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Partnership interests subject to risk of forfeiture.

Facts

On Dec. 31, 1989, Arnie and Jack formed a partnership, Eagle Co., to acquire and operate an apartment building. Each contributed $200,000 for a 50% interest. On Jan. 1, 1990, in exchange for an agreement to manage the building, Gary was admitted to the partnership with a 10% interest in partnership capital, profits and losses. Arnie's and Jack's capital accounts were reduced to $180,000 each; Gary was credited with a $40,000 capital account to reflect his 10% interest in Eagle's capital. Gary also was entitled to share in income, losses and current distributions. Under the agreement, Gary would forfeit his entire interest if he ceased performing building management services prior to July 1, 1991. Gary did not elect to be taxed immediately on this transfer.

For the partnership year ending on Dec. 31, 1990, Gary was allocated $10,000 as his distributive share of Eagle's income (for book purposes only). On Jan. 15, 1991, Gary received a $6,000 cash distribution from Eagle. On July 1, 1991, Gary's partnership interest became fully vested. At that time, Eagle's net worth was $500,000.

Issue

What are the tax effects to Eagle and its partners?

Analysis

Absent a Sec. 83(b) election, a service provider recognizes income from the receipt of property in the first tax year in which the service provider's rights to the property are not subject to a substantial risk of forfeiture or are transferable free of any such risk.

Substantial risk of forfeiture

If full enjoyment of the property is conditioned on the continued performance of substantial services, the rights are subject to a substantial risk of forfeiture. A substantial risk of forfeiture also exists if the recipient's rights are subject to another substantial condition, such as the recipient's refraining from competition for a specified period of time or the achievement of some goal related to the transfer.

Transferee as nonpartner

Under Regs. Sec. 1.83-1(a)(1), until the property becomes substantially vested, the transferor is regarded as the owner of the property for tax purposes. Any "income" received by the service provider is treated as compensation when received. There are no statutory exceptions that address the application of these rules to partnerships.

Gary will not be treated as a partner of Eagle for tax purposes until July 1, 1990. On that date Gary will recognize income equal to the fair market value (FMV) of the partnership interest. Assuming the FMV of the interest is measured by its share of Eagle's capital, which has a net FMV of $500,000, Gary recognized $50,000 of income on the receipt of the partnership interest. (If the interest had been fully vested on Jan. 1, 1990, he would have recognized only $40,000.)

Eagle is treated as having been the owner of Gary's interest prior to July 1, 1991. Therefore, for tax purposes, Gary apparently had no distributive share of Eagle's income prior to that date. The amount that otherwise would have been allocated to Gary was instead required to be reallocated between Arnie and Jack in accordance with their interests in Eagle; therefore, each was taxed on $5,000 more of Eagle's 1990 income than would have been the case if Gary had been recognized as a partner.

Similarly, Gary's $6,000 January 1991 distribution was treated as compensation income paid to Gary by Eagle. This would be true even if the partnership had no income and the distribution were intended to be a return of capital. The partnership would be entitled to a deduction for, or would capitalize, the amount of the payment. The tax adviser might suggest that the partners adopt special allocations to create distributive shares for each partner for 1991 that would be as close as possible to the shares they would have had if Gary had been a partner for the entire year. Any special allocations should take into account the tax effects of the vesting of the interest as well as the earlier cash distribution.

Conclusion

A partner who receives a partnership interest in exchange for services generally will not be treated as a partner for tax purposes until that interest has become substantially vested. Thus, Gary was not taxed as a partner of Eagle until July 1, 1991. Gary did not share in partnership income or loss prior to that date, and any distributions to Gary were treated as payments made to a nonpartner.
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Article Details
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Jan 1, 1992
Words:737
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