Types of Partnership & LLC interest.
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, the beginning basis in the partnership interest is the amount of income required to be reported for the services rendered. 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.
If the interest received by the service partner is restricted i.e. there are conditions that a partner must meet before he can completely receive the interest. This promised future capital interest is subject to risk or forfeiture. For example; a service partner may receive a capital interest in a partnership in exchange for three years of service. Under Sec 83, the receipt of such restricted interest may not result currently in taxable income. Once the service partner met all the conditions to acquire the interest and that interest is 100% vested, the interest becomes freely transferable and the fair market value of the service partner’s interest is taxed at that time. Note that if the Fair Market Value of the future LLC interest will be significantly higher than the current valuation of the LLC interest, the service partner will pay significanlty more in taxes due to the increase of the interest valuation. Therefore, a proper tax planning must be done to avoid larger tax bill in the future.
The transfer of a capital interest in exchange for services performed for the partnership is treated as an IRC Sec 707 (c) guaranteed payment (Reg. 1.721-1(b)(2)). If the service partner receives an interest solely in future partnership profits, the tax consequences may be different. In Revenue Procedure 93-27 the IRS ruled that the receipt of a partnership profits interest for services provided to or from the benefit of the partnership was not taxable except under very limited circumstances:
1. If the profits interest relates to a substantially certain and predictable stream of income from partnership assets such as income from high quality debt security or high quality net lease.
2. If within two year of receipt, the partner disposes of the profits interest.
3. If the profits interest is a limited partisanship interest in a publicly traded partnership, within the meaning of Sec 7704(b) of the IRC.
If any of the above conditions are applicable, then the tax consequence of profit interest are similar to taxation of the capital interest.
It should be noted that neither the partnership nor the partner may deduct the fair market value of the profit interest (Rev. Proc. 2001-43)Posted in:Business Tax ArticlesThis article was written by TaxBizPro, LLC 2023, all rights reserved ©.
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