Receipt of partnership interest for services: income or not?by Englebrecht, Ted D.
Several IRC sections (e.g., Secs. 701 and 702) treat the partnership as a pool for determining profit and loss to be divided among partners. This is the essence of the aggregate concept theory of a partnership-- that all partners will be taxed only in their separate capacities. On the other hand, the partnership is treated by other code sections as an entity for federal income tax purposes, e.g., Secs. 706, 703(d), and 707(a). The partnership has its own taxable year, it makes its own elections, and a partner may engage in transactions with the partnership other than in his or her capacity as a partner.
Because of the conflict between the entity and the aggregate concepts theories, confusion can arise in many areas of partnership taxation where clear guidance from legislation or regulation does not exist. One such area of confusion is the proper tax treatment when a partner contributes services (a service partner) to a partnership and, in exchange, receives an interest in the future profits of the partnership. When a partner contributes property in exchange for a capital or profits interest, application of the entity concept dictates that no gain or loss is recognized on the transaction. When a partner contributes services for a capital interest, the entity concept requires the partner to recognize income. However, if a partner receives only a profits interest, as opposed to a capital interest, in exchange for services, whether the entity or the aggregate concept should be applied is an unsettled issue.
A number of courts have addressed the question of taxing the receipt of a profits interest but with varying outcomes. The question was revisited in William G. Campbell v. Comm. 943 F.2d 815 (CA-8, 1991); 52 TCM 263 (1990). Although no test for income recognition was established, the Eighth Circuit did provide discussion of the proper underlying theories of income recognition upon a compensatory receipt of a profits interest.
This article examines the legislative, administrative, and judicial history leading up to Campbell and reviews the reasoning of the Eighth Circuit in finding for the taxpayer. It also analyzes the current status of the tax treatment for the compensatory receipt of a profits interest in a partnership. Finally, it provides tax planning recommendations to service partners for minimizing their risk of income recognition on compensatory receipts of interests in future profits.
LEGISLATIVE AND ADMINISTRATIVE HISTORY
Pursuant to Sec. 721, contributions of property in exchange for a partnership interest are not taxable events. Moreover, Sec. 721 makes no distinction between the receipt of a capital interest and a profits interest. A partner may contribute property to a partnership and, in turn, receive an interest in the capital and/or future profits of the partnership without recognizing gain or loss on the transaction.
Sec. 721 does not address the issue of the taxability of a partnership interest in exchange for services. Reg. Sec. 1,7211(b)(1), however, dictates that the receipt of a capital interest in exchange for services is not afforded tax-free treatment under Sec. 721. The regulation provides that "to the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share of partnership profits) in favor of another partner as compensation for services... Sec. 721 does not apply. "As a result, whenever a partner receives a compensatory transfer of a capital interest in the partnership, then an amount equal to the value of the partnership interest received must be included in gross income of the service partner.
Sec. 83, added to the IRC by TRA 69, applies to transfers of property in connection with the performance of services and determines the timing of income recognition. Sec. 83 requires that compensatory transfers be recognized as income in the year in which the transferee acquires beneficial ownership of the property. Reg. Sec. 1.83-3(e) specifies. that the term "property" does not include unfunded or unsecured promises to pay money in the future. Even though a capital interest in a partnership is. "property" for purposes of Sec. 83, whether the issuance of a mere profits interest falls under the purview of Sec. 83 is uncertain.
The parenthetical reference in Reg. Sec. 1.721-1(b)(1) to partnership profits may be read as indicating an administrative decision to exclude the receipt of a profits interest from current income recognition. Subsequent to enactment of Sec. 83, the IRS proposed an amendment to Reg. Sec. 1.721-1(b)(1) specifying that the provisions of Sec. 83 are intended to apply to compensatory transfers of partnership interests. The proposed amendment retains the parenthetical exclusionary clause referring to partnership profits, and it also makes direct reference to partnership "capital" in specifying the application of Sec. 83. The wording of the proposed amendment suggests that income recognition under Sec. 83 is intended to apply only to compensatory transfers of capital interests and not to transfers of profits interests. The proposed amendment to the regulation has neither been adopted nor withdrawn, perhaps because the IRS is unclear on the proper treatment of a compensatory transfer of a profits interest.
PRE-CAMPBELL JUDICIAL INTERPRETATIONS
The courts have not agreed regarding the tax treatment of a compensatory receipt of a profits interest in a partnership. In Herman M. Hale v. Comm. 24 TCM 1497 (1965), the taxpayer received a profits interest in a partnership in exchange for services. Prior to receiving any income from the partnership, the taxpayer sold the profits interest and treated the proceeds from the sale as gain from the sale of a capital asset. The Tax Court held that the income from the sale was ordinary income because the partnership interest was "an anticipation of future income." The court added a footnote stating "under Reg. Sec. 1.7211(b), the mere receipt of a partnership interest in future profits does not create a tax liability." The court provided no explanation as to how it reached its interpretation of this regulation. The footnote suggests, however, that the Tax Court felt the proper treatment was to hold the transaction open until such time as the service partner was allocated a share of the partnership income or sold or exchanged the partnership interest.
The Multi-Faceted Diamond Decision
In the controversial case Sol Diamond v. Comm. 492 F.2d 286 (CA-7, 1974) aff'g 56 TC 530 (1971), again a taxpayer was prevented from converting ordinary income to capital gains, but this time the court used a different line of reasoning to reach its conclusion. Diamond had entered into a joint venture with another individual to purchase an office building. Diamond, a mortgage broker, contributed no capital but agreed to arrange financing for the project in exchange for a 60% interest in future profits. Almost immediately following the purchase of the building, Diamond sold his interest to his joint venture partner. He reported no income from the receipt of his profits interest, but he did report the sale as short term capital gain. Diamond then offset this gain by an unrelated short term capital loss.
Diamond contended that the joint venture was a partnership, and citing Sec. 721 and Reg. Sec. 1.721-1(b)(1), he argued that the compensatory receipt of a profits interest in a partnership is not taxable. He proposed that the profits interest had no value upon receipt. Further, he took the position that, pursuant to Sec. 741, the sale of the interest produced capital gains.
The Tax Court held that the profits interest received by Diamond represented compensation for services rendered and must therefore be included in income under Sec. 61. The court noted that Sec. 721, which allows taxfree treatment for contributions of propercy to partnerships in exchange for a partnership interest, does not address the tax treatment of a profits interest. It rejected Diamond's argument that the parenthetical clause in Reg. Sec. 1.721-1(b)(1)"as distinguished from a share of partnership profits" brings the compensatory receipt of a profits interest into the purview of Sec. 721. The Tax Court also rejected Diamond's argument that the profits interest had no value upon receipt noting that the interest was sold for $40,000 less than three weeks following its receipt by Diamond.
In affirming the Tax Court's decision, the Seventh Circuit acknowledged some of the practical problems and uncertainties associated with taxing a profits interest received in exchange for services provided to the partnership and called for "the promulgation of appropriate regulations to achieve a degree of certainty." It agreed with the Tax Court, however, that nothing in the statute, regulations, administrative interpretations, or legislative history indicated that a compensatory receipt of a profits interest is not a taxable event. The Seventh Circuit conceded that in many cases a profits interest would have only speculative value or no value. This observation by the court appears to suggest its willingness to limit its holding in Diamond to situations whereby a profits interest has a readily determinable value.
The Chief Counsel of the IRS responded to Diamond with a General Counsel Memorandum (GCM 36346, July 25, 1977). The GCM proposed a revenue ruling stating that the IRS would not treat a compensatory receipt of an interest in future profits as a taxable event. Evidently, the Chief Counsel interpreted Reg. Sec. 1.721-1(b) to exclude from current taxation an interest in future profits received as compensation. The proposed revenue ruling was never issued, but the GCM has not been withdrawn.
Subsequent to Diamond, the courts generally have treated the receipt of a profits interest as taxable to the extent of its fair market value. However, they consistently have applied the liquidation valuation method which results in a zero value of a pure profits interest.(1) The liquidation method of valuation treats all partnership assets as if they were sold at fair market value and the resultant gains or losses allocated to the partners according to the partnership agreement. The partnership liabilities are assumed satisfied and the remaining cash distributed to the partners according to the partnership agreement in a complete liquidation.(2) The amount of liquidating proceeds the partner would receive is treated as determinative of the value of the profits interest received. Absent a positive capital account, the partner's share of the liquidating proceeds is necessarily zero. Thus, the application of the liquidation valuation method virtually assures that the service partner will not be taxed on a compensatory receipt of a profits interest.
CAMPBELL RECONSIDERS DIAMOND
The Campbell case provided the Tax Court the opportunity to reconsider the conclusions reached in Diamond. As compensation for services performed in connection with organizing, promoting, and financing the syndication of three limited partnerships, Campbell received special limited partnership interests. These special interests were profits interests and were subordinate to all other limited and general partnership interests. The Commissioner assessed a tax deficiency asserting that the value of the partnership interests received was taxable income to Campbell.
The Logic of the Tax Court
In holding for the Commissioner, the Tax Court ruled that Sec. 83, which requires the compensatory receipt of property to be included in income when received, applies to partnership profits interests as well as capital interests. The Tax Court's analysis in Campbell focused on whether a profits interest in a partnership is properly classified as property or as an unfunded, unsecured promise to pay. Reg. Sec. 1.721- 3(e) excludes "unfunded, unsecured promises to pay" from current income recognition. It concluded that a profits interest is property and thus taxable under Sec. 83. In response to Campbell's argument that the interest would have no value on liquidation, the court departed from the previous use of the liquidation method for determining value and applied a discounted cash flow valuation method. Consequently, the profits interests were held to have determinable values.
Eighth Circuit Hears the Appeal
On appeal to the Eighth Circuit, Campbell argued that no income is realized upon receipt of a mere profits interest and no income recognition is required.
The Commissioner conceded that the Tax Court erred in its holding that a service partner should be taxed on a compensatory receipt of an interest in' future profits. He argued that the partnership interests were received for services provided to Campbell's employer rather than to the partnerships and should be treated as compensation.
The court rejected the Commissioner's assertion that the interests were transferred by Campbell's employer as compensation, but it was not willing to dismiss the income realization issue. Citing Diamond, the Eighth Circuit pointed out that some support existed for the Tax Court's decision. The court also noted a lack of consensus among numerous previous cases regarding the proper tax treatment of the receipt of a profits interest in exchange for services provided and a deficiency of the courts in adequately analyzing the issue.
In support of Campbell's argument that no income is realized upon the receipt of a mere profits interest in a partnership, an amicus curiae brief was presented to the Eighth Circuit, by Deloitte & Touche, in which it was argued that the Tax Court had based its decision on an erroneous premise. The brief presented the argument that for income to be realized, that which is received must have a fair market value "within the meaning of our system of federal taxation of income."
Citing historical case law, the brief concludes that fair market value is an "exchange value" and that "the receipt of property results in the realization of income only when it has an exchangeable value constituting a cash equivalent." Accordingly, it concluded that the appropriate issue was not one of income recognition but rather one of income realization.
The First Consideration
The Eighth Circuit considered three arguments against treating a compensatory receipt of a profits interest as income. The first relates to the parenthetical clause in Reg. Sec. 1.721-1(b)(1) which has been interpreted as excluding a profits interest from its meaning of property for purposes of Secs. 61 and 83. It indirectly addressed the issue raised in the amicus curiae brief by distinguishing between a transaction which results in a transfer of capital and one which merely provides an interest in future profits. The Court agreed that the interpretation often placed on Reg. Sec. 1.721-1(b)(1) is not without merit. In distinguishing a compensatory receipt of a profits interest from that of a capital interest, it pointed out that the receipt of an interest in future profits does not shift capital away from existing partners to the service partner as does the receipt of a capital interest. Although the court did not go so far as to declare that no income was realized upon the receipt of a profits interest, it did conclude that different treatments for compensatory profits interests and compensatory capital interests is justified.
The Second Consideration
The next issue analyzed by the Eighth Circuit concerned the flow- through principal of partnership taxation. The court cited several cases where distributions to a partner were held to be distributive shares of partnership income rather than salary payments3 and noted that, except in certain circumstances, distributions of income to a partner are not treated as compensation. An exception to the general flow-through principles is provided by Sec. 707(a)(1) which stipulates that transactions between a partnership and a partner, acting in a non- partner capacity, are treated as occurring between the partnership and one who is not a member of the partnership. In such a case, payments to the partner are not considered a distributive share of partnership income. The court noted that Congress enacted the provisions of Sec. 707 to prevent partnerships from avoiding capitalization of certain expenditures by treating those payments as distributions to service partners. It also pointed out that Sec. 707 was not intended to apply when service partners act in their capacity as partners. The Court concluded that if compensatory transfers were taxable upon receipt, Sec. 707(a) would not be necessary (Sec. 707 was enacted subsequent to Diamond).
The Eighth Circuit distinguished Campbell from Diamond on two aspects. First, Diamond did not provide service as a partner nor did he intend to perform any duties as a partner or to remain a partner. Second, he sold his interest in the partnership and received money equal to the value of the services he performed. Therefore, value of those services was readily determinable. Campbell, on the other hand, was acting in the capacity of a partner and remained a member of the partnerships. Moreover, his interests were not transferrable, and he received no immediate return. Unfortunately, the Eighth Circuit did not overturn the Tax Court on this reasoning.
The Third Consideration--The One that Mattered
The last position considered by the Eighth Circuit, and the one upon which it reversed the Tax Court, relates to valuation. The Circuit Court rejected the method used by the Tax Court for determining the value of the profits interest and agreed with Campbell that the values, if any, were highly speculative. Although the Eighth Circuit addressed the violations of partnership principles in taxing a compensatory transfer of an interest in future profits, in essence, it found fault only with the Tax Court's determination of fair market value.
CURRENT STATUS ON PROFITS INTERESTS
The Eighth Circuit appeared to be in complete agreement with the Seventh Circuit in that Diamond-type transactions should not be treated as nontaxable contributions. The court stated that the receipt of Diamond's partnership interest was properly taxable because the profits interest was received for services performed not as a partner, and because the interest was subsequently sold at its fair market value. According to the court, these factors suggested that Diamond's purpose was the avoidance of ordinary income recognition.
The court noted several characteristics of Campbell which distinguish it from Diamond. Campbell intended to remain a member of the partnership, and his interest was not easily transferable and had little or no determinable value at the time of receipt. Campbell apparently did not receive the partnership interest for the purpose of avoiding income recognition. Even though no criteria other than a determinable value were expressly applied in overturning the Tax Court, the Eighth Circuit's discussion suggests that perhaps other traits should be considered.
Aside from the valuation issue, the Appellate Court gave recognition to attributes of the Campbell transaction which relate generally to the partner/ partnership relationship. It implied that, because Campbell provided the services to the partnership and remained a member of the partnership, he acted in a partner capacity. As a consequence, a Campbell-type transaction would not trigger Sec. 707(a) income recognition.
Sec. 707 requires that compensatory receipts of profits interests will generally be taxable to the recipient in Diamondtype transactions. Moreover, Campbelltype transactions still may be taxable unless the recipient can show that the interest received had no value or only a speculative value at the time of receipt. Since the Eighth Circuit acknowledged other distinguishing characteristics of Campbell-type transactions, those other characteristics could conceivably become a valuable defense in future litigation. For a summary of the attributes supporting a Diamond or Campbell outcome, see Figure 1.
TAX PLANNING RECOMMENDATIONS
Employees of partnership promoters and syndicators frequently receive limited partnership interests for services performed in forming the partnership and selling the partnership shares. Absent guidance from Congress or the IRS, tax advisors can look to Campbell in helping clients structure compensatory transactions involving partnership profits interests. To reduce the risk of having the transaction treated as a taxable receipt of income, the arrangement should be structured to avoid all appearances of a Sec. 707(a) transaction. Moreover, evidence of a fair market value should be minimized to the extent possible.
If the recipient of a profits interest is an employee, the interest should be received directly from the partnership rather than from the employer. Moreover, the interest should be in exchange for services provided to the partnership, and the structure of the transaction should indicate that the receipt is not in exchange for services provided to an employer or any general partners. The partnership agreement should specify, that the interest is transferred to the partner in exchange for services provided to the partnership.
The interest received should be a special class of pannership interest which is subordinate to other classes of interest and, ideally, would have substantial limitations placed on its transferability. The partnership agreement should make no mention of the value of the services provided by the recipient partner. In fact, an independent appraisal of the interest at the time of its receipt showing that it has no market value could be very beneficial as a defense against income recognition.
To minimize the possibility of having a value placed on the interest received, the partner should not sell the interest and leave the partnership. Remaining a member of the partnership also indicates that the partner is acting in the capacity of a partner and that the transaction is not a Sec. 707(a) transaction. Finally, the partner should avoid receipt of distributions which would indicate an immediate return on the interest and, therefore, a determinable value. For the purpose of advising clients in structuring compensatory transfers of profits interests, the starting point in a tax practitioner's analysis should be a review of the transaction attributes depicted in Figure 1.
WHAT'S AN ADVISOR TO DO?
For years, tax advisors, commentators, and the courts have grappled with the issue of taxability of compensatory receipts of profits interests. It is not clear if Congress intended such transfers to be excluded from current taxation. Few transactions involving the receipt of an interest in a partnership's future profits in exchange for services have been treated as taxable income. In situations where the tax-free treatment of such transactions has been challenged by the IRS, most have avoided income recognition by showing that the interest had no market value. For the first time, a court has addressed some of the problems associated with the concept that these transfers should be considered income at the time of receipt. The Eighth Circuit did not base its ruling on these issues in Campbell. It did propose factors to be analyzed in arriving at the proper tax treatment of compensatory transfers of profits interests.
Hopefully, the ruling in Campbell will provide the impetus for the IRS to issue guidelines with regard to profits interests received by service partners. Until such guidance is available, tax practitioners should advise clients to structure compensatory transfers of profits interests as closely to Campbell as possible.
1 See e.g., st. John v. United States, 84-1 USTC 9158 (DC 1983), KenroV, Inc. v. Comm., 47 TCM 1749 (1984), and National Oil Co. v. Comm., 52 TCM 1223 (1968).
2 McKee, Nelson, and Whitmire, "Federal Taxation of Partnerships and Partners," 2d ed., 1990.
3 Pratt v. Comm., 550 F.2d 1023 (CA-5, 1977), Comm. v. Moran, 236 F.2d 595 (CA-8, 1956), and Lloyd v. Comm., 15 B.T.A. 82 (1929).
Evelyn C. Hume is an assistant professor of accounting at Georgia State University. She is a member of the American Accounting Association and the American Taxation Association. She has published several articles on partnership taxation issues.
Ted D. Englebrecht is the KPMG Peat Marwick Professor of Accpimtomg at Geprgoa State University. He has previously published articles in The CPA Journal.
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