Partnership Equity For Services – New Rules Apply
By James C. Griggs
SAALFELD GRIGGS PC
Recently, the Internal Revenue Service issued proposed regulations (REG-105346-03, May 24, 2005) that will change the tax treatment relating to the receipt of a profits interest by a person in exchange for providing services to a partnership, including limited liability companies taxed as partnerships. These new rules will only apply to transfers of property on or after the day on which the regulations are finalized and published in the federal register. As written, the new regulations do not indicate whether a taxpayer who receives a transfer of either a profits interest or capital interest in a partnership prior to the effective date of the new regulations will be able to elect to have the final regulations apply to their transfer.
To fully appreciate the significance of the new rules, we need to put them in historical context. Under current rules, which were developed through case law and revenue procedures, with fairly narrow exceptions, the receipt of a profits interest by a person in consideration for providing services to a partnership or LLC is not treated as a taxable event to either the recipient of the interest or the partnership. For purposes of this rule, a “profits interest” is differentiated from a “capital interest.” A “profits interest” is an interest in the partnership that would not entitle the recipient to any share of the partnership assets if it were completely liquidated at the time the interest is granted. If the recipient of the partnership interest would obtain an interest in the partnership assets if the entity were completely liquidated at the time the interest is received, it would constitute a “capital interest.” The receipt of a capital interest, as opposed to a profits interest, in return for services is currently governed by Internal Revenue Code Section 83, and will be taxable when transferable or no longer subject to a substantial risk of forfeiture. The new rules will no longer differentiate between a profits interest and a capital interest. Instead, the new rules will treat the transfer of either a profits interest, capital interest, or option rights for services the same. They are all lumped into something the proposed regulation calls “partnership equity.”
So what does this mean to our clients? Let’s take an example that is not uncommon. If we have a developer who is to receive a fifty percent (50%) profit interest in an LLC which has been wholly funded by an Investor with a capital contribution based on the rules that currently apply, the value of the profits interest received by the developer in return for services is treated automatically as zero, and the IRS would not treat the receipt of the interest as a taxable event to either the partner or the partnership. The developer would receive a capital account as future income is earned, assuming some portion of the future profits is retained by the partnership. Under the rules which currently apply, if the developer received a fifty percent (50%) interest in both profits and capital, assuming the interest was transferable or no longer subject to a substantial risk of forfeiture at the time it was received, then developer would have to recognize as income the fair market value of his or her capital interest pursuant to IRC Section 83.
Now, if we apply the new rules to our fact situation, it does not matter whether the interest received by the developer is a profits interest or capital interest. Instead, the proposed regulations would apply IRC Section 83 rules to the receipt of developer’s interest in the partnership equity, whatever it is. Accordingly, developer would have to include in income the fair market value of the partnership equity at the time of receipt, assuming it is not forfeitable or not subject to a substantial risk of forfeiture.
Unfortunately, the new regulations do not shed any light on how you compute fair market value, which will surely lead to uncertainty and litigation. However, the proposed regulations permit a safe harbor election which will allow the developer in our example to treat the “liquidation value” of the partnership interest as its fair market value. For purposes of this rule, the liquidation value of the partnership equity interest received is the amount of cash that the recipient would receive if the partnership sold all of its assets at the time of transfer and then liquidated. If the interest received by the developer was a “profits interest” then the developer would receive nothing at the time of liquidation. Accordingly, the developer would not have to include any amount into income. For the developer to qualify for this treatment and avoid a current tax, the new rules require the partnership to make a “liquidation value safe harbor election” as provided in Notice 2005-43, 2005-24 IRB 1221. Moreover, the partnership agreement, or in the case of an LLC, the operating agreement, must contain specific provisions relating to the ability to make the liquidation value safe harbor election. The failure to make the safe harbor election will generally result in the taxpayer paying taxes on the fair market value of the partnership equity, which the IRS may assert is a function of the expected income.
Although the new regulations were intended to eliminate some of the uncertainties involved with both the partnership that issues partnership equity in exchange for services and as the recipient, the new rules have left many questions unanswered. Some commentators have suggested that existing partnerships and LLCs should be prepared to immediately adopt revisions that will allow for liquidation value elections and certain special “forfeiture allocations” if the new rules become applicable. Moreover, during the transition period preceding the effective date of the new rules, we may wish to add provisions to new LLC operating agreements and partnership agreements that incorporate the required consent to make the liquidation value election as provided by the proposed regulations. In advising our clients, once the new rules apply, service providers, the developer in our example, who receive partnership equity which is not transferable or remains subject to a substantial risk of forfeiture in consideration for services, should consider making timely Section 83 (b) elections in an effort to mitigate their current tax cost. Unfortunately, although the new rules were intended to resolve old uncertainties, they have created many issues of their own. Please call our office if you have questions on this topic.