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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.
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NOTE
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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.
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Example
1 
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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).
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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
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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.
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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.
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Exception
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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).
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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
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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).
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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.
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