Lynn F. Chandler Smith Moore Leatherwood LLP

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1 GRANTS OF PARTNERSHIP INTERESTS AS COMPENSATION FOR SERVICES 2010 South Carolina Bar Convention Probate, Estate Planning & Trust/Tax Law Section Seminar January 22, 2009 Lynn F. Chandler Smith Moore Leatherwood LLP I. Profits Interests vs. Capital Interests A. Distinguishing Between a Profits Interest and a Capital Interest 1. Two factors are used to identify a capital interest. a. A right to a distribution if the partnership interest were liquidated at fair market value immediately after receipt. (1) Treas. Reg (e)(1)(v) dealing with family partnerships provides: a capital interest in a partnership means an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership. (2) Case law also adopts Treas. Reg (e)(1)(v) approach. See Mark IV Pictures, Inc. v. Comm r, 969 F.2d 669 (8 th Cir. 1992), aff g 60 T.C.M (1990) (general partners right to receive 50% of any distribution of capital upon hypothetical liquidation constituted capital interest). (3) Careful drafting of partnership and operating agreements needs to consider that default provision under many LLC and partnership statutes provides that all interests are equal. i. Cf. S.C. Code Ann (a) ( Any distributions made by a limited liability company before its dissolution and winding up must be in equal shares. ) and S.C. Code Ann ( Distributions of cash or other assets of a limited partnership must be allocated among the partners, and among classes of partners, in the

2 manner provided in writing in the partnership agreement. If the partnership agreement does not so provide in writing, distributions shall be made on the basis of the value (as stated in the partnership records required to be kept pursuant to Section ) of the contributions made by each partner to the extent they have been received by the partnership and have not been returned. ) ii. Cf. S.C. Code Ann (b) ( After application of subsection (a), and if the company is required to maintain capital accounts for its members as contemplated by the Internal Revenue Code, as defined in Chapter 6 of Title 12 and applicable treasury regulations, all remaining cash and other assets must be distributed to the members in accordance with their positive capital account balances, determined after taking into account all capital account adjustments for the taxable year of the company during which the distribution occurs, including adjustments for distributions made pursuant to this section. ) and S.C. Code Ann (3) ( except as provided in the partnership agreement, to partners first for the return of their contributions and secondly respecting their partnership interests, in the proportions in which the partners share in distributions. ) b. An interest in partnership capital as reflected by a positive balance in the capital account immediately after receipt. 2. Absent liquidation rights and a positive capital account, a partner has only an interest in future partnership profits and the partnership interest will be treated as a profits interest. B. Differences in Tax Treatment: 1. Grant of a capital interest in exchange for services (which cannot be characterized as property under 721) is currently taxable to the service provider as compensation. a. Treas. Reg (b)(1) provides, in pertinent part: 2

3 ... 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.... (emphasis added) b. Diamond v. Comm r, 492 F.2d 286 (7 th Cir. 1974) involved an unsuccessful attempt to rely on the regulations under section 721 to characterize an interest in 60% of partnership profits as not taxable upon receipt. c. Service provider will be taxed on partnership interest as compensation when received even if it relates to future services. Service provider s basis in partnership interest and capital account will be adjusted to reflect the compensation. Treas. Reg (d)(1), (a)(1) and (b)(1). 2. Grant of a profits interest in exchange for services is generally taxable to the service provider as partnership profits are reported and allocated to the service provider by the partnership. See Campbell v. Comm r, 943 F.2d 815 (8 th Cir. 1991) rev g 59 T.C.M. 936 (1990) (relying on section 707(a) in concluding that profits interest for services provided in capacity of a partner is not taxable upon receipt). II. Current Tax Treatment of Partnership Interests Received in Exchange for Services A. Rev. Proc , C.B. 343 represents IRS current position on tax treatment: 1. Capital interest is 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. 2. All other partnership interests are profits interests and receipt of such an interest will not be a taxable event. 3

4 3. Determination as to whether an interest is a capital interest is to be made at time of receipt. No distinction is made between past and future services. 4. Implicit in Rev. Proc is that taxable income is realized by the service provide through an allocation of future partnership income and appreciation in partnership assets. This principle results in the service provider being taxed on income that retains its character as ordinary income, capital gain or tax- exempt income. See Wheeler v. Comm r, 37 T.C.M. 883 (1978) (taxpayer s contribution of know- how in exchange for share of profits was a partnership relationship and not that of employer- employee so that taxpayer s share of profits retained its character as capital gain and not compensation for services). 5. Exceptions to Rev. Proc : a. Three exceptions appear to be based on facts of Diamond case: (1) Profits interest relates to a substantially certain and predictable stream of income from partnership assets; (2) Partner disposes of the profits interest with two years after receipt; or (3) Partnership is a publicly traded partnership. b. Rev. Proc provides no guidance on tax treatment of partnership interests that fall within these exceptions. There is no mention of section 83 or the ability to make an election under section 83(b). 6. Grants of capital interests in exchange of services should be rare in view of IRS position under Rev. Proc B. Rev. Proc , I.R.B. 191 (8/20/2001) clarifies Rev. Proc and provides that the determination as to whether or not a partnership interest is a capital interest is to be made at the time of receipt even if the partnership interest is substantially nonvested within the meaning of Treas. Reg (b). 1. To be eligible for protection of Rev. Proc : a. Profits interest must satisfy all conditions of Rev. Proc ; b. Service provider must be treated as a partner by the partnership and its partners; and 4

5 c. The partnership must not claim a compensation or other deduction on the grant date or the vesting date. 2. A protective section 83(b) election should be considered if there is any concern regarding whether or not the interest fits within the conditions of Rev. Proc C. Proposed REG , 70 Fed. Reg (5/24/05) would prescribe rules on the application of section 83 to partnership interests and the tax treatment of the transfer, vesting and forfeiture of partnership interests granted to service providers in exchange for services. 1. Proposed REG , 68 Fed. Reg (1/22/03) proposing regulations on the federal income tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest and the exchange of a preferred interest in a partnership for a common interest in the same partnership are withdrawn. 2. New proposed regulations under section 83 would obsolete The proposed regulations would reconcile the existing conflict between the existing regulations under section 707(c) by treating partnership interests issued to partners in exchange for services as guaranteed payments except to the extent inconsistent with the timing rules of section 83. See. D. Notice , I.R.B (6/13/2005): 1. Proposed Revenue Procedure would establish a safe harbor under proposed Treas. Reg (l) for transfer of partnership interests in exchange for services: a. Partnership and all partners may elect a safe harbor electing to treat the fair market value of a partnership interest transferred in connection with the performance of services as equal to the liquidation value of that interest.; b. Effective for transfers after the date final regulations are published in the Federal Register; and c. Partnership agreement must have provisions authorizing the election of the safe harbor and requiring all partners to comply with the requirements of the safe harbor (or all partners must execute a document authorizing the election and agreeing to comply with the requirements of the safe harbor). 5

6 2. Taxpayers may not rely upon the safe- harbor in the proposed revenue procedure and should continue to rely on Re. Proc and current law until such time as the revenue procedure is finalized. III. Other Considerations Affecting Tax Treatment A. Potential for Disguised Compensation under Section 707(a)(2)(A) 1. Distributive share of partnership income allocated or distributions of partnership assets to a partner may be recharacterized as disguised compensation where...the performance of such services (or such transfer) and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership.... Section 707(a)(2)(A)(iii). 2. Principal concern of 707(b)(2)(A) was to address situation where expenditures required to be capitalized were effectively converted into deductible expenses. Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 227 (1984) ( 1984 Bluebook ). 3. Legislative history lists five factors relevant to determining whether or not a service provider is receiving an allocation of partnership income or a distribution of partnership assets as a partner or as a non- partner: a. Significant entrepreneurial risk as to amount that is dependent upon success of the partnership s business venture. Specific concerns suggest that risk is not present in the following: (1) Capped allocations reasonably expected to be met. (2) Allocations for a fixed number of years. (3) Allocations of gross income of short duration. See Pratt v. Comm r, 550 F.2d 1023 (5 th Cir. 1977). b. Transitory partnership status (but continuing partnership status is not particularly relevant); c. Allocations that are close in time to provision of services (as opposed to allocations over an extended period that are remote in time to the services provided). 6

7 d. Motivation to become a partner was to obtain tax benefits not otherwise available as a third- party (but non- tax motivations are not particularly relevant). e. Value of interest in continuing partnership profits is small in relation to the allocation in question (but existence of a substantial interest in continuing profits does not suggest the arrangement is that of a partner- partnership) Bluebook, Timing of recognition of income for partnership interests received in a non- partner capacity will depend upon method of accounting of recipient rather than the partnership s method. a. Cash method service provider taxed on guaranteed payments as partner under partnership s accrual method of accounting. b. Section 267(e) requires partnership to use service provider s method of accounting for deduction of amounts paid or allocated to a partner having a profits interest even in a non- partner capacity unless the partner has no other interest in the partnership. However, the deduction may also be delayed by rules under section 83 and section Section 707(a)(2)(A) is inapplicable to situations where the partnership interest is received from another partner for services provided for the benefit of the transferring partner. However, service provider will be immediately taxable upon receipt of the interest based upon its fair market value. B. Disguised Capital Shifts - Bookup of Capital Accounts to Reflect Unrealized Gains 1. Rev. Proc reference to sale of partnership assets at fair market value in determining whether or not a partnership interest is a capital interest indirectly eliminates potential for a disguised shift of capital. 2. For an existing partnership, unrealized gains should be allocated to continuing partners under a reverse 704(c) approach in order to avoid a capital account shift that would constitute compensation. See Treas. Reg (b(2)(iv)(d). 3. The capital account maintenance rules require revaluations of partnership property upon certain events that now include the grant of a partnership interest in exchange for services: 7

8 In connection with the grant of an interest in the partnership (other than a de minimis interest) on or after May 6, 2004, as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner. Treas. Reg (b)(2)(iv)(f)(5)(iii). C. Conditional Capital Interest vs. Profits Interest 1. A grant of a capital interest upon the satisfaction of a condition (e.g., upon the completion of 1 year of employment or the attaining of specified financial objectives) is not a taxable transfer until the condition is satisfied. Treas. Reg (e)(unfunded, unsecured promise to pay money or property). 2. Distinction between conditional grant of capital interest and present transfer of capital interest subject to substantial risk of forfeiture will depend upon language of grant. a. An agreement to perform future services in exchange for promise to grant partnership capital interest upon satisfaction of certain conditions was a conditional promise not taxable until partnership capital interest was actually transferred to the service provider. U.S. v. Frazell, 335 F.2d 487 (5 th cir. 1964), reh g denied, 339 F.2d 885 (5 th Cir. 1964), on remand, 296 F.Supp. 885 (W.D. La. 1967). b. A conditional agreement to transfer partnership interest as compensation for past services was not taxable until actual transfer in the future. Vestal v. U.S., 498 F.2d 487 (8 th Cir. 1974). c. A law firm s interest in a partnership holding estate claims contributed by heirs was a mere promise to pay compensation in a contingency fee agreement. The law firm s interest in the partnership did not vest until the services for the prosecution of those claims were completed and, therefore, the law firm was not taxable on the partnership interest under section 83 until the services were completed. FSA The time at which the service provider becomes a partner will depend upon the distinction and could affect whether or not the partnership interest is viewed as a profits interest or a capital interest. 8

9 4. Consideration should be given to whether or not partnership status is advantageous, such as the rules under Section 707 relating to disguised sales. D. Applicability of Section 409A and Section 83 Rules 1. Notice , Q&A 7, I.R.B. 274 (1/10/2005) provides interim guidance on application of Section 409A to transfers of partnership interests in exchange for services: Specifically, until additional guidance is issued, for purposes of section 409A, taxpayers may treat an issuance of a profits interest in connection with the performance of services that is properly treated under applicable guidance as not resulting in inclusion of income by the service provider at the time of issuance, as also not resulting in the deferral of compensation. Similarly, until additional guidance is issued, for purposes of section 409A, taxpayers may treat an issuance of a capital interest in connection with the performance of services in the same manner as an issuance of stock. 2. Prop. Regs (b)(4)(xii), REG , 70 Fed. Reg (5/24/05) would apply section 83 to all transfers of partnership interests in exchange for services. Absent an election under section 83(b), the service provider would not be treated as a partner for federal income tax purposes until the partnership interest became substantially vested. IV. Future Legislative Changes A. Legislation introduced in the 110 th Congress: 1. H.R (Levin, Rangel, Stark, McDermott, Lewis (GA), Neal, Pomeroy, Larson (CT), Blumenauer, Kind, Pascrell, Frank (MA), and Jones (OH)) would generally treat net income from an interest held by a person who provides services to an investment services partnership as compensation income taxed at ordinary income rates and subject to self- employment tax. The services to which this would apply are: (i) advising the partnership as to the value of or advisability of investing in, purchasing, or selling a specified asset, (ii) managing, acquiring, disposing of or arranging financing with respect to specified assets, or (iii) activities that support the foregoing services. Specified assets include securities, real estate, commodities, options or derivative contracts with respect thereto. 2. S (Baucus and Grassley) and H.R (Welch) would provide an exception from corporate tax treatment of a publicly traded 9

10 partnership that derives income, directly or indirectly, from investment advisory or related asset management services. 3. H.R (Rangel) would require investment fund managers to treat carried interest as ordinary income received as compensation for the performance of services to the extent it did not reflect a reasonable return on invested capital, but would continue to tax carried interest at capital gain tax rates to the extent it reflected a reasonable return on invested capital. Section 1201 of this bill would add a new section 710 to the Internal Revenue Code. B. Major Tax Issues in the 111 th Congress 1. The current Administration s budget plan includes a provision to revise the taxation of carried interest that would tax capital gains of investment managers as compensation subject to tax at ordinary income rates. 2. H.R (Levin) would treat the carried interest of investment fund managers as ordinary income subject to self- employment taxes rather than capital gains. This bill is similar to H.R and also provides for the addition of new section 710 to the Internal Revenue Code but makes changes to the invested capital exception to continue the tax treatment of allocations to a qualified capital interest. 3. Treasury recently announced that the Administrations proposal on changes the tax treatment of carried interests would apply broadly to all partnership interests received in exchange for services. CHARLOTTE

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