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Sunday, March 26, 2006

NEW RULES FOR PARTNERSHIP AND LLC PROFITS INTERESTS RECEIVED FOR SERVICES

Oftentimes, people working with a partnership are granted an interest in the “profits” of the partnership. For many years, there was substantial uncertainty, engendered by contradictory case law, as to whether a recipient of a profits interest is taxed upon receipt and how much they should be taxed. In Rev. Proc. 93-27 4 and Rev. Proc. 2001-43, the IRS resolved much of the uncertainty by holding that when the following four criteria are met, the issuance of a profits interest for services rendered generally will not trigger income to the service provider (and no compensation deduction to the partnership).

The four criteria to be met are (1) there is no substantial and predictable income stream, (2) the profits interest is not sold for two years, (3) the partnership interests are not publicly traded, and (4) the partnership treats this incoming individual as a partner. Testing for these criteria is made at the date of issuance of the profits interest, whether such interest is vested or not. No election to treat such an interest as vested needs to be made - the IRS, in effect, deems a Section 83(b) election to have been made in such circumstances. As to the partnership income allocable to the unvested interest, the widely-accepted view has been to treat such unvested share of allocable profits as taxable income to the service recipient.

The Revenue Procedures did not address all questions regarding treatment of profits interests. For example, they did not address what happens when the individual holding an unvested interest terminates employment prior to vesting - what happens to the build-up of previously taxed but unvested and undistributed income?

In an effort to address some of these issues, in 2005 the IRS issued proposed regulations and a proposed revenue procedure that alter somewhat the rules of the Revenue Procedures. In them, the IRS adopts a Section 83 analysis. For recipients of an interest that is subject to a substantial risk of forfeiture (such as being forfeited if they cease to work for the partnership), the recipient of the profits interest must make a decision whether to make a Section 83(b) election (a Section 83(b) election is an election to immediately include in income at its fair market value the value of property received for services that would otherwise not be subject to immediate taxation because subject to a substantial risk of forfeiture).

If the election is made, the recipient is taxable immediately on the value of the interest received, and is then treated as a partner for all purposes even if the partnership interest remains subject to a substantial risk of forfeiture. If the election is not made, the recipient is not taxed on receipt of the interest until it vests (the substantial risk of forfeiture terminates) and is allocated ordinary income on any actual distributions made to the holder from the partnership.

At least in regard to when the Section 83(b) election is made and the recipient is taxed on receipt of the interest, the proposed rules have two methods of valuation. Under the liquidation approach, which generally is available in situations similar to the four criteria under the current proposed regulations, the received interest is valued at the value of property that would be received by the recipient partner if the partnership was immediately liquidated - this will typically result in a zero value.

Under the second valuation method, if the liquidation value rules are not used, then more traditional fair market valuation rules must be applied.

For a more detailed discussion of these issues, see Prop. Regs. Tackle Compensatory Partnership Interest Issues, by Magda B. Szabo, Practical Tax Strategies (April 2006), from which much of the foregoing has been obtained.
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