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.

TRUST CONSIDERED TO BE A GRANTOR TRUST BASED SOLELY ON POWER TO PAY INSURANCE PREMIUMS ON LIFE OF GRANTOR

A grantor trust is a trust whose income is generally taxable to the grantor/settlor by reason of specific Internal Revenue Code provisions that mandate such treatment. In contrast, a nongrantor trust is a separate taxpayer whose income is generally taxable either to the trust itself and/or its beneficiaries and not the grantor.

Code Section 677(a)(3) is one of those provisions that gives rise to grantor trust status. It provides that a trust will be a grantor trust if its income, without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse. There is case law to the effect that where no insurance policy is owned by the trust, the mere power to purchase a policy and pay premiums is not enough to create grantor trust status. Thus, there is uncertainty as to when and how these provisions apply. Do they if the trust does not own an insurance policy? Do they apply only to the extent that trust income is applied to premium payments? There is conflicting authority on these questions.

A recent IRS field advice (LAFA 20062701F) muddies the water further. In the advice, a trust explicitly allowed the use of trust funds to purchase life insurance on the life of the grantor. The trust funds were used to pay premiums on life insurance on the life of the grantor, but the trust was not the owner of the policy. The advice concludes that a grantor trust existed - it was enough that the trust was authorized to pay the premiums - it did not have to own a life insurance policy to give rise to grantor trust status.

INTERNAL REVENUE CODE PROVISION FOUND UNCONSTITUTIONAL

While taxpayers may often assert constitutional arguments against the enforcement of the Internal Revenue Code, the actual finding of a provision to be unconstitutional is an extremely rare event. Subject to possible review by the U.S. Supreme Court, the U.S. Circuit Court of Appeals for the District of Columbia circuit did just that in the recent case of Murphy v. United States, No. 05-5139.

For the nonlawyers, a little constitutional background is helpful. Until the 16th Amendment to the U.S. Constitution was enacted, an income tax was not allowed. The 16h Amendment allows a tax on income, and Section 61 of the Internal Revenue Code imposes such a tax on "gross income." The U.S. Supreme Court in Helvering v. Clifford has found these provisions coextensive. It has further found that "income" means "gain derived from capital, from labor, or from both combined" (Eisner v. Macomber), and further includes all "accessions to wealth" (Commissioner v. Glenshaw Glass).

The issue in the instant case was whether a damage award for mental distress is "income" when not arising from a physical injury or physical sickness. Section 104(a) of the Code provides that gross income does NOT include the amount of damages (other than punitive damages) received on account of physical injury or physical sickness. In 1996, Congress amended the Section to further provide that "emotional distress shall not be treated as a physical injury or physical sickness" - so that mere emotional distress would not fall within the Section 104(a) exclusion from gross income.

The taxpayer challenged the 1996 amendment, claiming that the new provision is unconstitutional since by treating emotional distress damages as income, Congress is including as income something that is not income under the 16th Amendment authorizing a tax on income. The Circuit Court noted that Congress does not have the power to declare any economic benefit as income, but is bound by what was intended to be included as income under the 16th Amendment. After reviewing interpretations of the term "income" from around the time of the enactment of the 16th Amendment in 1913, and that damages for emotional distress are similar to physical damages in that they are a return of damaged "human capital" and not an asccession to wealth, the Circuit Court held that Section 104(a) is unconstitutional to the extent "it permits the taxation of an award of damages for mental distress and loss of reputation."

This finding has far reaching consequences in the area of employment law, where damages often relate to mental distress without any physical sickness or illness.