Receipt of a conditional partnership interest for services.
A person who receives property subject to a substantial risk of forfeiture in connection with the performance of services his two choices: (1) report the income when the property becomes vested or (2) elect within 30 days of the receipt to report the property as income in the year of receipt. If this election (commonly referred to as a Sec. 83 (b) election) is made, the service provider is taxed at the time of receipt on the excess of the property's FMV over the amount (if any) paid for it.
The electing recipient receives a basis in his partnership interest equal to the sum of the compensation income recognized plus the amount (if any) paid for the interest. This basis is used to determine any subsequent gain or loss on disposition of the partnership interest. If a Sec. 83(b) election is made, the service provider is treated as the owner of the interest and is taxed on receipt as if the interest were not subject to any substantial risk of forfeiture. The later lapse or satisfaction of the condition giving rise to the risk is not a taxable event.
Benefits of a Sec. 83(b) Election
The benefits of electing to be taxed in the year of receipt are twofold: (1) the recipient avoids recognizing subsequent appreciation in the partnership interest as compensation income when the interest becomes vested and (2) any amounts received as partnership distributions are not recharacterized as compensation--the service partner is treated as a partner for purposes of allocating partnership income and loss.
When a person receives a partnership interest in exchange for services, and the person's full rights in the interest are subject to a substantial risk of forfeiture, there are two circumstances in which a Sec. 83(b) election may be especially beneficial: (1) when FMV is paid for the interest or the difference between the FMV of the interest and the amount paid for the interest is relatively small at the time of receipt or (2) when the FMV is likely to appreciate greatly prior to the lapse of the risk of forfeiture.
The tax adviser should always advise a partner to make a Sec. 83 (b) election if the partner contributes FMV for the interest but the interest is subject to forfeiture. A failure to make the election in such an instance causes the partner to be treated as a nonpartner, with any distributions taxed as compensation when received and any appreciation taxed as ordinary income when the interest becomes fully vested. The failure to make a Sec. 83(b) election in these circumstances can create a near-term tax cost when an indefinite deferral of income is possible with a Sec. 83(b) election.
Risks of a Sec. 83(b) Election
While a Sec. 83(b) election may be beneficial, tax advisers should be aware of a potentially significant risk. If the FMV of the interest when the election is made exceeds the amount paid for the interest by the service partner, the election guarantees that compensation income will be recognized even if the interest is subsequently forfeited.
If the interest is forfeited while it remains substantially nonvested, the forfeiture is treated as a sale or exchange on which the service partner may realize a loss. However, the loss is limited to the extent of the excess (if any) of the amount paid for the property by the service provider over the amount received on forfeiture. Because a partnership interest is generally a capital asset, the loss is usually a capital loss. However, under Regs. Sec. 1.83-2(a), no loss or deduction is permitted for the compensation income previously recognized by the service provider. In addition, if there is a transfer in contemplation of a forfeiture, the service provider's loss is determined as if a forfeiture had occurred. Thus, the service provider's loss is limited to his cash-out-of-pocket loss.
Without a See. 83(b) election, Harry will be taxed as having received the partnership interest when construction of the building is completed and the risk of forfeiture lapses. At that time, Harry will recognize compensation income of $500,000--one-third of the partnership's $1.5 million equity. The partnership will also recognize gain on the transfer of capital. Income, loss and distributions during the interim are taxed as if Harry is not a partner. Moreover, because No Trump Tower's expense relates to the construction of the building, it is capital in nature and is not deductible. Because the expense must be capitalized, the other partners bear a tax cost, at least in terms of timing, because of the late vesting of the interest.
If Harry makes a Sec. 83(b) election, he recognizes $200,000 of compensation income on May 1, 1997, and is treated thereafter as a partner for tax purposes. Harry defers recognizing compensation income from the $300,000 increase in the value of his share of the partnership's property through April 15, 1998. Thus, post-formation property value appreciation is taxed only when Harry transfers his partnership interest or the partnership transfers its assets. If the value were to decline after the vesting date, some of the value at the time of vesting might never be taxed.
In addition, No Trump Tower avoids gain on the hypothetical transfer to Harry of an interest in its appreciated assets. By making the election, however, Harry recognizes $200,000 of income on which he pays tax. He also assumes the risk of having neither the property nor a tax loss if he subsequently forfeits the interest.
The tax adviser should inform Harry of the availability of the election to accelerate the recognition of income and its advantages and disadvantages. In determining whether Harry should make the election, the following factors should be considered:
* How certain is Harry that he will be able to meet the conditions for vesting?
* How much income will Harry recognize immediately if he makes the election?
* Is the expected increase in the value of the partnership interest, from the time of receipt to the time the risk of forfeiture has lapsed, substantial?
* Considering the time value of money, how beneficial is the tax deferral?
* Does Harry have the cash to pay the tax if he elects to accelerate the timing of the income?
In this case, the expected increase in value is substantial--$300,000. The vesting period is less than a year and, therefore, Harry should be able to meet the vesting conditions. Also, since there is only one year until the vesting occurs, the time value of the deferral obtained if the election is not made would be small, while the tax deferral from recognizing income of $200,000 in 1997 (as opposed to $500,000 in 1998) would be substantial.
Based on the magnitude of the tax deferral and the low risk of forfeiture, the tax adviser should recommend that Harry make a Sec. 83(b) election. If Harry does not have the cash available to pay the tax, he may be able to renegotiate the arrangement with Tom and Dick to include a cash distribution.
By making a Sec. 83(b) election, a partner who receives a conditional partnership interest in exchange for services can defer being taxed on appreciation occurring prior to the vesting of the interest. Unless the service partner paid FMV for the interest, such an election also involves risks that must be evaluated. If Harry elects to be taxed on the partnership interest in the year of receipt, he will defer recognizing an additional $300,000 of compensation income resulting from appreciation of the partnership property prior to the time the risk of forfeiture lapses.
Editor's note: This case study has been adapted from PPC Tax Planning Guide--Partnerships, 11th Edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1997.
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|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1998|
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