The complex simplicity of partnership interests exchanged for services

Editors: Alexander J. Brosseau, CPA, and Greg A. Fairbanks, J.D., LL.M.

The taxation of the grant of a partnership interest exchanged for services is not a new topic. Partnership interests have been used to compensate and incentivize partners for many years. However, the terms and provisions found in award and partnership agreements continue to evolve, leaving even the seasoned practitioner with the need to recognize factual elements that may lead to unanticipated tax results.

This item examines two common compensatory partnership interest scenarios for which the likely tax treatment may, for some, be unanticipated: an interest sought to be a profits interest that risks being viewed as a capital interest, and an interest that might not actually qualify as a partnership interest but instead might be properly viewed as compensation income.

Treatment of compensatory partnership interests

Before considering the scenarios, a review of current guidance that may be relevant in determining the tax treatment of partnership interests exchanged for services may be helpful. The receipt of an interest in the capital of a partnership in exchange for services does not qualify for nonrecognition treatment under Sec. 721(a). Rather, receipt of a capital interest for services provided to a partnership is taxable to the service provider currently as compensation. Specifically, Regs. Sec. 1.721–1(b)(1) provides:

To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61. The amount of such income is the fair market value of the interest in capital so transferred, either at the time the transfer is made for past services, or at the time the services have been rendered where the transfer is conditioned on the completion of the transferee’s future services.

Regs. Sec. 1.721–1(b)(2) further provides that “to the extent that the value of such interest is: (i) compensation for services rendered to the partnership, it is a guaranteed payment for services under section 707(c).”

Rev. Procs. 93–27 and 2001–43 provide long–standing safe–harbor guidance shielding both the partner and the partnership from having a taxable event when a partner receives a partnership profits interest in exchange for services. Rev. Proc. 93–27 provides that the receipt of a partnership profits interest for services to or for the benefit of a partnership is not a taxable event so long as the person receives that interest either in a partner capacity or in anticipation of being a partner and certain conditions are met. Those conditions are: (1) The profits interest does not relate to a substantially certain and predictable stream of income from partnership assets; (2) the partner does not dispose of the partnership interest within two years of receipt; and (3) the profits interest is not a limited partnership interest in a publicly traded partnership within the meaning of Sec. 7704(b) (see Rev. Proc. 93–27, §4).

Rev. Proc. 93–27 defines a profits interest as “a partnership interest other than a capital interest.” The revenue procedure defines a capital interest 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 generally is made at the time of receipt of the partnership interest.” Rev. Proc. 2001–43 provides a clarification to Rev. Proc. 93–27 by addressing the situation where the granted partnership profits interest is substantially nonvested.

Rev. Proc. 2001–43 provides that “whether an interest granted to a service provider is a profits interest is … tested at the time the interest is granted, even if, at that time, the interest is substantially nonvested.” Rev. Proc. 2001–43 includes all of the criteria in Rev. Proc. 93–27 and additionally requires that (1) the partnership and the 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 in computing the service provider’s income tax liability for the entire period during which the service provider has the interest; and (2) upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value (FMV) of the interest.

Per Rev. Proc. 2001–43, “where a partnership grants a profits interest to a service provider in a transaction meeting the requirements of [Rev. Proc. 2001–43] and Rev. Proc. 93—27, the [IRS] will not treat the grant of the interest or the event that causes the interest to become substantially vested (within the meaning of section 1.83–3(b) of the Income Tax Regulations) as a taxable event for the partner or the partnership.” Further, per Rev. Proc. 2001–43, taxpayers to which the revenue procedure applies “need not file an election under section 83(b) of the Code.”

In practice, taxpayers often make a Sec. 83(b) election anyway to protect themselves against the possibility that not all the safe–harbor conditions are met, which would potentially result in taxation at receipt or vesting. A Sec. 83(b) election enables a service provider to elect to include in gross income the excess (if any) of the property’s FMV at the time of transfer (i.e., the grant) over the amount (if any) paid for the property as compensation for services, rather than at the first time that the transferee’s rights in the property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.

Without a Sec. 83(b) election, the general rule of Sec. 83(a) applies — that is:

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 (determined without regard to any restriction other than a restriction which by its terms will never lapse) 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, 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 first taxable year in which 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 is applicable.

Often, the FMV on the date of grant is viewed as being zero, as opposed to a potentially higher value when the partner is fully vested in the arrangement. However, the value of a partnership interest may be determined using different valuation approaches and does not necessarily tie to liquidation value (i.e., the amount a person would receive with respect to the interest if, immediately after the transfer of the interest, 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).

Note that proposed regulations on partnership equity for services published in 2005 (REG–105346–03, 70 Fed. Reg. 29675 (May 24, 2005)) would provide for an election to treat the FMV of partnership interests provided to service providers as being equal to the liquidation value of those interests. Concurrently with the publication of those proposed regulations, the IRS released Notice 2005–43, which provided a proposed revenue procedure that would set forth additional rules to follow when the election under the proposed regulations is made. The proposed regulations have not been finalized, and the revenue procedure proposed in Notice 2005–43 has not been issued. Once Notice 2005–43 is finalized, Rev. Procs. 93–27 and 2001–43 will be obsolete. Until that time, taxpayers may rely upon Rev. Procs. 93–27 and 2001–43.

Example scenarios and their tax implications

With that brief background on some of the relevant guidance, consider the following common scenarios.

Scenario 1: Partnership AB is held 50/50 by Partner A and Partner B. Partner A contributes $100,000 cash for its 50% interest in the partnership, and Partner B contributes services in exchange for its 50% interest in the partnership. Partnership AB liquidates in accordance with the distribution provisions of the partnership agreement rather than in accordance with positive capital account balances. The distribution provision provides for Partners A and B to share 50/50 in all distributions. There is no separate award or services agreement that provides any terms related to Partner B’s 50% interest in exchange for services (e.g., what services will be provided, or any time vesting or performance–related metrics that must be met in order to receive the benefits of the partnership interest). There are no plans for Partner B to dispose of their partnership interest within two years. Partners A and B agree that Partner B’s interest is intended to be a profits interest and had a value of $0 when it was granted. Partner B did not file a Sec. 83(b) election because Partner B viewed their interest as fully vested.

In evaluating the tax treatment of Partner B’s interest, a threshold question practitioners should consider is whether a profits interest versus capital interest has been received in exchange for services. The distribution section of the partnership agreement provides that the partners share 50/50 in all distributions, with the result that Partner A does not have a right to a return of capital before Partner B starts to share in distributions. Applying the definition of a capital interest from Rev. Proc. 93–27, it appears that Partner B would receive a share of the proceeds if the partnership’s assets were sold at FMV and the proceeds were distributed in a complete liquidation of the partnership immediately after the grant of the partnership interest. As a result, Partner B appears to have received a capital interest in exchange for services. The fact that the partners intended for the interest to be a profits interest does not control.

In accordance with Regs. Sec. 1.721–1(b), the FMV of the partnership interest received for services constitutes income to Partner B. No cash is exchanged in this scenario, but if the partnership were to liquidate, Partner B would be entitled to 50% of the value of the assets. Immediately after the transaction, presumably, the only value in the partnership is the $100,000 cash that Partner A contributed. In order for Partner B to receive a 50% value in the partnership, there is an apparent capital shift from Partner A to Partner B of $50,000. This shift is not derived from partnership profits but rather from Partner A giving up the right to be repaid 50% of his contributions. As such, Partner B appears to have an income realization event of $50,000, and the partnership appears to have a $50,000 deduction.

The Tax Court came to a similar conclusion in Lehman, 19 T.C. 659 (1953), where Harry Lehman was the general partner of a limited partnership and operated its business. Pursuant to the partnership agreement, Lehman and his wife, Florence, were entitled to an increase in their capital accounts of $5,000 each (totaling $10,000) when certain performance targets were met. The accounting entries made to effect this provision were an increase to the capital account of each of the Lehmans and a decrease to the capital accounts of the other partners in the partnership.

The Tax Court held that, while no cash exchanged hands, the Lehmans had an income event on the date that all contingencies of the partnership agreement were met and they were entitled to the additional capital under the terms of the partnership agreement. As such, the Lehmans were required to report the $10,000 shift in capital as income.

Scenario 1A: What if the facts of Scenario 1 were changed slightly to include a return of capital to Partner A before Partner B shares in 50% of any distributions? If Partner A receives their capital before Partner B starts to share, it does not appear that Partner B would be entitled to any proceeds immediately after the grant of the interest.

This slight change of facts (and economics) appears to change the partnership interest transferred from a capital interest to a profits interest. Alternatively, if the partnership agreement included a distribution amount threshold to Partner A (e.g., the amount of Partner A’s contribution or a higher amount), needed before Partner B can participate in distributions, then Partner B ought not to be viewed as receiving an entitlement to Partner A’s capital. Another alternative is to modify the liquidating distribution provision so that the partnership liquidates in accordance with positive capital account balances. This change in the liquidating distribution provision also ought to ensure that Partner A’s capital does not shift over to Partner B at formation.

However, the potential result under one of these alternatives should be tested by modeling the partnership agreement provisions to ensure that no distributions otherwise would be made to Partner B immediately after the grant of this interest.

Scenario 1B: If Partner B’s interest in Scenario 1A included vesting provisions, then Rev. Proc. 2001–43 can be used to determine the tax consequences to Partner B and Partnership AB. Applying the previously noted criteria of Rev. Procs. 93–27 and 2001–43, Partner B appears to meet the safe–harbor criteria, and, as a result, the receipt of the profits interest would not be a taxable event to Partner B or PartnershipAB.

If Partner B did not continue to meet one of the safe–harbor criteria (e.g., if the profits interest was disposed of within two years), having an election under Sec. 83(b) in effect could be beneficial. If a Sec. 83(b) election is not made and Partner B does not meet the safe–harbor requirements of Rev. Procs. 93–27 and 2001–43, Partner B would be required to determine the FMV of the partnership interest when they are no longer subject to vesting conditions. This value could be significantly higher than the $0 FMV that was sought to be assigned on the date of grant.

Scenario 2: Partnership EF issued two types of award units, PI and PH. Both PI and PH units are placed in the same tier in the distribution waterfall from a numerical perspective, with the same language on time and performance vesting and restrictions on receiving distributions until a disposition by the partnership of all or substantially all of its assets (a disposition transaction), but those are their only common features. PI unit holders are allowed to keep the vested portion of their interest should they cease being employed (as a “good leaver”) by the partnership before the partnership engages in a disposition transaction and have rights as members of the partnership under local law (e.g., the right to vote). PH unit holders, on the other hand, must be employed by the company when the disposition transaction occurs in order to receive something and do not have any rights as a member under local law, ever.

This scenario requires understanding who is treated as a partner in a partnership and what rights a service provider has under the partnership agreement. While the PH units do have some rights under the partnership agreement with respect to a disposition transaction, the PH unit holders must be employed by the company when the disposition transaction occurs in order to receive a distribution. When met with this type of arrangement in a partnership, a practitioner should review the partnership agreement to further identify what rights the PH unit holders have under the partnership agreement. Did the unit holders sign an addendum to the partnership agreement or otherwise agree to comply with its provisions? Do the PH unit holders have a right to inspect the books and records of the partnership or have any voting rights?

Additionally, the Tax Court set forth a list of factors in Luna, 42 T.C. 1067 (1964), that is often used to determine whether an arrangement is a partnership for tax purposes and the individuals involved in the arrangement are partners. The case provides eight factors, none of which is conclusive: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, that each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and co–proprietor, sharing mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise (Luna, 42 T.C. at 1077—78).

The arrangement for the PH units in Scenario 2 might more closely align with that of a phantom equity plan by a corporation rather than the receipt of partnership units that would entitle a PH unit holder to a distributive share allocation from the partnership. Phantom equity, as the name suggests, is not actual equity in the corporation but does mirror the economic benefits and appreciation of actual equity. A holder of phantom equity receives the benefits of the phantom equity when certain performance targets are met. Phantom equity generally does not meet the definition of “property” in Sec. 83 and likely is treated as deferred compensation (rather than a distributive share) and may need to be analyzed for compliance with Sec. 409A and the regulations thereunder. Phantom equity is generally considered to be an unfunded and unsecured promise for payment in the future.

Partnership interests exchanged for services remain an effective incentive

Partnership interests exchanged for services have been and will continue to be an effective way for companies to incentivize and reward their partners. Often, these partnership interests seem uncomplicated and easy to grant. However, as this item has discussed in limited fashion, there may be numerous issues that arise regarding their taxation. Thus, advisers and advisees alike need to tread carefully, ensuring they understand the guidance in this area as well as the specific facts of their arrangement.

Editors

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Deloitte Tax LLP or Grant Thornton LLP as noted in the byline.

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