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Receipt of partnership profits interest.

The taxability of the receipt of a profits interest in a partnership in exchange for services provided has been the cause of litigation for many years. However, the IRS recently issued general guidelines in Rev. Proc. 93-27, which hopefully will reduce future controversy.

Sec. 721 states that no gain or loss will be recognized in the case of a contribution of property to the partnership in exchange for a partnership interest. The section appears to be silent on an exchange for services, but Prop. Regs. Sec. 1.721-1(b)(1) states that "[t]o the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation..., section 721 does not apply." (Emphasis added.) Prop. Regs. Sec. 1.721-1(b)(1)(i) provides that for partnership interests transferred after June 30, 1969, the receipt of the capital interest is taxable income to the service provider under Sec. 83 and the regulations thereunder. For interests transferred on or before June 30, 1969, the value of the partnership interest in capital transferred to such partner is included in income to the partner as determined under Sec. 61. Therefore, the tax treatment of the receipt of a capital interest (contrasted with a profits interest) in a partnership as compensation for the providing of services to the partnership is clearly taxable.

Many taxpayers have interpreted the italicized language in Prop. Regs. Sec. 1.721-1(b)(1) to mean that the receipt of a profits interest in a partnership for services rendered is not taxable compensation to the service provider at the time of the transfer. However, in Diamond, 56 TC 530 (1971), aff'd, 492 F2d 286 (7th Cir. 1974), it was held that a partner who received a profits interest in a partnership in exchange for services rendered was currently taxable, as Sec. 721 did not apply. The court valued the profits interest received based on a subsequent sale of the profits interest that occurred less than three weeks after receipt of the profits interest.

In Campbell, 943 F2d 815 (8th Cir. 1991), rev'g TC Memo 1990-162, the Eighth Circuit held that the receipt of a profits interest was not taxable income to the partner on receipt. Campbell was employed by a collection of business entities involved in the formation and syndication of limited partnerships. Campbell located suitable properties, negotiated the acquisition of properties, obtained the necessary financing to acquire the properties, organized the partnerships and assisted in the preparation of the offering materials. As part of his compensation agreement, he received special limited partnership interests (profits interests) in these partnerships. As it held in Diamond, the Tax Court found that Sec. 72 1 was inapplicable and applied Sec. 83 to determine when the income should be recognized. However, the Eighth Circuit held that the profits interest had only speculative, if any, value, and therefore was not income in the year of receipt. Obviously, Diamond and Campbell were both decided based on valuation. This would make it likely that the courts would be called on in the future to make numerous partnership valuation determinations.

In order to reduce the need for substantial future litigation, the IRS issued Rev. Proc. 93-27. If a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such profits interest as a taxable event for the partner or the partnership. However, the revenue procedure will not apply "[i]f the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;" or, "if within two years of receipt, the partner disposes of the profits interest;" or, "if the profits interest is a limited partnership interest in a |publicly traded partnership' within the meaning of section 7704(b) of the Internal Revenue Code."

In Rev. Proc. 93-27, the Service defines a profits interest as a partnership interest other than a capital interest. A capital interest is defined as an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were then distributed in complete liquidation of the partnership. This determination is made at the time of receipt of the partnership interest.

Finally, tax advisers should not overlook, as an alternative to a profits interest, the deferral of the tax in otherwise taxable situations by having the partnership capital interest subject to substantial risk of forfeiture or not transferable.
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Author:Odzer, Joseph A.
Publication:The Tax Adviser
Date:Oct 1, 1993
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