Current. Law. A partnership interest other than a capital interest. Rev Proc IRS Administrative Concession For Vested Profits Only Interest

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1 Current 5-1 Law Sections 83 and 721; Rev Procs & Rev Proc IRS Administrative Concession For Vested Profits Only Interest Rev Proc Profits Interest Profits Intererst not taxable if NOT: Definition 1) A substantially certain and predictable stream of income. 2) Disposed of within two years of receipt. 3) A limited partnership interest in a publicly traded partnership. 3 A partnership interest other than a capital interest

2 Capital Interest Definition 5-6 A capital interest is an interest that would give the holder a share of the proceeds if the partnership s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. 5 Example Vested Profits Only Interest Current Law

3 5-6 Rev Proc IRS Administrative Concession for Unvested Profits Only Interest 10 Rev Proc No taxation on grant or vesting if the partnership and grantee: 1) Otherwise meet the conditions in Rev Proc ) Agree to treat the grantee as a partner. 3) Not claim a compensation deduction. 11 Sec. 83 No need for a Sec. 83(b) election. (Rev. Proc ) 12

4 Example 5-6 Forfeitable Profits Only Interest Current Law Capital Interests For Services 15 16

5 Example 5-8 Vested Partnership Capital Interest Current Law. 5-9 Facts 17 ABC each contribute $100,000 (25% ptrs). D provides services (25% ptr) Profits, losses and capital are equal. On liquidation following formation, each partner would receive $75,000 (300,000 4). 18 Capital Interest Definition 5-4 A capital interest is an interest that would give the holder a share of the proceeds if the partnership s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. 19 How a Profits Interest? D s interest would be a profits interest if ABC were each entitled to a priority return of the $100,000 of contributed capital on liquidation, and all profits were shared 25%. 20

6 Issue (1) Is the grant of a vested partnership capital (and profits) interest in exchange for services, taxable to the service provider, Dinah? How is the FMV of Dinah's partnership interest measured? Yes Issue (2) 1) Liquidation value--$75,000 2) The "value added" approach--$100,000 3) The "cost of services" approach--? 4) The "discounted value" approach--$45,000 (with 40% discount) Sec. 83 supports. 23 Issue (3) What are the tax consequences to the other partners--alice, Bill and Carol? 24

7 Issue (3) Per Reg (b)(2), the $75,000 of compensation to Dinah is a guaranteed payment for services under section 707(c), deductible by the other partners. 25 The service provider s subsequent allocable share of partnership capital gains retain their character. 26 Example 5-9 Unvested (Forfeitable) Partnership Capital Interest Current Law Timing Sec 83 An unvested capital interest will be taxable: upon vesting or upon grant if an election is made under section 83(b). 28

8 With Section 83(b) Election: She would recognize $75,000 in Year 1 and nothing extra in Year 4. In addition, in Year 1, the ABCD partnership deducts $75,000 per Sec. 83(h) Downside To Sec. 83(b) Forfeiture: If Dinah forfeits her partnership interest following the Section 83(b) election she cannot claim a deduction to counteract the fact that she reported $75,000 of income in Year 1 (Sec. 83(b)(1)). The Section 83 election is a gamble. Upside To Gamble Subsequent recognized gains (whether distributive share, sale gain, etc.) can be characterized as capital gains

9 Upside To Sec. 83(a) Deferral Without Section 83(b) Election: Because Dinah s capital interest is subject to substantial risk of forfeiture (unvested), she need not recognize any income when the partnership interest is issued in Year Downside to Sec. 83(a) When Dinah s partnership interest vests in Year 4, she recognizes $500,000 of ordinary income (a guaranteed payment). Downside to Partner Failure to make the Sec. 83(b) election causes all of Dinah s pre-vesting date profits, and unrealized appreciation, to be characterized as ordinary income

10 Partnership Impact The ABCD partnership can claim a $500,000 deduction in Year 4, under Section 83(h). Partnership Capital Interest Open Questions? Does Sec 83 Control? Prop. regs. say yes. Is Dinah a partner when her interest is unvested? Prop. regs. say no unless IRC Sec. 83(b) election If Dinah received distributions prior to vesting how are they treated? Prop. regs. say, if no 83(b) election, W-2 wages or 1099 compensation. How is a forfeiture handled? See prop. regs Proposed Regs

11 Disguised Payments For Services 5-16 Sec. 707(a)(2)(A) JCT Analysis of President s Proposal On Carried Interests

12 2005 Proposed Regs Answers To Open Questions? Does Sec 83 Control? Yes Is Dinah a partner when her interest is unvested? No, unless a Sec. 83(b) election. Rev Proc and are superseded. 2 The Service Provider is a Partner: 1) If the interest is vested, after issuance of the partnership interest. 3 The Service Provider is a Partner: 2)If the interest is not vested (is subject to a substantial risk of forfeiture): a)after vesting if no Section 83(b) election is made, or b)after issuance if a Section 83(b) election is made. 4

13 Example 5-10 Same as Ex. 5-6 but Apply the Prop. Regs. Vested Profits Only Interest-- Proposed Regs Dinah is a partner on the date of issuance 5 6 Zero income on issuance, assuming election of liquidation value method, for the profits only interest. Same result as current law. 7 The service provider s subsequent allocable share of partnership capital gains retain their character. 8

14 Dinah s K-1 Years 1-5 Year 1: $0 rental income Year 2: $0 rental income Year 3: $7,500 rental income* Year 4: $30,000 rental income Year 5: Sale gain of $250,000 (25% x 1,000,000) Example Forfeitable Profits Only Interest-- Proposed Regs With Section 83(b) Election: The Sec. 83(b) election is required to reach the same outcome as current law. The liquidation value election is also required to match current law. 11 Results W/Sec. 83(b) The service provider s subsequent allocable share of partnership capital gains retain their character. 12

15 Without Sec. 83(b) Dinah is not a partner until year Per Section 83(a) Dinah would recognize $362,500 of ordinary income at the beginning of year 5 when the interest vests. W/0 Sec. 83(b) In years one through four, Alice, Bill and Carol recognize all of the net rental income of $120,000 per year

16 W/O Sec. 83(b) If Dinah receives distributions, those distributions are reported on a W-2 (if Dinah is an employee) or Form 1099 W/O Sec. 83(b) Dinah is deemed to first become a partner on January 1, Year 5. Her tax and Sec. 704(b) book capital accounts reflect the liquidation value of her partnership interest on January 1, Year 5--$362, Dinah s failure to make a Section 83(b) election is beneficial to the other partners, because, per Sec. 83(h), the partnership would be entitled to deduction in Year 5 for the $362,500 guaranteed payment to Dinah. The deduction should be allocated to the other partners. 19 From the service partner s perspective, current law Rev. Proc is superior to the 2005 proposed regulations. In Rev Proc , the IRS agrees to treat both the grant and vesting of the profits interest as a tax-free transactions without the need for an 83(b) election. 20

17 Example Vested Capital Interest-- Proposed Regs. 21 Dinah recognizes a $75,000 guaranteed payment for services. ABCD Partnership deducts $75,000. Dinah s outside basis is $75,000 Dinah s 704(b) capital account is increased by $75, Example The service provider s subsequent allocable share of partnership capital gains retain their character. Forfeitable Capital Interest-- Proposed Regs

18 With 83(b) With the Sec. 83(b) election, Dinah recognizes a $75,000 guaranteed payment upon receipt of the forfeitable partnership She is treated as a partner from the moment of issuance. The ABCD partnership deducts the $75,000 guaranteed payment (assuming no need to capitalize it). interest With 83(b) Subsequent gains (distributive share, sale gain, etc.) can be characterized as capital gains, so the Sec. 83(b) election is desirable. With 83(b) Vesting. As with current law, when, and if, Dinah s partnership interest vests, no other reporting is required. Section 83(b) eliminates Sec. 83(a)

19 With 83(b) On Forfeiture Prior to Vesting. If Dinah forfeits her partnership interest prior to vesting, then she must make forfeiture allocations With 83(b) No Loss for Sec. 83(b) Inclusion. Despite having recognized $75,000 in the year of issuance, Dinah is not allowed a deduction in the year of forfeiture per Code Sec. 83(b). Conversely, the other partners must recognize income of $75, Example 5-13 Results Without Sec. 83(b) Election W/0 83(b) Dinah is not treated as a partner until the beginning of year 4. 32

20 W/0 83(b) Per Section 83(a) Dinah would recognize $500,000 of ordinary income at the beginning of year 4 when the interest vests. W/0 83(b) Her tax and Sec. 704(b) book capital accounts reflect the liquidation value of her partnership interest on January 1, Year 5--$500, W/0 83(b) Dinah s failure to make a Section 83(b) election is beneficial to the other partners, because, per Sec. 83(h), the partnership would be entitled to deduction in Year 4 for the $500,000 guaranteed payment to W/0 83(b) In effect, all of the asset appreciation occurring between issuance and vesting (potential capital gain) is converted to ordinary income for Dinah (but deductible by the other partners)

21 Disguised Payments For Services Sec. 707(a)(2)(A) 5-17 IRS Partnership Audit Guide Excerpts on Sec. 707(a)(2(A) Possible Legislation On Carried Interests 39