Study Outline For:

Partnership Taxation

 

Module: Overview Sub-K

Sect:

Section C. Partnership Interest for Services - Selected Readings
 

Please browse the following statutory provisions

 

Code Sections
Regulations

83

1.83-1
1.83-2

Receipt of Partnership Interest for Services

The nonrecognition provisions of IRC Sec. 721 do not apply to the transfer of services in exchange for a partnership interest. The taxable partnership interest received in exchange for the services may be a capital interest, a profits interest, or both.

A capital interest refers to a partner's entitlement to a portion of the initial and subsequent contributions of capital to the partnership,- in other words, an interest in the assets (net of any liabilities) of the partnership. The receipt of a capital interest is taxable immediately at its fair market value (FMV).

A profits interest generally refers to the right to share in the future income of the partnership and in the appreciation in the value of the assets. The receipt of an interest for future profits is usually taxable only when and as those profits are actually realized.

NOTE
At one time, the IRS tried to tax the RECEIPT of a profits interest . This is not the norm, however, due to tremendous valuation problems. But it can happen when the VALUE of the profits interest is evident.

 

Example 1
A, an attorney, performs legal services for the ABC partnership in exchange for a 20 percent capital interest. The FMV of ABC is $50,000. Accordingly, A must recognize $10,000 (20 percent of $50,000). If the exchange was for a profits interest of 20 percent, the interest is generally not taxed to the partner until such time that the partnership earns a profit. At that time, A will report a 20 percent share of profits (or losses, if any).

Tax consequences of the services

The Regulations provide that when a partnership interest is exchanged for services, the service partner must recognize income to the extent of the fair market value of the interest received. The value of the interest, so determined, will be recognized by the service partner as compensation. This compensation must be recognized at the time of the transfer if the interest in the partnership is for past services. A transfer conditioned on the performance of future services will be taxed at the completion of such services.

The basis to a service partner for a partnership interest is the amount of income recognized. If the service partner is an existing partner, the amount recognized is added to the old basis.

The partnership will treat the amount of services performed in exchange for an interest as either a capitalized cost or as an expense item. This treatment will vary depending upon the nature of the services performed. IRC Sec. 707(c)

Example 2
P, a plumber, performs services in exchange for a 20 percent capital interest in the XYZ partnership worth $50,000. If the services are performed prior to the transfer, P must recognize as compensation income $10,000 (20 percent of $50,000). P's basis in XYZ will be $10,000. If the services are for general plumbing services, the partnership will expense the $10,000. If the services are major plumbing repairs, the partnership will capitalize and depreciate the $10,000.

Restricted interests

The previous discussion has been primarily concerned with unrestricted interests. That is, partnership interests that are transferred for services without strings attached. Many times, partnerships want to restrict the complete passage of an interest until some contingent event occurs. That event could be the passage of time, a partner's performance, or any other condition to which the partner and the partnership agree. When a transfer is restricted, the timing of income recognition can vary.

A restricted partnership interest for services is one that is nontransferable until some contingency is fulfilled and is subject to a substantial risk of forfeiture. In a restricted interest, income is deferred until the restrictions lapse or the interest is no longer subject to a substantial risk of forfeiture, whichever comes first. A substantial risk of forfeiture simply means that the partner will forfeit the right to the partnership interest if all conditions of the contingency are not met.

Exception
Under IRC Sec. 83(b), a service partner that receives a restricted capital interest may elect (within 30 days) to recognize compensation in the year the partnership interest is initially transferred. Under this election, the partnership interest is valued as if no restrictions exist and the service partner is immediately elevated to the status of partner for federal tax purposes (i.e., the partner receives a K-1).

The advantage of making the election is to fix the amount of compensation currently so that any subsequent appreciation goes untaxed as ordinary income. However, should a partner make this election and subsequently forfeit his or her interest, no deduction is allowed for the amount of income recognized at the time of transfer.

Example 3
E, an executive, is offered a 10 percent interest in the ABC partnership (currently worth $80,000) upon agreement to manage it for five years. If E leaves before that time, the interest is forfeited. Since this agreement involves a substantial risk of forfeiture, under Sec. 83(b), E can elect to include $8,000 (10% of $80,000) as compensation. By doing so, E can avoid recognizing 10% of ABC's value in five years when the restrictions lapse and the partnership is possibly worth much more. If E should gamble and report the $8,000 currently, no deduction is allowed on any future forfeiture of the interest (i.e., E doesn't stay five years).

 

NOTE

The partnership records the transaction on its books at the same time that the partner recognizes income. The Regs specify how the partnership is informed of this election.

Study Questions Make your selection by clicking the appropriate response letter.

1. . .

Which of the following is not true regarding a restricted capital interest given to a service partner?
 
If no election is made, the income is reported by the service partner either when the restrictions are removed or when the Capital interest is received,

A service partner who receives a restricted capital interest can elect to be taxed currently rather than when the restriction is removed.

If a service partner elects to be taxed currently, the amount of includable income is the value of the interest on the date it was received, determined as if no restriction existed.
 
If a service partner elects to be taxed currently, an offsetting deduction is allowed if the interest is subsequently forfeited

2. . .

V is to perform services in exchange for a 20 percent capital interest in a partnership. Both the services and the capital interest are valued at $30,000. However, the agreement between V and the partnership states that the capital interest is forfeited if V violates any part of the service contract during the next five years. V believes the market value of the interest at the end of the fifth year will be $70,000. (Assume this $70,000 value is accurate when choosing among the answers below,) V has a choice of recognizing.
$0 now and $70,000 at the end of the fifth year.

$30,000 now and $40,000 at the end of the fifth year,

$70,000 now and $0 at the end of the fifth year.
$70,000 now and $0 at the end of the fifth year.

3. . .

T exchanges services for a 20 percent interest in the ABC partnership. The value of the entire partnership is $100,000, Based upon this information, which of the following is true?
If the interest is a profits interest, T must recognize $20,000 in the year that the services are performed.

If the interest is a restricted partnership capital interest, T must recognize $20,000 in the year the services are performed.

If the interest is an unrestricted profits interest, the income will be recognized in the future as profits are recognized.
If the interest is an unrestricted capital interest, no income will be recognized until the capital interest is sold or exchanged.

4.

In return for services rendered to it by P, the LMN partnership transfers a one-fourth ownership interest to P when it only has one asset, a tract of land with a basis of $25,000 and fair market value of $40,000. The partnership has no liabilities. As a result of this transaction, Partnership LMN has, respectively.

Realized === Recognized

$15,000 ====$40,000

$ 5,000=====$30,000

$ 5,000=====$35,000
$15,000 ====$25,000

Copyright © 2000 Bizzer.com Jump to BeginningPrevious PageNext Page