Partnership interests subject to risk of forfeiture.

• Author: Ellentuck, Albert B.

Facts

On Dec. 31, 1989, Arnie and Jack formed a partnership, Eagle Co., to acquire and operate an apartment building. Each contributed $200,000 for a 50% interest. On Jan. 1, 1990, in exchange for an agreement to manage the building, Gary was admitted to the partnership with a 10% interest in partnership capital, profits and losses. Arnie's and Jack's capital accounts were reduced to $180,000 each; Gary was credited with a $40,000 capital account to reflect his 10% interest in Eagle's capital. Gary also was entitled to share in income, losses and current distributions. Under the agreement, Gary would forfeit his entire interest if he ceased performing building management services prior to July 1, 1991. Gary did not elect to be taxed immediately on this transfer.

For the partnership year ending on Dec. 31, 1990, Gary was allocated $10,000 as his distributive share of Eagle's income (for book purposes only). On Jan. 15, 1991, Gary received a $6,000 cash distribution from Eagle. On July 1, 1991, Gary's partnership interest became fully vested. At that time, Eagle's net worth was $500,000.

Issue

What are the tax effects to Eagle and its partners?

Analysis

Absent a Sec. 83(b) election, a service provider recognizes income from the receipt of property in the first tax year in which the service provider's rights to the property are not subject to a substantial risk of forfeiture or are transferable free of any such risk.

Substantial risk of forfeiture

If full enjoyment of the property is conditioned on the continued performance of substantial services, the rights are subject to a substantial risk of forfeiture. A substantial risk of forfeiture also exists if the recipient's rights are subject to another substantial condition, such as the recipient's refraining from competition for a specified period of time or the achievement of some goal related to the transfer.

Transferee as nonpartner

Under Regs. Sec. 1.83-1(a)(1), until the property becomes substantially vested, the transferor is regarded as the owner of the property for tax purposes. Any "income" received by the service provider is treated as compensation when received. There are no statutory exceptions that address the application of these rules to partnerships.

Gary will not be treated as a partner of Eagle for tax purposes until July 1, 1990. On that date Gary will recognize income equal to the fair market value (FMV) of the partnership interest. Assuming the...