There are two types of interest in a partnership: Capital Interest and Profits Interest.  Both Capital Interest and Profit Interest are determined based on the contribution of property to the partnership and or services performed for the partnership.  The Tax Court has described a Capital Interest is any interest that would entitle the holder to receive a share of partnership assets upon liquidation of the partnership.  Profit Interest is any interest that would not entitle the holder to receive assets on an immediate liquidation but that does give the partner the right to share in future partnership profits or earnings (Mark IV Pictures Inc. v. Commissioner, T.C. Memo 1990-571), Reg. 1.721-1(b)(1) and Reg. 1.704-1(e)(1)(v) respectively.

If a partner receives an interest in the partnership in exchange for services, is beginning basis the partnership interest is the amount of income required to be reported for the transaction.  Under Reg. 1.721-1(b)(1), service provided is not a property that will satisfy the regulation for non taxable transaction.  Therefore, the LLC is deemed to have paid the individual partner for services in cash and the individual partner in return, contributed an equal amount of value (cash) to the partnership in acquisition of an interest in the partnership.  

When services are contributed to a partnership, the tax consequences will depend on the type of partnership interest received by the partner, i.e. whether or not that interest is restricted to the service partner in some way.  If non-restricted interest is received by the service partner, the fair market value of the interest is taxable to the service partner as ordinary income.  The LLC deducts or capitalizes that interest, based on the type of services rendered.  For example, if the service rendered by the partner was related to a capital project e.g. computer programmer created a code that will be used for a software, this type of service must be capitalized by the LLC and cannot be deducted as ordinary expense.

[Read the rest of this article...]