Receipt of a conditional partnership interest for services.

• Author: Ellentuck, Albert B.

Facts: On May 1, 1997, Tom, Dick and Harry formed a partnership, No Trump Tower, to construct and operate an office building. Tom and Dick each contributed half interests in a lot with a total value of $600,000 for their one-third interests in partnership capital, profits and losses; Harry has agreed to contribute services in supervising the construction of the building for the remaining one-third interest. Tom and Dick, however, want assurance that Harry will perform as agreed. To this end, the partners have agreed that Harry will forfeit his partnership interest if he fails to perform the agreed-on services through the completion of construction, unless the failure is caused by his death or disability. The building is expected to be completed on April 15, 1998, at which time Harry's interest will vest. At that time, the partners expect the fair market value (FMV) of the land, building and related property to be $8 million and the property to be subject to a $6.5 million mortgage. Harry is uncertain of the tax effects of this transaction and asks his tax adviser for help. Issue: How can Harry minimize his compensation income from the receipt of an interest in No Trump Tower?

Analysis

A person who receives property subject to a substantial risk of forfeiture in connection with the performance of services his two choices: (1) report the income when the property becomes vested or (2) elect within 30 days of the receipt to report the property as income in the year of receipt. If this election (commonly referred to as a Sec. 83 (b) election) is made, the service provider is taxed at the time of receipt on the excess of the property's FMV over the amount (if any) paid for it.

The electing recipient receives a basis in his partnership interest equal to the sum of the compensation income recognized plus the amount (if any) paid for the interest. This basis is used to determine any subsequent gain or loss on disposition of the partnership interest. If a Sec. 83(b) election is made, the service provider is treated as the owner of the interest and is taxed on receipt as if the interest were not subject to any substantial risk of forfeiture. The later lapse or satisfaction of the condition giving rise to the risk is not a taxable event.

Benefits of a Sec. 83(b) Election

The benefits of electing to be taxed in the year of receipt are twofold: (1) the recipient avoids recognizing subsequent appreciation in the partnership interest as compensation income...