What's your interest? Clarifying the issuance of partnership interests for services.

• Author: Uhler, David
• Position: Safe Harbor Partnership Interest

Partnerships and LLCs have historically been used for passive investments, mainly for flow-through taxation and liability protection. But more taxpayers have recently chosen to use partnerships and LLCs for non-passive ventures, including hospitality or manufacturing businesses.

As a result, business owners have had to face complex tax issues associated with issuing equity ownership to employees or other service providers for their services.

Notice 2005-43

While corporate tax law related to the issuance of equity for services (i.e. restricted stock, stock options, etc.) is well established, the same can't be said for partnerships and LLCs.

Rev. Proc. 93-27 and Rev. Proc. 2001-43 provide the general framework for the taxation of service providers receiving both vested and nonvested profit interests in a partnership. However, both revenue procedures tend to raise more questions than provide answers.

Enter Notice 2005-43, issued in May 2005, and proposed regulations under both IRC Sec. 83 and various sections of Subchapter K.

Taken together, Notice 2005-43, which contains a proposed revenue procedure, and the proposed regulations aim to provide the same level of clarity for partnerships and LLCs already found in corporate tax law related to the issuance of equity to service providers.

This is a lofty goal considering it requires coordination between two of the more commonly misinterpreted areas of the IRC--Sec. 83 and Subchapter K.

Significantly, Notice 2005-43 and the proposed regulations eliminate the different tax treatments for the issuance of profits and capital interests.

Instead, all interests in partnerships, capital and profits will be subject to the same rules, thus making Rev. Procs 93-27 and 2001-43 obsolete.

Under the proposed regulations, if a service provider receives a partnership interest of profits or capital that is substantially vested and not subject to a substantial risk of forfeiture, or substantially nonvested with a Sec. 83(b) election in effect, then it will be taxed on the difference between the value of the partnership interest, less the amount they paid (if any) for the partnership interest.

Safe Harbor Partnership Interest

How does a partnership determine the value of a capital or profits interest? The proposed regulations provide clear guidelines related to determining value by introducing a new type of partnership interest, the Safe Harbor Partnership Interest.

An SHPI is any interest in a partnership, capital...