What's your interest? Clarifying the issuance of partnership interests for services.

Partnerships and LLCs have historically been used for passive investments, mainly for flow-through taxation and liability protection. But more taxpayers have recently chosen to use partnerships and LLCs for non-passive ventures, including hospitality or manufacturing businesses.

As a result, business owners have had to face complex tax issues associated with issuing equity ownership to employees or other service providers for their services.

Notice 2005-43

While corporate tax law related to the issuance of equity for services (i.e. restricted stock, stock options, etc.) is well established, the same can't be said for partnerships and LLCs.

Rev. Proc. 93-27 and Rev. Proc. 2001-43 provide the general framework for the taxation of service providers receiving both vested and nonvested profit interests in a partnership. However, both revenue procedures tend to raise more questions than provide answers.

Enter Notice 2005-43, issued in May 2005, and proposed regulations under both IRC Sec. 83 and various sections of Subchapter K.

Taken together, Notice 2005-43, which contains a proposed revenue procedure, and the proposed regulations aim to provide the same level of clarity for partnerships and LLCs already found in corporate tax law related to the issuance of equity to service providers.

This is a lofty goal considering it requires coordination between two of the more commonly misinterpreted areas of the IRC--Sec. 83 and Subchapter K.

Significantly, Notice 2005-43 and the proposed regulations eliminate the different tax treatments for the issuance of profits and capital interests.

Instead, all interests in partnerships, capital and profits will be subject to the same rules, thus making Rev. Procs 93-27 and 2001-43 obsolete.

Under the proposed regulations, if a service provider receives a partnership interest of profits or capital that is substantially vested and not subject to a substantial risk of forfeiture, or substantially nonvested with a Sec. 83(b) election in effect, then it will be taxed on the difference between the value of the partnership interest, less the amount they paid (if any) for the partnership interest.

Safe Harbor Partnership Interest

How does a partnership determine the value of a capital or profits interest? The proposed regulations provide clear guidelines related to determining value by introducing a new type of partnership interest, the Safe Harbor Partnership Interest.

An SHPI is any interest in a partnership, capital or profits, that is transferred to a service provider in connection with past or future services. A partnership interest will not qualify as an SHPI if it:

* relates to a substantially certain, predictable stream of income;

* is transferred in anticipation of a subsequent disposition; or

* is an interest in a publicly traded partnership.

The significance of qualifying as an SHPI is that the value of said interest will be equal to its liquidation value. Liquidation value is the amount of cash that would have been received for the partnership interest had the partnership sold all of its assets--both tangible and intangible--for cash, immediately after the partnership interest was issued.

An interesting point related to the issuance of a profits interest: a true profit interest substantially vested at the time of issuance has no liquidation value immediately after it is issued. This still allows partnerships to issue profits interests while avoiding potential adverse income tax ramifications.

A partnership must make a formal Safe Harbor Election and attach the election to its tax return, which includes the effective date of the election, if it wants to issue an SHPI.

To take advantage of this election, partnerships and operating agreements must be amended to include certain provisions that are legally binding on all of the partners.

More Work to be Done?

While the amount of clarity Notice 2005-43 and the proposed regulations provide is laudable, these rules impose a significant burden on partnerships and LLCs wishing to issue partnership interests, especially capital interests, to service providers. Those burdens include:

1) The use of liquidation value will require partnerships to engage valuation experts on a regular basis to ensure their continued compliance with the safe harbor provisions.

2) By requiring liquidation value, it appears that lack of marketability and minority interest discounts may not apply.

3) Partnerships must engage legal counsel to amend their operating agreements to ensure their operating agreement complies with the new proposed regulations

The Treasury Department and IRS have yet to finalize the revenue procedure proposed in Notice 2005-43, so these rules are not yet effective. When this revenue procedure becomes effective, Rev. Procs. 93-27 and 2001-43 will become obsolete.

How will these new rules impact the use of partnerships in the future? Only time will tell. Let's hope these proposed rules do not go the way of the LLC self-employment tax proposed regulations that are in their ninth year without amendment or adoption.

By David Uhler, CPA 

David Uhler, CPA is a partner in the tax department at Santa Barbara-based Bartlett, Pringle & Wolf, LLP and a member of the IRS Advisory Council. You can reach him at [e-mail].