Proposed Rules Could Affect Tax Treatment of Compensatory Partnership Interests

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September 14, 2005

The IRS and Treasury recently issued proposed regulations and a notice of a proposed revenue procedure (Notice 2005-43) relating to the federal income tax treatment of the receipt of partnership interests in connection with the performance of services. Although not effective until they are published in final form, these rules could have significant implications for any compensatory arrangement involving partnership profits interests.

Current Rules Regarding the Taxation of Compensatory Partnership Interests

Under Internal Revenue Code §83(a) and other authorities, if property is issued in connection with the performance of services, the excess of the value of the property over the amount paid for the property is generally included in the gross income of the service provider. This income is included in the first year that the property received by the provider is both transferable and not subject to a substantial risk of forfeiture (i.e., the property is considered vested). However, a special election can be made (commonly referred to as a “§83(b) election,” named after the applicable section of the Internal Revenue Code), that will cause the recognition of income in the year the property is transferred rather than the year it becomes vested. A §83(b) election is commonly made because it has the potential to convert subsequent appreciation in the property from ordinary income into capital gain, which is generally taxed at a reduced rate for individual service providers.

Although the §83 rules generally apply to the compensatory receipt of a partnership capital interest, the tax consequences of the receipt of a profits interest was unclear. In an effort to reduce this uncertainty, the IRS issued Revenue Procedure 93-27, which provided that the receipt of a profits interest for services is generally tax free to the recipient. A profits interest is typically defined as an interest that would not give the holder a share of the proceeds if at the time of the receipt of the interest, the partnership’s assets were sold at fair market value and the proceeds were then distributed in a complete liquidation of the partnership. Revenue Procedure 93-27 did not, however, completely address the issue of profits interests that were subject to a substantial risk of forfeiture.

The IRS subsequently addressed the unvested profits interest issue in Revenue Procedure 2001-43, which provides that if a partnership grants an interest to a service provider, the time for testing whether the interest qualifies as a profits interest is when the interest is granted, rather than at the time of vesting. In order to meet the requirements of Revenue Procedure 2001-43, (1) the service provider must be treated as a partner from the time of grant; (2) neither the partnership nor the other partners could deduct any amount in respect of the vesting of the interest; and (3) the interest otherwise must qualify as a profits interest under Revenue Procedure 93-27. If the profits interest satisfies all of these requirements, the service provider will avoid income recognition on both the receipt and the vesting of the profits interest. If all of those requirements are satisfied, it is unnecessary for the service provider to make a §83(b) election in order for subsequent appreciation to be taxed at capital gains rates; however, service providers often file “protective” §83(b) elections in case a requirement is not satisfied.

The Proposed Regulations and the Application of §83 to Partnership Interests

Under the proposed regulations, a compensatory partnership interest is treated as property for purposes of §83 and the rules under §83 will apply to all partnership interests, whether capital or profits interests. Accordingly, a service provider will have gross income at the time a vested partnership interest (capital or profits) is received in an amount equal to the excess of the fair market value of the interest over the amount paid for the interest.

However, unless a timely §83(b) election is made, a substantially nonvested partnership interest will not be taxed and the recipient will not be treated as a partner until the interest is vested. If a §83(b) election is made and the partnership interest is subsequently forfeited, the partnership may be required to make special forfeiture allocations to offset allocations and distributions made to the service partner before the forfeiture.

Upon finalization, these regulations will supersede the guidance in Revenue Procedures 93-27 and 2001-43, which currently do not require a service provider to file a §83(b) election for subsequent appreciation of a non-vested profits interest to be taxed at capital gains rates.

Valuation and the Safe Harbor Election

Determining the fair market value of a partnership profits interest is often difficult. Thus, the proposed regulations provide a “Safe Harbor Election” that may be made by the partnership and its partners to value the partnership interest at its “liquidation value,” which for a true profits interest would generally be equal to zero.

So long as the partnership interest received does not entitle the recipient to any distribution if the partnership’s assets were sold at fair market value and the partnership was liquidated immediately after the grant of the interest, a Safe Harbor Election would ensure that the issuance of the partnership interest would not result in any income recognition to the recipient. Without the Safe Harbor Election, it may be possible for the IRS to argue that the partnership profits interest has some value and that the recipient must include this amount in gross income.

In order to be eligible for the Safe Harbor Election, several requirements must be satisfied: (1) the partnership and all of its partners must consent to make the Safe Harbor Election, either in the partnership agreement or other document signed by all of the partners; (2) the election must be filed with the IRS; and (3) no partner or the partnership may report income or fail to file information reports in a manner inconsistent with the election. Moreover, the Safe Harbor Election will not apply if the partnership interest is sold or disposed of within two years of the date of receipt, the interest is in a publicly traded partnership, or the interest is in a partnership with a substantially certain and predictable stream of income (these limitations are similar to those contained in Revenue Procedures 93-27 and 2001-43). Finally, unlike current law which permits the services for which the partnership interest is issued to be to, or for, the benefit of the partnership, the Safe Harbor Election requires that the services be rendered directly to the partnership.

The procedural requirements of the Safe Harbor Election will not always be easy to meet and in some cases satisfaction may not be possible. In addition, the tax consequences of the Safe Harbor Election will not always be favorable and can be administratively burdensome. Thus, careful consideration of the consequences is recommended before making the election. Nevertheless, under the proposed regulations, if the partnership does not qualify for or decides not to make the Safe Harbor Election, it will be required to value partnership interests each time an interest is granted or vests.

What To Do Now

As currently contemplated, the proposed regulations would only apply to post-effective date grants of interests in existing partnerships. In light of the significant shift in approach to the taxation of partnership profits interests, as well as the IRS’s acknowledgment that additional issues still need to be addressed, it can be assumed that the final regulations will differ somewhat from the proposed version. Nevertheless, it is advisable for partners and partnerships to prepare for future compliance by examining the manner in which they compensate service providers. For instance, in new partnership agreements, partners should consider including a provision requiring all partners to consent to and to provide any required information in connection with any tax elections, forfeiture allocations, or other matters that are necessary or desirable under the final rules. With respect to existing partnership agreements that are otherwise being amended, partners should consider inserting a similar provision.

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