Category: Sales & Exchanges; Partnerships &
LLCs Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer will receive an interest in the capital and profits of a partnership in exchange for past services. Taxpayer will be prohibited from selling the partnership interest without a majority vote of the other partners. Normally, receipt of a capital interest in a partnership gives rise to immediate taxation. Does the restriction on sale defer taxation until the restriction lapses? Under Section 83(a), the reporting of income by a service partner is deferred until the year in which the interest becomes substantially vested. Substantial vesting occurs in the first year in which A) the interest is transferable; or B) the interest is no longer subject to a substantial risk of forfeiture. IRC Section 83(a)(2). Note that taxation occurs whenever either of these two restrictions lapses. Accordingly, in order to avoid immediate taxation on the receipt of property in exchange for services, it is necessary that the property be non-transferable and subject to a substantial risk of forfeiture. Thus, a mere restriction on transferability based on a vote of the other partners is not sufficient to delay taxation to the recipient partner in this case. Suppose the parties are willing to subject the interest in question to
a substantial risk of forfeiture. Restrictions that by their terms will
never lapse, such as a right of first refusal in a buyout agreement, are
not treated as restrictions that defer taxation. I bring up this point because
frequently transferability restrictions of the type we are discussing very
closely resemble first refusal rights. §1.83-3(c) provides as follows. Substantial risk of forfeiture--In general. For purposes of section 83 and the regulations thereunder, whether a risk of forfeiture is substantial or not depends upon the facts and circumstances. A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied. Property is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property. The risk that the value of property will decline during a certain period of time does not constitute a substantial risk of forfeiture. A nonlapse restriction, standing by itself, will not result in a substantial risk of forfeiture. Do the parties expect the taxpayer to perform substantial future services? If not, it may be very difficult to structure a forfeiture restriction that passes muster under these rules. We should discuss this. As an alternative, suppose the parties give the taxpayer an option to purchase an interest in the partnership at some time in the future. Current taxation could be avoided by making the option price equal to the current fair market value of the interest. Clearly, this changes the economics of the deal significantly, and the question becomes how much is tax deferral worth to this taxpayer. As a further alternative, the parties could consider giving the taxpayer a profits-only interest. In general, this option would allow the partner to share in future appreciation and cash flow without immediate taxation beyond K-1 flow-through. Again, this is a significantly different economic deal. Also, there is a great deal we should discuss from a technical perspective if this alternative is desired. |
