Saturday, September 09, 2006

SECTION 83(b) ELECTION RISK FOR PARTNERSHIP INTERESTS

A recent article notes a risk for a Code Section 83(b) election for partnership interests received for services.

Persons performing services for a partnership (or LLC taxable as a partnership) often receive an interest in the partnership as incentive compensation. When issued, the person performing the service may be obligated to provide continued services for the partnership - otherwise the partnership may be able to take back the partnership interest. Section 83 of the Internal Revenue Code indicates that the service partner need not recognize compensation income when the partnership interest is issued, due to it being subject to a "substantial risk of forfeiture" (provided it is also not transferable free of the risk of forfeiture). Instead, the service provider can defer income taxes for the receipt of the interest until the risk of forfeiture lapses or terminates.

There is a risk that the value of the partnership interest may increase signficantly between its issuance and when the substantial risk of forfeiture may lapse (and thus increase the compensation income to the service partner). To avoid the risk of such increased taxation, the service partner can make an election to be taxed on the receipt of the interest when it is received (at the value at the time of issuance) under Code Section 83(b).

The tax risk of such an election relates to what occurs if the service partner has to surrender the interest due to not continuing to provide services. Per Treas.Regs. Section 1.83-2(a), at the time of a forfeiture of the interest the service provider can recognize a loss (presumably a capital loss) to the extent of what the service partner paid for the interest over what the service partner is paid for the interest upon the forfeiture (if anything). The problem with this rule is the service provider gets no credit/loss for the ordinary income incurred by the service provider at the time of the Section 83(b) election. Further, it does not allow for any adjusted basis (and thus loss) relating to any increase in tax basis in the forfeited partnership interest that arose while the partnership interest was owned by the service partner due to being allocated his or her share of partnership income from the partnership under the partnership tax rules.

Example: A taxpayer receives a partnership interest that is subject to being forfeited if he does not work for the partnership for 5 years. The taxpayer elects to be taxed upon receipt of the partnership interest at a time that the interest is worth $50,000 - largely because he believes the partnership interest could be worth at least $200,000 in 5 years when he would otherwise be taxed for the receipt. In year 3, the taxpayer ceases to work for the partnership and has to return his partneship interest. In years 1-3, the taxpayer was allocated $30,000 of partnership income on his partnership interest, all of which he included in income. No partnership distributions were made to him during the term. According to the regulation, at the time of the forfeiture, the taxpayer has no loss from the forfeiture, since he paid nothing for his interest. He does not get a loss for the $50,000 in compensation income he received, nor does he get a loss for the $30,000 in partnership income that was allocated to him during the term.

This risk of not being able to get a loss for income so earned needs to be considered in making a determination whether to make a Section 83(b) election.

Source: Article by Richard Harris in March/April 2005 issue of Business Entities.
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