I. INTRODUCTION
On May 24, 2005, the Treasury Department ("Treasury") published proposed treasury regulations (the "proposed regulations") and a proposed revenue procedure (the "proposed revenue procedure") governing the issuance and vesting of capital and profits partnership interests issued in connection with the performance of services (such interests, "compensatory partnership interests").1 As discussed below, the proposed regulations represent a significant change in the government's approach to the taxation of compensatory partnership interests.2
The proposed regulations would alter the basis for taxing compensatory partnership interests (or not), while attempting to preserve the tax consequences under the current rules. Achieving this goal may depend in large part on whether final regulations expand the scope of the liquidation value safe harbor and reduce the procedural hurdles associated with its use. Treasury has postponed work on finalizing the proposed regulations while Congress considers proposed carried interest legislation.3
Very generally, section 409A4 limits the ability of taxpayers to defer compensation under nonqualified deferred compensation plans by imposing stringent deferral election and distribution requirements, and section 457A effectively precludes service providers of "nonqualified entities" from deferring compensation by taxing such amounts when they cease to be subject to a substantial risk of forfeiture. Treasury and the Internal Revenue Service ("IRS") have issued only very limited guidance applying these Code sections to partnership and LLC interests.
II. SECTION 83 GOVERNS COMPENSATORY PARTNERSHIP INTERESTS
- Section 83 generally applies to service-related transfers of
property, and courts have held that a partnership capital interest
is property for this purpose.5 Resolving a long history
of case law questioning the status of profits interests as property
for section 83 purposes,6 the proposed regulations
provide that section 83 governs the tax consequences of both
capital and profits interests issued for
services.7
- Although the proposed regulations apply section 83 to both
capital and profits interests, they do not govern a bare right to
receive allocations and distributions from a partnership described
in section 707(a)(2)(A), because such a right does not constitute a
partnership interest.8 The preamble to the proposed
regulations explains that Congress has directed that, consistent
with its substance, such an arrangement is properly treated as a
disguised payment of compensation to the service
provider.9
- Excepting section 707(a)(2)(A) payments from the section 83
regime adopted by the proposed regulations creates considerable
uncertainty regarding the type of payments the proposed regulations
would govern.
Section 707(a) provides that a transaction between a partner and its partnership other than in his or her capacity as a partner will be treated as occurring between the partnership and a party who is not a partner. Although section 707(a)(2) authorizes Treasury to promulgate regulations to determine when allocations and distributions should be treated as such payments to a partner not acting in such capacity, Treasury has not issued such regulations.10
- Thus, the description in the 1984 Committee Report to section 707 of the factors to be considered in promulgating regulations still represents the only guidance on the scope of section 707(a)(2)(A).11 Entrepreneurial risk appears to be the determining factor as to when and under what circumstances a service provider's interest should be treated as a partnership interest (and so subject to the proposed regulations).
- Excepting section 707(a)(2)(A) payments from the section 83
regime adopted by the proposed regulations creates considerable
uncertainty regarding the type of payments the proposed regulations
would govern.
- Although the proposed regulations apply section 83 to both
capital and profits interests, they do not govern a bare right to
receive allocations and distributions from a partnership described
in section 707(a)(2)(A), because such a right does not constitute a
partnership interest.8 The preamble to the proposed
regulations explains that Congress has directed that, consistent
with its substance, such an arrangement is properly treated as a
disguised payment of compensation to the service
provider.9
- The proposed regulations include significant section 83-related amendments to subchapter K regulations, including changes to (i) conform the subchapter K rules to the section 83 timing rules; (ii) revise the section 704(b) regulations to take into account the fact that potentially transitory allocations with respect to an unvested interest may be forfeited; and (iii) revise the section 721 regulations to provide that a partnership generally does not recognize gain or loss on the transfer of a compensatory partnership interest.
- Revenue Procedures 93-2712 and 2001-4313 will be modified to reflect the proposed regulations if and when they are published in final form, although the revenue procedures will remain the operative guidance until final regulations are issued.14
A. Section 83(b) Elections for Compensatory Partnership Interests
- Consistent with the principles of section 83, the proposed
regulations provide that if a section 83(b) election is made for an
unvested capital or profits interest, the service provider will be
treated as a partner for all income tax
purposes.15
- A section 83(b) election with respect to an unvested profits interest that complies with the liquidation safe harbor (described below) will typically eliminate both the service provider's ordinary income and the partnership's corresponding compensation deduction that would be allocated among the other partners.16 A service provider may decide whether to make a section 83(b) election (or not) for each separate compensatory interest received.
- By contrast, if a section 83(b) election is not made for an unvested compensatory partnership interest, the service provider will not be treated as a partner until the interest becomes substantially vested. At that time, the service provider would recognize ordinary compensation income.17
- Query whether a section 83(b) election will be required only
for the initial grant of a profits or capital interest to a service
provider who is not then a partner, or whether separate elections
will also be required for subsequent grants of interests to the
same person. If so, query whether fluctuations in the relative
value of a compensatory partnership interest as a result, for
example, of redemptions of other partnership interests, could
constitute a deemed transfer of a new interest that would require a
new section 83(b) election.
- Discussions with government officials indicate that while separate section 83(b) elections must be made for each actual grant of a separate compensatory interest, fluctuations in the value of a single interest should not require separate elections.
- Notably, the proposed regulations apply only to compensatory
interests issued in connection with services provided to the
issuing partnership.18 As a result, the regulations do
not appear to govern the transfer of an interest in a lower-tier
partnership in exchange for services provided to the upper-tier
partnership. The government appears to recognize the need to expand
these rules, as Treasury and the IRS have requested comments on the
income tax consequences of such transactions.19
- Responding to comments that the presently proposed regulations would exclude many of the compensatory interests typically issued by funds, government officials have indicated that final regulations may apply on some type of affiliated partnership group basis (although no final decisions have yet been made).
- To cover such transfers, the proposed regulations could be applied on either a control group basis, testing only general partners (or LLC member-managers), or on a commonly controlled group basis, which would cover the transfers by many fund families of varying interests in several funds within a fund family to the manager of a single fund.
B. Retroactive Compensatory Partnership Interests
- The government has requested comments regarding the timing of
retroactive transfers of partnership interests for section 83
purposes and what, if any, actions may be appropriate to address
the associated administrative concerns.
- Query whether section 83(b) elections can be made with respect
to retroactively effective profits interests, and, if so, what the
operative date would be for valuing the interest, and whether the
limited period during which a section 83(b) election can be made
would run from the date of grant, rather than the (retroactive)
effective date of the interest.
- A strong argument can be made that the date the interest is actually granted should begin the 30 day period for making a section 83(b) election, since no property is actually transferred until such date. The retroactive share of profits and losses that accompanies the interest should be viewed as merely an attribute of the interest that would not cause the interest to be deemed transferred on an earlier date.
- Query whether retroactive profits interests can be granted to service providers who are not partners during the entire retroactive period in which they would be considered partners if a retroactive section 83(b) election were permitted, or only to individuals who held separate partnership interests during such retroactive period. It appears that retroactive grants to non-partners would be permitted, although the proposed regulations do not address this issue.
- Query whether section 83(b) elections can be made with respect
to retroactively effective profits interests, and, if so, what the
operative date would be for valuing the interest, and whether the
limited period during which a section 83(b) election can be made
would run from the date of grant, rather than the (retroactive)
effective date of the interest.
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Footnotes
* I'm grateful to Simon Friedman and Shelly Banoff for discussing these issues with me, posing many of the questions discussed below, and catching my mistakes.
1 REG-105346-03 (May 24, 2005); Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005).
2 For a discussion of the current taxation of compensatory partnership interests, see Swartz, L. Z., A Layman's Guide to LLC Incentive Compensation, published in the PLI LLC and Corporate Tax Conference Materials.
3 If enacted, proposed legislation, which would generally tax income allocated to profits interests, i.e., "carried interests," held by service providers at ordinary rates, could significantly affect the proposed regulations. Partnership Guidance On Hold Pending Legislative Action, Treasury Officials Say, 2009 TNT 100-3 (May 28, 2009) (regulation project not entirely off the table, but taxpayers should not expect to see final regulations in the near future). For a discussion of the proposed carried interest legislation, see Section VII below.
4 All section references herein are to sections of the Internal Revenue Code of 1986, as amended (the "Code"), or to sections of Treasury regulations promulgated thereunder.
5 See Schulman v. Commissioner, 93 T.C. 623 (1989) (section 83 governs the issuance of an option to acquire a partnership interest as compensation for services provided as an employee); Mark IV Pictures, Inc. v. Commissioner, 60 T.C.M. (CCH) 1171 (1990), aff'd, 969 F.2d 669 (8th Cir. 1992) (applying section 83); Kenroy, Inc. v. Commissioner, 47 T.C.M. (CCH) 1749 (1984) (all partnership interests are property for section 83 purposes).
6 See, e.g., Campbell v. Commissioner, 59 T.C.M. (CCH) 236 (1990), aff'd in part and rev'd in part, 943 F.2d 815 (8th Cir. 1991) (Tax Court found that partnership profits interests are property within the meaning of section 83; Eighth Circuit considered whether partnership profits interests are property without articulating a definite position); St. John v. U.S., 84-1 USTC ¶ 9158 (C.D. Ill. 1983) (without discussion, partnership profits interests assumed to be property for section 83 purposes, but taxpayer's interest was not subject to tax since it had no value); Kenroy, Inc. v. Commissioner, 47 T.C.M. (CCH) 1749 (1984) (all partnership interests are property within the meaning of section 83); Kobor v. U.S., 88-2 USTC ¶ 9477 (C.D. Cal. 1987); U.S. v. Pacheco, 912 F.2d 297 (9th Cir. 1990). For commentary summarizing the debate, see, e.g., Schmolka, Leo L., Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell Quietly Die, 47 Tax L. Rev. 287 (1991) (section 83 not applicable to profits interest because it is not property); but see, e.g., Cunningham, Laura E., Taxing Partnership Interests Exchanged for Services, 47 Tax L. Rev. 247 (1991) (no reason a profits interest should not constitute property for section 83 purposes). For a general discussion of the taxation of compensatory partnership interests, see Kahn, Douglas A., The Proper Tax Treatment of the Transfer of a Compensatory Partnership Interest, 62 Tax Law. 1 (2008).
7 Prop. Reg. § 1.83-3(e).
8 REG-105346-03 (May 24, 2005); Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005), section 2.
9 See REG-105346-03 (May 24, 2005), Preamble; S. Rep. No. 98-169, at 226 (1984).
10 See I.R.C. § 707(a)(2).
11 See S. Rep. No. 98-169, at 230 (1984).
12 1993-2 C.B. 343.
13 2001-2 C.B. 191.
14 See REG-105346-03 (May 24, 2005), Preamble.
15 Prop. Reg. § 1.761-1(b); Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005), citing Rev. Rul. 83-22, 1983-1 C.B. 17.
16 REG-105346-03 (May 24, 2005); Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005), sections 5.01 and 6, Ex. 1.
17 Prop. Reg. § 1.761-1(b); Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005), section 2.
18 Prop. Reg. § 1.721-1(b)(3).
19 See REG-105346-03 (May 24, 2005), Preamble.
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