Compensatory Transfers of Restricted Partnership Interests

The tax treatment of a partnership interest received in exchange for services has long been an area of controversy. Much of the controversy was settled through the issuance of Rev. Proc. 93-27, which provided taxpayers with definitive guidance on the taxability of a partnership profits interest received in exchange for services provided to (or for the benefit of) a partnership.

Basically, under Rev. Proc. 93-27, if a person receives a profits interest in exchange for services provided to (or for the benefit of) a partnership in a partner capacity (or in anticipation of becoming a partner), the IRS would not treat the receipt of such an interest as a taxable event for the partner or the partnership.

Rev. Proc. 93-27 differentiates a profits interest from a capital interest. A capital interest gives the holder a share of the proceeds if the partnership's assets are sold at fair market value (FMV) and the proceeds distributed in a complete partnership liquidation. A profits interest is an interest other than a capital interest (i.e., the partner would be entitled to share in the partnership's future profits, but not in any proceeds if the partnership was to liquidate when the interest was granted). This determination is made generally at the time of receipt of the partnership interest. The receipt of a capital interest in exchange for services is dealt with under Regs. Sec. 1.721-1(b)(1), which provides that the receipt of a partnership capital interest for services provided to (or for the benefit of) a partnership is taxed to the provider as compensation for services rendered.

The Rev. Proc. 93-27 nonrecognition rule does not apply when:

• The profits interest relates to a substantially certain and predictable income stream from partnership assets (such as income from high-quality debt securities or a high-quality net lease);
• Within two years of receipt, the partner disposes of the profits interest; or
• The profits interest is a limited partnership interest in a "publicly traded partnership" (within the meaning of Sec. 7704(b)).

Although Rev. Proc. 93-27 provided welcome relief, it did not specifically address the issues relating to receipt of a restricted partnership interest. Quite often, partnership interest transfers are subject to various restrictions, including a substantial risk of forfeiture or a required sale-back to the partnership for less than FMV when a service provider ceases to provide services for a certain period of time.

Under Sec. 83(a), property transferred in connection with the performance of services is taxed as compensation when it is not subject to a substantial risk of forfeiture. This also applies to partnership interest transfers. Therefore, when partnership interests are restricted, many taxpayers make a Sec. 83(b) election and include the partnership interests' FMV in income when they receive them.

The IRS issued Rev. Proc. 2001-43 to clarify the tax treatment when a partnership grants a profits interest to a substantially nonvested service provider. Neither the service provider nor the partnership treats the grant (or the event that causes the interest to become substantially vested) as a taxable event, as long as:

• The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of the partnership interest's grant, and the service provider takes into account the distributive share of partnership income, gain, loss, deduction or credit associated with the interest granted in computing income tax liability for the entire period during which the service provider has the interest;
• On granting the interest or when the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation or otherwise) for the interest's FMV; and
• The partnership and the service provider satisfy all other Rev. Proc. 93-27 conditions.

Taxpayers affected by Rev. Proc. 2001-43 no longer need to file a Sec. 83(b) election. However, this applies only to a grant of a profits interest. A transfer of a capital interest would still require a Sec. 83(b) election if the service provider wanted to include the interest's value in income in the year of transfer. Therefore, if the interest transferred includes elements of both a profits and a capital interest, the transferee should consider making a Sec. 83(b) election.

Rev. Proc. 2001-43 is effective for partnership interests granted after June 8, 1993.

From Ronald L. Garman, CPA, Cleveland, OH