Profits Interest in a Service Partnership: Entrance and Forfeiture Under the 2005 Proposed Regulations

• Publication year: 2021

85 Nebraska L. Rev. 1093. Profits Interest in a Service Partnership: Entrance and Forfeiture Under the 2005 Proposed Regulations

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Comment*

Profits Interest in a Service Partnership: Entrance and Forfeiture Under the 2005 Proposed Regulations

TABLE OF CONTENTS

I. Introduction .................................................. 1094 R
II. Analysis of Current Law ....................................... 1095 R
A. Entrance of a New Partner .................................. 1095 R
1. I.R.C. § 83 ............................................. 1095 R
2. Campbell and Diamond .................................... 1096 R
3. Revenue Procedure 93-27 and Revenue
Procedure 2001-43 ....................................... 1097 R
B. Forfeiture of a Profits Interest ........................... 1100 R
III. Analysis of the Proposed Method ............................... 1102 R
A. Entrance of a New Partner--I.R.C. § 83 Applies ............. 1102 R
1. I.R.C. § 83(b) Election--Do or Die ...................... 1103 R
2. Valuation of a Profits Interest ......................... 1105 R
a. Resurrecting Campbell and Diamond .................... 1105 R
b. The Not-So-Safe Safe Harbor? ......................... 1105 R
B. Forfeiture ................................................. 1108 R
1. Forfeiture Allocations--General Application ............. 1108 R
2. The Crystal Ball--Predicting Sufficiency and
Character ............................................... 1110 R
IV. Conclusion .................................................... 1112 R

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I. INTRODUCTION

In May 2005 the Internal Revenue Service (IRS) and the Treasury Department issued proposed regulations and a revenue procedure that covered the federal income tax consequences of partnership equity transferred in connection with the performance of partnership services.1 A notable context in which the proposed regulations and revenue procedure may apply is the practice of law. For example, a law firm associate may become eligible for the coveted title of "partner" after several years of employment with his law firm. Depending on the law firm's structure, the associate-now-partner may act as a pure "service partner" whereby he will make no further contribution to the partnership other than his continued provision of services. In exchange, the new partner is entitled to an ownership share of the partnership's profits in addition to his regular salary. Thus, with the exception of a higher billing rate and an increased level of authority over the younger associates, the partner's duties remain largely the same as they were when the partner was an associate. Moreover, the time may come when the partner will leave his firm and either retire or seek other employment. As a result, his compensation will cease, and assuming that he has no desire to take clients with him, speaking in terms of tangibles, he will walk away with little more than what he started with--a law degree and a license to practice law.

As simple as the above scenario seems, tax practice in this area has been a topic of debate, confusion, and impending change. Commentators have expressed varying opinions on the subject, and the tax bar has extensively critiqued the recent proposed changes in this area of law.2 This Comment will focus on two narrow aspects of the scenario described above: (1) the entering of a service partner for a profits interest to a "service partnership," a partnership in which substantially all of its activities involve the provision of services; and (2) the later forfeiture by the partner of the profits interest. The purpose of this Comment is to describe the current law and methods of practice in this area. In addition, this Comment will highlight and analyze areas of importance that a practitioner should understand if the proposed methods become final. Finally, this Comment will conclude by noting a few areas that are in need of clarification by the IRS and the Treasury Department before finalization of the proposed scheme.

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II. ANALYSIS OF CURRENT LAW

A. Entrance of a New Partner

The existence of a service partnership depends on the people who come together to participate in the joint venture. Unlike a venture into the sale of goods, service partnerships do just what the label en-tails--provide services for a fee. Therefore, the individuals are the focus of the partnership's success and growth. Furthermore, the ability to attract highly skilled and qualified individuals (or those that have shown the potential to become highly skilled and qualified) is essential to the service partnership's success. In this context, one of the most attractive aspects of many service partnerships is the prospect of sharing in the partnership's profits. "Making partner" in a law firm can be thought of as a great achievement, not so much from the personal practice development standpoint, but rather, because of the ability to share in the profits of the partnership. Therefore, the entrance of a new partner is not only an event of substantial significance to the service partnership's success, but consequently, it is also an area in which the service partnership and the partner may seek a tax practi-tioner's advice.

Currently, the entrance of a new partner by way of a profits interest given in exchange for services is governed administratively by Revenue Procedure 93-27,3 as clarified by Revenue Procedure 2001-43.4 These revenue procedures attempted to correct conflicting legal authority as to whether a profits interest is currently taxable as property with a determinable value, or rather, a contractual interest that is too speculative to warrant immediate taxation. Before progressing, a brief description of I.R.C. § 83 is necessary.

1.I.R.C. § 83

Under I.R.C. § 83(a), the fair market value of property received in exchange for services is included in income in the year in which the rights of the service provider with respect to the property are "substantially vested," i.e., either transferable or no longer subject to a substantial risk of forfeiture.5 However, under § 83(b), the service provider may choose, if an election is made, not to apply § 83(a).6 Rather, the partner may include the fair market value of the property received for services in gross income in the year of transfer and not at such later time when the rights to the property are no longer subject to transfer or forfeiture restrictions.7 The application of I.R.C.

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§ 83(a)-(b) to a profits interest, however, is somewhat ambiguous for two reasons. First, the current definition of "property" as laid out in Treasury Regulation § 1.83-3(e) for I.R.C. § 83 purposes does not specifically include partnership profits interests.8 It is unclear from the language of the regulation whether the writers intended "property" to include a profits interest based on the fact such interests may be intangible personal property under state law,9 or instead intended to exclude such interests based on the idea that profits interest should be treated more like a contract right to receive future compensation.10 Second, since profits interests, by nature, carry no value other than the expectation to receive money in the future, determining fair market value for either § 83(a) or § 83(b) purposes is a difficult task. Such difficulty is best demonstrated by prior conflicting case law.

2. Campbell and Diamond

In the landmark case of Campbell v. Commissioner,11 the Eighth Circuit held that a taxpayer could not be currently taxed on profits interest because its value was too speculative. Since the determination of an interest's fair market value is one of fact, a battle of the experts ensued between the taxpayer and the IRS:

Campbell's expert testified that the values of the partnership interests were speculative and not in excess of $1,000. His opinion was based on the present values of the cash distributions projected in the offering memoranda. He discounted these values because of the restrictions on transferability and the lack of participation rights in management of the partnerships. He attached no present value to the projected tax benefits because of the substantial risk of disallowance upon likely audits. The Commissioner used the same basic method of valuation, except that he included the present value of the tax benefits in his calculations and used a much lower discount rate resulting in higher present values.12

Given that the Eight Circuit sided with the taxpayer's view that the profits interest was too speculative to tax, this holding eliminated the need to resolve the issue of whether a profits interest is indeed "property" subject to I.R.C. § 83. This result, however, was in marked contrast to an earlier Seventh Circuit case, Diamond v. Commissioner.13 In Diamond, the Seventh Circuit held that a profits interest acquired in the month of February of the applicable tax year, and which was subsequently sold three weeks later in March, had a readily determi 1097

nable fair market value at the time of acquisition--namely, the value of the subsequent sale.14 Consequently, after Campbell and Diamond a taxpayer could only speculate as to whether a profits interest would have a determinable and taxable value upon acquisition, and whether the interest was subject to § 83.

3.Revenue Procedure 93-27 and Revenue Procedure 2001-43

To rectify the conflicting case law and to provide a workable framework for the taxation of profits interest, the IRS drafted Revenue Procedure 93-27, which states:

[I]f a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership.15

In determining whether an interest at issue is a true...