection with the issuance of the interest, the partners make the Liquidation Value Safe Harbor Election and value the interest at $10. SP includes $10 in income, and in accordance with Prop. Reg. § 1.704-1(b)(2)(iv)(b)(1), SP receives a $10 capital account. A and B are each allocated a $5 compensation deduction. Absent a book-up, the capital accounts of the partners after these transactions are as follows:
====== 2-786 ====== Upon a sale of the partnership’s asset for its value of $100, $70 of gain would be recognized. The gain would be allocated 10 percent to SP ($7) and 45 percent to each of A and B ($31.50 each). After the allocation, the capital account of SP would be $17, and the capital account of A and B would each be $41.50. Upon liquidation of the partnership, SP would receive 17 percent of the proceeds ($17) if the partnership made liquidating distributions in accordance with positive capital account balances, not 10 percent as intended by the parties. As illustrated by Example 4, a book-up upon the admission of SP will effectuate the intended business deal, but will raise some issues of its own. |
Assume the same facts as in Example 3, except that the partnership books-up under Prop. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii). The partnership’s tax and book balance sheets would be as follows:8
Prop. Reg. § 1.704-1(b)(2)(iv)(b)(1) specifies that SP’s book capital account is equal to the $10 that SP included in income. A critical question not answered by the regulations is the amount of SP’s tax capital account. Although the Code Sec. 704(b) regulations nowhere specify the mechanics of a book-up in any detail, it appears likely that the amount of gain that must be allocated to each partner under Code Sec. 704(c) principles immediately after a book-up is the difference between that partner’s book and tax capital accounts.9 Thus, if SP’s tax and book capital accounts differ, ====== 2-787 ====== Certainly, if A and B had each transferred a five percent interest in profits and capital to SP as compensation, SP’s tax capital account would be $3.10 Nevertheless, astute readers (who are able to add and subtract) will recognize that if SP’s tax capital account is $3, then the partnership’s tax basis balance sheet will not balance. Moreover, other untoward consequences would ensue if SP’s tax capital account were $3, such as a requirement that SP be allocated gain under Code Sec. 704(c) principles, which would result in SP recognizing an offsetting amount of gain if the partnership liquidated for cash. Accordingly, we conclude that C’s tax basis capital account must be $10. Assuming SP’s tax basis capital account is $10, then the book-up succeeds in effectuating the intended business deal. Upon a sale of the partnership’s asset for its value of $100, $70 of tax gain and $0 of book gain would be recognized. The entire $70 tax gain would be allocated $35 to each of A and B under Code Sec. 704(c) principles, increasing their tax capital accounts to $90. Upon liquidation of the partnership in accordance with book capital accounts, SP would receive $10 and A and B would each receive $45. Thus, SP would receive 10 percent of the net proceeds, effectuating the intended business deal. |
Practitioners were relieved (but not surprised) to have Treasury and the Service issue regulations that do not require partnerships to recognize gain upon the issuance of Compensatory Partnership Interests. Clearly, the issuance of such interests is prevalent and taxpayers deserve certainty as to the tax treatment of such transactions. Given the historical experience in this area, however, and the existence of Rev. Proc. 93-27 and Rev. Proc. 2001-43, a question inevitably arises as to whether issuance of the Proposed Regulations was necessary11 The traps and mechanical difficulties that are found in these provisions call into question whether a better approach would merely be to adopt the approach in prior guidance, which ====== 2-788 ====== |
| 1. | For a comprehensive discussion of the proposed regulations and notice, see Steven R. Schneider and Brian J. O’Connor, Proposed Rules Substantially Change the Treatment of Compensatory Partnership Interest: Are You Ready?, Journal of Passthrough Entities, Vol. 8, No. 5 (September - October 2005). |
| 2. | See Reg. § 1.83-4(a). |
| 3. | The Proposed Regulations also in effect provide that the rules of Reg. § 1.83-7 apply with respect to options to acquire partnership interests issued in connection with the performance of services. |
| 4. | Reg. § 1.704-1 (b)(2)(iv)(f)(5)(iii). |
| 5. | See Robinson v. U.S., 335 F.3d 1365 (Fed. Cir. 2003), cert. denied, Jan. 12, 2005 (employer’s deduction under Code Sec. 83(h) not limited to amount included by employee on his tax return). |
| 6. | See Reg. § 1.704-1(b)(5) Example 14 (iv). |
| 7. | See Prop. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii). |
| 8. | “Book” capital accounts are capital accounts maintained in accordance with the capital account maintenance rules set forth in Reg. § 1.704-1(b)(2). “Tax” capital accounts are maintained in the same manner as “book” capital accounts, except that contributed (or revalued) property is reflected at its adjusted tax basis and thereafter adjusted to reflect depreciation allowable for tax purposes. See Reg. § 1.704-1(b)(5) Examples 17 and 18. |
| 9. | See generally Blake D. Rubin and Andrea M. Whiteway, “Exploring the Outer Limits of the Section 704(c) Built-in Gain Rule,” 89 Journal of Taxation Nos. 3, 4 and 5 (September, October and November, 1998). |
| 10. | See Reg. § 1.704-1(b)(2)(iv)(l). |
| 11. | The genesis of the Proposed Regulations was the desire to clarify the treatment of the issuance and exercise of options to acquire partnership interests issued in a compensatory context. Guidance on that point could have been issued in a short Revenue Procedure stating that rules similar to the rules of Reg. § 1.83-7 will apply. |
| 12. | The New York State Bar Report on Proposed Regulations and Revenue Procedure Relating to Partnership Equity Transferred in Connection with the Performance of Services, (October 26, 2005) (the “NYSBA Report”) recommends that there be a simple mandatory rule that all compensatory partnership interests be valued based on their liquidation value. If that recommendation is not embraced by the government, the NYSBA Report recommends that the Proposed Regulations be withdrawn and the area continued to be governed by Rev. Proc. 93-27 and Rev. Proc. 2000-43. The Texas State Bar Association gave the Proposed Regulations a somewhat warmer reception, concluding that they in general provide “clear and sensible rules.” State Bar of Texas, Report No. 1 — Proposed Regulations relating to the tax treatment of certain transfers of Partnership equity in connection with the performance of services, August 22, 2005, Section III.A.1. |