Over the years the law governing partnership and the payments to be allocated to the partners either for the services offered or for the property was being treated like a transaction. This aspect of partnership laws includes but not limited to payments received as interests of profit made in the partnership as payments for services rendered and this could either be viewed either as a capital or profit interests.
This has for many years caused rows which are taken to the corridors of justice, courtesy of the existing substantial uncertainty and in the same vein the conflicting precedents of tax laws cases on decisions on whether profit interest should be taxed and at what rate.
Albeit, in 2005 May, the IRS( Internal Revenue Service) formulated a proposal of regulations touching on the alteration of and creation a distinction profits interests and capital, establishing section 83 which determines the general rules on interest that is issued in connection with service performance, the timing, amount and income of the service provider and the issue of partnership deduction in relation to amount and timing, the recognition of gain and losses on the partnership interest and lastly the provision of a safe harbor which based on the assumption that the value of fair market equals to the liquidation value (Blum 1).
The current regulations provide for regulations of taxation. The issue unclear provisions on treatment of a service partner contributing service to a partnership and receives interests in the partnership’s future profits. The issue has been that when a partner receives profit interest only and not capital interest, for services rendered, is it the aggregate or the entity concept that should be applied? The courts have attempted to solve this conflict and to clarify the situation only to come up with contradicting decisions.
Case law on revenue ruling. The laws were explored and revisited in the famous case of William G. Campbell v. Commissioner 943 F. 2d 815(CA 8,1991) and also in the case of Sol Diamond V. Commissioner 492 F. 2d 286 (CA-7, 1974) on profit interest taxation (Englebrecht 1). In the Diamond case a taxpayer was restrained from converting capital gains from ordinary income. Diamond entered a joint venture with a partner for purposes of purchasing a building to be used as an office.
The appellant did not contribute any capital but they made an arrangement where he would be the financier for the project and in return he receives 60% interest on the future profits. The appellant after the purchase of the building, sold off his interest to the partner and did not declare income he received from the profit interest. Nevertheless, he reported a short term capital gain the sale resulting to him to offset this gain.
The seventh circuit concurring with the tax court ruled that no laws were clear on provision that profit interests which are compensatory receipts are free from taxation. The decision in both case in favour of the commissioner, in the later case it cited the tax rule section 83. was clear and that property received in compensatory to be income on receipt and falls within both the capital interest and profit interests According to section 1. 21-3 (e) excludes unfunded and /or unsecured promises from income recognition. Tax court ruled that profit interest per se is property thus taxable as under the provisions of section 83. On appeal to the eight circuit though it considered that there was no proof that Campbell did not receive his partnership interest for purposes of tax avoidance the circuit did not overturn the decision of the tax court but pointed out that when deciding such cases other factors should also be considered (Englebrechtc3).
The loophole in the revenue regulations is the cause of the there is no clear cut rule to be applied when deciding revenue cases. This could be a factors that led to the proposal of the new regulations by the IRS. Profits interest Profits interest can be defined as an interest with a zero capital account and in case of liquidation of a partnership on a material date of transfer then such an account will be entitled to nothing (Bartlett 1).
Notice 2005-43 (section 83 principles apply) This is the proposed revenue procedure regarding partnership interests transferred in connection to service performance. Under these new rules the provisions are that a person who receives a partnership interest will be liable to pay income tax rates which rate will have it’s basis on fair market interest value at the specific time when the interest was received and a consequent corresponding deduction made to the partnership.
Apparently, in the partnerships there is no recognition of loss or gain in connection to the issuance of the interest (partnership interest) to the specified service provider. According to Bruce Hood if there is a substantial risk of forfeiture of the partners interest at the time of issue, then it cannot be subjected to current taxation rules until the time it vests 30 days from grant date, then the recipient has an option to be taxed under section 83(b) which has provision on non-vest interest (12).
Distinctions between capital and profits interests. Capital interests is interest obtained when existing partners in a partnership opt to retain their rights wholly to the partnership assets in the marker value that is current, while profit interest occurs when new partners are granted right to receiving (shares of)future profits. The later can also be referred to as carried profits ( Cain 8). The two scenarios occur when partners enter into an agreement to divide the components of their existing equity interest.
In a nutshell the guidance of the proposed regulations eliminates the stated distinction between capital interest and profit interest. In this regard interest in the partnership issued and in connection to the service performance are treated in a like manner as such and thus are taxable in accordance to section 83. In summary the major distinction between the two is that capital interest are clearly taxable while the has been a conflict on provisions on whether profit interest should be taxable depending on if it falls under service provision or otherwise.
Safe harbor (for profits interests) election based on liquidation values. The provision for safe harbor is under section for of the new IRS regulations, this can generally be described to be a statute provision either reducing or eliminating a party’s liability, so long as the party acted in good faith and it is a methodor option by which patnerships would incur tax. Specifically, the procedure effectively permits a patnership to elect under its terms and qualify to value its interests depending on the liquidation value of the patneship interests.
Arthur Willis and his co- authors explain that under the Safe Harbor, the fair market value of a Safe Harbor Partnership Interest is treated as being equal to the liquidation value of that interest and thus, liquidation value is determined without regard to any lapse restriction (as defined at 1. 83-3(i)) this means that the deduction is available in accordance with the service recipient’s method of accounting(Willis et al,13). Vested and non-vested profit interests (what happens when vested)
According to section 83 a non-vested interest should not be subjected to taxation unless it becomes vested. The non-vested interest which no election has been made under section 83 (b), will not be treated as ownership of the recipient and at the same time the recipient cannot be treated like a partner and thus not allocated partnership tax until the time when vesting will occur or a subsequent election for it to be taxed in current state is made.
Vested interest are expounded on as being governed by section 83a and non-vest interest under section 83b of the revenue regulations (Haufler 21). Section 83(b) and its election The proposed regulations make clear that both capital and profits interests in a partnership are property subject to the rules of Code section 83. 30 . According to Rubin the proposed regulations also clarify that the non-recognition rules of section 721 (applicable to receipt of a partnership interest in exchange for property) are inapplicable to the receipt of any partnership interest ( Rubin 3).
For capital account created for maintenance purposes, proposed regulations thus increase the capital account of service provider by the amount the provider takes into income as provided under Code section 83 including the amount paid for the interest, if any. RP 93-27 -when someone is qualified (qualifications) and status as a partner.
The aforementioned procedure revenue procedure 93-27 as provided for in the regulation, alters the historic view on profit interests but in the spirit elaborates that issuing of profit interest made by a partnership in exchange of services does not result to it being a current income while if the capital interest was issued and it was not subject to a risk of forfeiture which was not substantial then it can be said that it was a recognition of income by the service provider resulting to a deduction from the partnership or depending if it is applicable a currently capitalized expenditure (Blum 4).
What should taxpayers do now in response to the proposed regulations? In concluding this discussion, due to the absent guidance from the IRS then it is recommendable and advisable for partners to know how they can deal with the profit interests. First, the partners can together scrutinize section 707 and ensure that their arrangements to be structured in such a way that it avoids in total appearance of stated income in the section. This will help reduce the risk of the transaction being treated as a taxable receipt of income (Englebrecht 4).
Secondly the interest received should ideally be classified as subordinate to other classes and the agreement should not mention the value of the services to be provided by the recipient partner. Another credible advise is that the partners should not leave the partnership after sell of his/her interest this will help to minimize the risk the interest received being placed on a value and lastly the partner should avoid receipt of distributions which would indicate an immediate return on the interest and thus a determinable value.