Missed Sec. 83(b) elections: Partnership and LLC special issues

Editor: Alexander Semerano, CPA

Questions about missed Sec. 83(b) elections can arise when a company’s founder or other employee receives stock or other equity that is subject to vesting. The default tax rule under Sec. 83 for stock subject to vesting is that income will be recognized when the stock vests, at the value at the time of vesting. But if a Sec. 83(b) election is made, the recipient is taxed at the time of the grant of the stock, at its value at that time.

In many cases, making the election is an obvious choice, particularly for stock in early-stage startup companies that have low valuations. But in the hectic atmosphere of starting a company or closing on an investment, the task of making the election is sometimes overlooked, and there is generally only a 30-day window to notify the IRS of the election.

I previously wrote about potential solutions for taxpayers who missed making their Sec. 83(b) elections. That article provided an overview of the subject, and the examples involved employees receiving stock of a corporation. Although that analysis also applies to partnerships and limited liability companies (LLCs) taxed as partnerships, taxpayers may encounter partnership-specific issues and opportunities in addressing their Sec. 83 situations.

After first providing some background on Sec. 83, this discussion focuses on grants of profits interests in a partnership or LLC (both of which this item refers to as “partnerships”) and the relevance of Sec. 83(b) elections.

Sec. 83 generally

Not making a Sec. 83(b) election, or making it late, generally means that the receipt of the property that is subject to a substantial risk of forfeiture (e.g., corporate stock granted to employees subject to time-based vesting) will be taxed under the rules of Sec. 83(a). In such a case, the recipient will not need to recognize any taxable income upon receipt of the property, but when the vesting condition is met, the fair market value (FMV) of the property at the time of vesting becomes taxable income, taxable as compensation. This can be a double disadvantage: If the company has increased in value, the holder generally must take into account a greater amount of income at vesting than they would have had they made the Sec. 83(b) election, and such income is taxed as ordinary income rather than as, potentially, capital gain.

In contrast, if a Sec. 83(b) election is made, the holder of the property is taxed on the value at the time of transfer, which is generally low for startups (or at least a lot lower than the company hopes it will be in a few years), and any appreciation in the property after that will generally be taxed as capital gain upon a sale of the property (e.g., a sale of the company’s stock). Note that this tax treatment matches that of a grant of property that is not subject to vesting.

Special considerations for profits interests in a partnership or LLC

In some cases, the property subject to vesting will not be corporate stock but rather interests in a partnership. If those are profits interests, then the situation with respect to Sec. 83 is slightly different. In particular, the rules may present a “way out” for certain recipients who missed making a Sec. 83(b) election.

Defining a profits interest: The first question is, is it a profits interest? For these purposes, the universe of partnership interests can be divided into two nonoverlapping groups: capital interests and profits interests. Under Rev. Proc. 93-27, a capital interest is an interest in a partnership that would give the holder a share of the proceeds if the partnership’s assets were sold at FMV and the proceeds were then distributed in a complete liquidation of the partnership (this is generally determined at the time of receipt of the partnership interest). Anything that is not a capital interest is a profits interest.

In other words, a grant of a profits interest gives the recipient an interest only in the future profits of the partnership. Also derived from Rev. Proc. 93-27, the conceptual test for whether an interest is a profits interest is to model the following hypothetical: If the interest were granted, and the partnership liquidated immediately after the grant, paid off all creditors, and distributed the net proceeds, would the recipient of the interest be entitled to any proceeds of the liquidation? If yes, it is a capital interest. If no, then it is a profits interest.

Basic rules for profits interests: Rev. Procs. 93-27 and 2001-43 lay out the rules applicable to profits interests. The receipt of a capital interest in exchange for services is taxable as compensation under Regs. Sec. 1.721-1(b) (1) (and under general tax principles). However, prior to Rev. Proc. 93-27, courts were not consistent about whether the receipt of a profits interest was generally taxable and how the ability to value the profits interest factored into the tax analysis (see Section 3 of Rev. Proc. 93-27). The two revenue procedures clarify these issues.

In the case of a profits interest that is granted “for services provided to or for the benefit of the partnership,” Rev. Proc. 93-27 provides that the actual receipt of the interest will generally not be treated as a taxable event. Further, under Rev. Proc. 2001-43, if the profits interest is subject to vesting, then generally, the vesting of the profits interest will also not be treated as a taxable event (even if, at the time of vesting, the interest has a nonzero value). Finally, Rev. Proc. 2001-43 provides that no Sec. 83(b) election needs to be made with respect to a profits interest to get this tax treatment (unlike corporate stock).

Prerequisites: However, there are certain requirements for these revenue procedures to apply. For one, these rules do not apply if the recipient disposes of the profits interest within two years. The rationale seems to be that if the interest is worth something in two years, it was worth something at grant and that the value was reasonably determinable.

For another, if the profits interest relates to a “substantially certain and predictable stream of income from partnership assets,” such as a “highquality net lease” or “high-quality debt,” then these revenue procedures cannot be relied upon. Unfortunately, neither the IRS nor the courts have provided any further insight into what constitutes a “substantially certain and predictable stream of income,” “highquality debt,” or a “high-quality net lease.”

The reason for excluding partnership interests that relate to a predictable stream of income seems to be that if a recipient knows its future income with a high degree of certainty and is not taking on any entrepreneurial risk, then perhaps taxation upon receipt would be proper, because one could calculate the value of the interest (e.g., based on the discounted cash flows), and such value would be greater than zero.

The third exception stated in Rev. Proc. 93-27 is for limited partnership interests in a publicly traded partnership (as defined in Sec. 7704(b)). The rationale here seems to be that a publicly traded interest does have a reasonably determinable price, as set by the market. As an aside, in 2005, the IRS issued proposed regulations and a notice that would have changed the rules applicable to partnership profits interests, simplifying the rules overall and establishing a regulatory safe harbor that a partnership would need to elect into regarding how to value the interests but also requiring an affirmative Sec. 83(b) election (REG-105346-03). These regulations were never finalized and may not be relied upon, but it is possible that similar regulations will be introduced in the future.

Another consideration: One other situation that could cause issues is if the “profits interest” was actually a capital interest; for example, if the parties took the position that the value of the partnership at the time of grant was lower than it should have been.

To put numbers to it, if the parties claim the partnership is worth $1 million, then a profits interest should be entitled to nothing upon a hypothetical liquidation of the partnership immediately after grant. The recipient of the profits interest could share in future appreciation of the partnership to the extent the partnership’s value exceeded $1 million. But if the partnership were actually worth $5 million at the time of grant, then upon a hypothetical liquidation immediately after grant, instead of being entitled to zero proceeds, the recipient of the purported profits interest could be entitled to share in some of the preexisting $4 million of value (above the $1 million threshold), which is contrary to the definition of a profits interest.

Helping clients who receive profits interests

From a planning perspective, it may seem as though no Sec. 83(b) election is necessary for a partnership or LLC profits interest. However, the benefit of these revenue procedures is not guaranteed, due to the need to meet the requirements described above. The better course in most cases is to make a “protective” Sec. 83(b) election with respect to unvested profits interests; in other words, file the election as if your client could not rely on Rev. Proc. 93-27 and Rev. Proc. 2001-43 (even though you hope and expect them to apply). There is essentially no downside to a protective election, and that way, if the profits interest fails to meet the requirements of these revenue procedures (e.g., by being sold within two years of grant), the employee retains most of the hoped-for tax benefits: a zero or low initial tax bill in connection with the grant of the interest and the potential for long-term capital gains on all future appreciation.

From the perspective of representing an employee who missed making a Sec. 83(b) election, there may be good news. If the employee received a true profits interest in exchange for services, does not dispose of the interest within two years, the interest does not relate to the kind of predictable income stream noted, and the interest is not in a publicly traded partnership, then the employee generally should be treated the same way as if they had timely made a Sec. 83(b) election. However, employees may not always have control over the timing of their interest’s disposition or the assumed value of the partnership. In some cases, it may make sense to try to remediate their situation.

As I noted in my prior article, if you are up at night sweating over a client’s not making a Sec. 83(b) election, just keep calm — hope is not necessarily lost.

Editor Notes

Alexander Semerano, CPA, is a partner with Pease Bell CPAs in Cleveland.

For additional information about these items, contact Alexander Semerano at taxclinic@cpamerica.org.

Unless otherwise noted, contributors are members of or associated with CPA America.