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Eighth Circuit reverses Campbell decision.

Last year, the Tax Court held that the fair market value (FMV) of a profits interest in a real estate limited partnership issued as compensation for services was currently taxable to the recipient under Sec. 83. This decision added new uncertainty to an area of partnership tax law that many practitioners regarded as reasonably well-settled. The Eighth Circuit, however, recently reversed the Tax Court, and held that no income was realized on receipt of the profits-only interests, because the interests had only speculative (if any) value (Campbell, 8th Cir., 1991, rev'g TC Memo 1990-162).

Campbell was employed by a real estate brokerage and consulting firm. He performed a variety of services, including locating suitable properties, negotiating their acquisition, obtaining necessary financing, organizing partnerships to acquire the properties and assisting in the syndication of the partnerships. His compensation consisted of a 15% syndication fee, and he also received a special limited partnership interest in the profits of each partnership he helped to organize. Campbell did not acquire any direct interest in the capital contributed by the other partners, however.

When the Tax Court considered the issue of taxability, it rejected Campbell's argument that the receipt of a profits interest for services should be nontaxable under Sec. 721. The court also rejected his argument that the profits interests were merely unfunded, unsecured promises to pay money in the future. The Tax Court held that Campbell was taxable under Sec. 83, since the profits interests received were "property," the interests were transferred to him in connection with his performance of services and his interests were not subject to a substantial risk of forfeiture. The court measured the value of Campbell's interests by reference to the amounts contributed by other partners for their interests, and by financial projections that appeared in the partnerships' offering memoranda.

On appeal, Campbell renewed his argument that a service partner who receives a profits interest in a partnership is not taxable on receipt of that interest. In the alternative, Campbell argued that, even if a service partner can be taxed on the receipt of a profits interest, he realized no income in this instance because the profits interests had no (or only speculative) value.

Backing away from the position it had successfully advocated in the Tax Court, the IRS conceded that a service partner should not be taxed on receipt of a profits interest. Instead, the Service argued that Campbell received his profits interests not for services rendered to each partnership he organized, but as compensation for services he rendered to his corporate employer in the course of his regular employment.

The court of appeals refused to even consider this issue. However, it would not accept the IRS's concession that the Tax Court erred when it found a service partner's receipt of a profits interest taxable, noting that the only other circuit to address this issue had reached the same conclusion as the Tax Court (Diamond, 56 TC 530 (1971), aff'd, 492 F2d 286 (7th Cir. 1974)). The court then proceeded to consider the issue of taxability at length.

When a service partner receives an interest in partnership capital, a taxable event clearly occurs. However, when a service partner receives only an interest in partnership profits, the tax consequences are less certain. After noting that the Internal Revenue Code does not expressly exempt a service partner's receipt of a profits interest from tax, the court considered three theories that might nevertheless support such a position: (1) based on Regs. Sec. 1.721-1(b), a profits interest is not "taxable property" for purposes of Secs. 61 and 83; (2) the principles of Sec. 707 (governing the taxability of transactions between a partner and a partnership) preclude taxation; and (3) a profits interest ordinarily has no taxable FMV.

In general, Sec. 721 provides that a partner who contributes property to a partnership in exchange for an interest in the partnership recognizes no income. Regs. Sec. 1.721-1(b)(1) explains that these nonrecognition principles do not apply when a partner receives an interest in partnership capital as compensation for services. Campbell argued that a negative inference can be drawn from the specific language of Regs. Sec. 1.721-1(b)(1), i.e., that a service partner's acquisition of a profits-only interest (as opposed to a capital interest) is not a taxable event. The court acknowledged that a substantial distinction exists between the receipt of a capital interest and of a profits interest, but refused to adopt this negative inference as a rule of law.

The second theory involved the application of Sec. 707. This provision generally governs the taxability of payments for property or services contributed to a partnership by a partner other than in his capacity as a member of the partnership. A partner performing services for a partnership generally receives a distributive share of the partnership's income rather than a specific payment as compensation for his services. It is only when a transaction is treated as occurring between the partnership and a partner acting in a nonpartner capacity that distributions are treated as payments directly taxable to the partner.

The court explained that the taxpayer in Diamond became a partner solely in an attempt to avoid ordinary income from services he performed in obtaining a mortgage loan for the partnership; he had no intent to function as a partner and, in fact, he sold his partnership interest shortly after receiving it. Thus, the taxpayer had provided services to the partnership in a nonpartner capacity, and the receipt of his partnership interest was properly treated as compensation. Unlike the taxpayer in Diamond, however, Campbell was acting in his role as a partner in rendering services. Moreover, Campbell's partnership interests were not transferable and were not likely to provide any immediate financial return. Although these findings apparently eliminated Sec. 707 as a basis for taxation in Campbell, the court did not agree that this totally precluded taxability.

While both of these arguments cast doubt on the Tax Court's holding, the court ultimately made its decision on a factual finding that the profits interests received by Campbell lacked value.

As noted, the Tax Court had valued Campbell's interests by reference to the value of limited partnership interests issued to other partners, and by reference to tax and financial projections appearing in the partnerships' offering memoranda. The appellate court found that such valuation was clearly erroneous, since the rights associated with Campbell's special limited partnership interests differed substantially from the rights of the other limited partners. Moreover, the assumptions used in the offering memoranda were frequently wrong, and since the partnerships had no track record, their future success was purely speculative. The court concluded that the profits interests received by Campbell had only speculative, if any, value. Accordingly, the court reversed the Tax Court, and held that Campbell was not taxable on the receipt of the profits interests in question.

It is unfortunate that this case was not resolved on the basis that the receipt of a partnership profits interest in exchange for services is not a taxable event as a matter of law. By basing its decision on the value of the interests acquired, the court left the door open for further controversy. Perhaps more significant than the court's holding, however, is the IRS's attempt to concede on appeal that the receipt of a profits interest in exchange for services is not taxable. The Service's concession of this issue, despite the narrowness of the Eighth Circuit's ultimate holding, may signal the end of IRS efforts to tax service partners in Campbell-type situations. Only time will tell whether this issue has truly been laid to rest.
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Title Annotation:Campbell v. Commissioner
Author:Kurtz, N. Patricia
Publication:The Tax Adviser
Date:Dec 1, 1991
Previous Article:The progeny of Sec. 2036(c); the valuation of retained interests.
Next Article:Prohibited transactions: IRS expands self-dealing rules.

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