The following discussion addresses the rules that currently govern the receipt of a partnership interest in exchange for services. Practitioners should be aware that proposed regulations and Notice 2005-43 provide new rules and new safe-harbor provisions that will apply to the receipt of a partnership interest by a service partner when the regulations are finalized.
The issue of value is always important when Sec. 83 applies to a transfer of property—including a partnership interest transfer to a service partner. Indeed, the problem of valuation is especially tricky when the property is a partnership interest, because a ready market seldom exists to help establish value.Valuing Capital Interests
If the transferred partnership interest is a capital interest, the liquidation value is often assumed to establish the interest's fair market value (FMV). While this is certainly a convenient rule of thumb and may often establish an appropriate value consistent with the overall tax treatment of the transaction, practitioners may have room to argue for a lesser value—because of lack of liquidity, transfer restrictions, and other factors. Such factors are certainly considered in other contexts when property is valued (see, e.g., Rev. Rul. 59-60 (discussing factors to be considered in valuing stock for estate and gift tax purposes), amplified by Rev. Ruls. 83-120, 80-213, and 77-287; Evans, 29 B.T.A. 710 (1934), acq. 1934-1 C.B. 6).
The time at which the interest is valued may be an issue. In Johnston, T.C. Memo. 1995-140, the Tax Court found that the taxpayer (the general partner in a limited partnership) had to recognize taxable income when he received a 1% interest in partnership capital. The 1% interest was shifted from the limited partners to the general partner and was described as compensation in partnership documents. The proper time for valuing the 1% interest was determined to be when all limited partners were on board, rather than at an earlier date when the partnership had been legally formed but not yet fully capitalized.Nonlapse Restrictions and Minority Ownership
A nonlapse restriction is a restriction on the property that, by its terms, will never lapse and that allows the transferee to sell only at a price fixed pursuant to a formula (e.g., book value or a percentage of gross revenues) (Sec. 83(d)(1)). In such cases, the price determined by taking into account the nonlapse provision will be the property's FMV for Sec. 83 purposes. A later cancellation of the restriction, however, can generate taxable income (Sec. 83(d)(2)).
While nonlapse restrictions are common when stock is transferred to employees, the practitioner considering using a nonlapse restriction in connection with the transfer of a partnership interest must be careful. The restriction will almost certainly be considered part of the partnership agreement and could affect the viability of partnership allocations under the substantial-economic-effect test.
Another factor that commonly affects the reported value of a transferred interest is a minority discount. A minority discount is most typically used when interests are transferred as part of an estate plan, but has equal validity in valuing any transferred interest. Generally, a minority discount reflects the minority status, lack of control, and limited marketability of a minority interest in the partnership. (In Rev. Rul. 93-12, the IRS agreed that minority discounts could apply even in a situation where other family members control the entity.) The courts have held that any discount must be supported by the facts of the specific case.
In the case of a transferred partnership interest, the IRS may throw out a minority discount and require valuation based on the liquidation value of the partnership interest, since some state statutes provide for the partnership's termination upon the withdrawal of a partner. In such cases, the value of the transferred interest will be the FMV of the partner's proportionate share of the partnership's assets. Taxpayers concerned about the inability to use discounts because of a partner's right to withdraw and receive payment for the interest should consider forming the partnership in a more restrictive state.Valuing Profits Interests
Most practitioners consider a profits-only interest in a partnership to have little or no present value. This concept is based on using a liquidation value approach to value the profits interest. According to the liquidation value approach, the profits-only partnership interest has little (or no) value because:
- The service partner has no initial interest in partnership capital—if the partnership is liquidated on the date the interest is transferred, the partner receives none of the liquidation proceeds.
- The future allocation of profits to the service partner is impossible to value, since such profits are contingent on a number of uncertainties.
Under Rev. Proc. 93-27, the receipt of a profits interest for services rendered by a partner is taxable in three situations. The valuation required in each situation is as follows:
- If the profits interest relates to a substantially certain and predictable income stream, the value of the interest will probably be the present value of the income stream.
- If the profits interest received is disposed of within two years of receipt, the value will probably be determined at the time of disposition and equal the value on the disposition date.
- If the profits interest is an interest in a publicly traded partnership, the value will probably be the market value of similar interests.
Under Prop. Regs. Sec. 1.83-3(l) and a proposed revenue procedure in Notice 2005-43, a partnership and all of its partners can elect to follow a set of safe-harbor valuation rules in which the FMV of a partnership interest transferred in exchange for the performance of services would equal the liquidation value of that interest for transfers on or after the date the regulations are finalized. However, until the proposed regulations are finalized, they are not effective. Likewise the rules in the proposed revenue procedure will not be effective until it is issued in conjunction with the final regulations.
Under these taxpayer-friendly rules, the FMV of a partnership interest transferred in connection with the performance of services is deemed to be equal to the liquidation value of that interest. Liquidation value means the amount of cash that the recipient of the compensatory partnership interest would receive if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going-concern value, and any other intangibles associated with the partnership's operations) for cash equal to the FMV of those assets and then liquidated.
A safe-harbor partnership interest is any interest in a partnership that is transferred to a service provider (either before or after the partnership's formation), provided the interest is not (1) related to a substantially certain and predictable stream of income from the partnership's assets (such as income from high-quality debt securities); (2) transferred in anticipation of a subsequent disposition; or (3) an interest in a publicly traded partnership within the meaning of Sec. 7704(b).
Warning: Unless it is established by clear and convincing evidence that the partnership interest was not transferred in anticipation of a subsequent disposition, the interest is presumed to be transferred in anticipation of a subsequent disposition if the interest is sold or disposed of within two years of the date of its receipt (other than a sale or disposition by reason of death or disability of the service provider).
The elective safe-harbor valuation rules apply when the following conditions are satisfied:
- The partnership must prepare a document (executed by a partner who has responsibility for federal income tax reporting) stating that the partnership is electing (on behalf of the partnership and each of its partners) to have the safe-harbor valuation rules apply irrevocably as of the stated effective date with respect to all partnership interests transferred in connection with the performance of services while the safe-harbor election remains in effect. The election must specify the effective date of the election, which cannot be prior to the date the election is executed. The election must be attached to the partnership's Form 1065, U.S. Return of Partnership Income, for the tax year that includes the effective date of the election.
- The partnership agreement must contain provisions that are legally binding on all of the partners stating that (a) the partnership is authorized and directed to elect the safe-harbor rules, and (b) the partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with the performance of services) agree to comply with all requirements of the safe-harbor rules with respect to all partnership interests transferred in connection with the performance of services while the election remains effective. If an amendment to the partnership agreement is required, it must be effective before the date on which a transfer occurs for the safe-harbor rules to apply.
- If the partnership agreement does not contain the provisions described in item 2 (or the provisions are not legally binding on all partners), each partner must execute a legally binding document stating that (a) the partnership is authorized and directed to elect the safe-harbor valuation rules, and (b) the partner agrees to comply with all requirements of the safe-harbor rules with respect to all partnership interests transferred in connection with the performance of services while the election remains effective. The document must be effective before the date a transfer occurs for the safe-harbor rules to apply.
- The partnership must retain the records necessary to indicate that an effective election has been made and remains in effect.
Vested vs. Nonvested Partnership Interests
Under the safe-harbor valuation rules, a partnership interest is treated as substantially vested if the right to the associated capital account balance equivalent is not subject to a substantial risk of forfeiture or the interest is transferable. An interest is treated as substantially nonvested only if, under the terms of the interest at the time of the transfer, the interest terminates and the holder may be required to forfeit the capital account balance equivalent that is credited to the holder under conditions that would constitute a substantial risk of forfeiture, and the interest is not transferable. If the service provider receives a partnership interest that is substantially nonvested, does not make a Sec. 83(b) election, and holds the interest until it substantially vests, the service provider recognizes compensation income in an amount equal to the liquidation value of the interest on the date the interest substantially vests, less any amount paid for the interest.
Impact of Sec. 83(b) Election
A service provider who receives a substantially nonvested partnership interest and makes a Sec. 83(b) election recognizes compensation income on the date of transfer equal to the liquidation value of the interest, determined as if the interest were substantially vested, less any amount paid for the interest. Under Sec. 83(h), the partnership is generally entitled to a deduction equal to the amount included as compensation income by the service provider.
Forfeiture of Compensatory Interests
Prop. Regs. Sec. 1.704-1(b)(4)(xii) provides detailed rules that address what happens when a Sec. 83(b) election is made and the affected partnership interest is subsequently forfeited. The rules cover the partnership and the person who makes the Sec. 83(b) election and later forfeits the partnership interest.Collective Impact of Proposed Rules
The big difference between the outcome under the existing rules and the outcome under the proposed new rules is that no partnership-level gain or loss is triggered by the compensatory transfer of the partnership interest. Typically, the outcome under the proposed rules will be preferable to the partners.
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 28th edition, by William D. Klein, J.D.; Sara S. McMurrian, CPA; and Linda A. Markwood, CPA; published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).
|Albert B. Ellentuck, Esq. is of counsel with King & Nordlinger LLP in Arlington, Va.|