Compensating partnership employees with corporate partner stock.

In a recently published letter ruling, the IRS appears to have adopted the cash purchase model of proposed regulations under Sec. 1032 in determining whether a partnership recognizes gain when it compensates its employees with stock of its corporate partner.

In Letter Ruling 9903037, corporate partners A and B (and subsidiaries of their respective consolidated groups) transferred employees (partnership employees) to their partnership. As part of the arrangement, it was anticipated that B and C (A's parent and the parent of the consolidated group that included A) would grant nonstatutory stock options and stock appreciation rights (SARs) to the partnership employees, under B's and C's stock incentive plans. The options would not have a readily ascertainable fair market value (FMV).

Analysis

One issue that the Service addressed was whether the partnership had to recognize gain on the transfer of the B and C stock to its employees when they exercised the options and SARs. More specifically, the IRS examined whether the partnership would be deemed to have a "zero basis" in the B and C stock transferred to the employees.

The letter ruling focused on Sec. 83, which generally provides for the tax treatment of compensatory transfers of property for services, and Rev. Rul. 80-76, which applies those rules when a parent's stock is used to compensate a subsidiary's employees. In Rev. Rul. 80-76, a P shareholder transferred P stock directly to X, a key employee of S, a controlled subsidiary of P. S was treated as receiving P stock as a contribution to capital and immediately disposing of that stock to compensate its employee. The IRS concluded that, because Sec. 83 applied to the transfer of the parent's stock to the subsidiary's employee, the subsidiary did not have to recognize gain on the transfer.

In Letter Ruling 9903037, the Service relied on Rev. Rul. 80-76 to conclude that the partnership would not recognize gain or loss as a result of the transfer of the B and C stock to its employees on the exercise of the options or SARs. In addition, the partnership would be entitled to a deduction equal to the FMV of the B and C stock transferred on exercise of the options and SARs that would be granted after the employees were transferred to the partnership. Finally, the Service concluded that A, B and C would not recognize gain or loss as a result of the transfer of B and C stock.

The conclusion that the partnership did not recognize gain on the transfer of the B and C stock is significant for a number of reasons. First, it appears that the IRS has adopted a cash purchase model in dealing with compensatory transfers of corporate stock to partnership employees. Although Rev. Rul. 80-76 did not provide a rationale for concluding that S did not recognize gain or loss on the transfer of the P stock to S's employee, the preamble to the Sec. 1032 proposed regulations provides some guidance. The preamble states that "as in Rev. Rul. 80-76, the cash purchase model of these proposed regulations provides that the acquiring corporation will not recognize gain or loss on the transfer of the stock of the issuing corporation" (Emphasis added.)

The cash purchase model cited in the proposed regulations treats an acquiring corporation (i.e., a subsidiary) as purchasing the issuing corporation's stock (i.e., the parent's stock) from the issuing corporation for FMV with cash contributed to the acquiring corporation by the issuing corporation (or, if necessary, through intermediate corporations), if all the requirements of the proposed regulations are satisfied. Applying this approach in the partnership context, a partnership would be treated as purchasing stock from its corporate partner for FMV with cash contributed to the partnership by the corporate partner. Also, the corporate partner would be protected from gain recognition under Sec. 1032. Letter Ruling 9903037 is the first time the Service has applied the model of Rev. Rul. 80-76 in the partnership context to conclude that a partnership does not recognize gain. (In Letter Ruling 9822012, the IRS previously cited Rev. Rul. 80-76 in a compensation arrangement in the partnership context, but did not address the gain recognition issue at the partnership level.)

Departure from Earlier TAM

Also of significance, the Service's use of the cash purchase model is a departure from the approach taken in Letter Ruling (TAM) 9822002. In a slightly different context, that ruling addressed whether a partnership recognizes gain on a transfer of contributed corporate partner stock.

Letter Ruling 9822002 involved a partnership's stock transfer (previously contributed by a corporate partner) to another partner in a disguised sale transaction under Sec. 707. In analyzing the transaction, the IRS concluded that the partnership received a carryover basis in the contributed stock under Sec. 723. As a corporation has a zero basis in its own stock (and generally any stock contributed to it by its parent, with certain exceptions), the partnership received a zero basis in the stock it held. On the partnership's transfer of the stock to the other partner in the disguised sale transaction, the partnership recognized gain on the transfer; such gain was allocated back to the corporate partner under Sec. 704(c). The Service applied an aggregate theory of partnership taxation to conclude that the corporate partner whose stock was transferred did not have to recognize the gain under Sec. 1032, which provides that a corporation does not recognize gain or loss on the receipt of money or other property in exchange for its stock or rights to acquire its stock.

If the approach of Letter Ruling 9822002 had been applied to the facts of Letter Ruling 9903037, the partnership would have recognized gain equal to the difference between the stock's FMV and the partnership's basis (i.e., zero). This gain would have been allocated back to B and C, respectively (depending on whose stock was transferred), and such gain would not be recognized as a result of Sec. 1032.

IRS Approach

Although not discussed in the recent letter ruling, it appears that, for the Service to apply the cash purchase model in the partnership context, requirements similar to those imposed in the corporate context under the Sec. 1032 proposed regulations would need to be satisfied. To meet those requirements:

* The acquiring corporation (e.g., the subsidiary), under a plan to acquire money or other property, must acquire the issuing corporation's (i.e., the parent's) stock directly or indirectly from the issuing corporation in a transaction in which, but for the proposed regulations, the basis of the issuing corporation's stock would be determined with respect to the issuing corporation's basis in its stock under Sec. 362(a) (i.e., a carryover basis);

* The acquiring corporation must immediately transfer the issuing corporation's stock to acquire money or other property; and

* No party receiving issuing corporation stock from the acquiring corporation may receive a substituted basis in the issuing corporation's stock within the meaning of Sec. 7701(a)(42). For purposes of the proposed regulations, "property" includes services.

Applying similar requirements in the partnership context, a partnership would need to acquire (or be deemed to acquire) the corporate stock from its corporate partner in a carryover basis-type transaction and immediately transfer the stock of its corporate partner for services rendered to the partnership by its employees.

Although the cash purchase model appears to be the IRS'S current approach for compensatory transfers of corporate partner stock to partnership employees, its continued validity may be questionable. The proposed regulations under Sec. 1032 cover only transfers of a parent's stock to its subsidiary's employees; they do not cover a transfer of stock in the partnership context. In the preamble to the proposed regulations, the Service indicates that Rev. Rul. 80-76 may become obsolete when the proposed regulations under Sec. 1032 are finalized, because they address the same issues as Rev. Rul. 80-76. If this is the case, the basis for the conclusion reached in Letter Ruling 9903037 would appear to be obsolete. This may result in the IRS resorting to the model set forth in Letter Ruling 9822002 in dealing with compensatory transfers in the partnership context.

FROM JOSEPH M. CALIANNO, CPA, MBA, J.D., LL.M., WASHINGTON, DC