Valuing partnership interests acquired in exchange for services.

• Author: Ellentuck, Albert B.

The following discussion addresses the rules that currently govern the receipt of a partnership interest in exchange for services. Practitioners should be aware that proposed regulations and Notice 2005-43 provide new rules and new safe-harbor provisions that will apply to the receipt of a partnership interest by a service partner when the regulations are finalized.

The issue of value is always important when Sec. 83 applies to a transfer of property--including a partnership interest transfer to a service partner. Indeed, the problem of valuation is especially tricky when the property is a partnership interest, because a ready market seldom exists to help establish value.

Valuing Capital Interests

If the transferred partnership interest is a capital interest, the liquidation value is often assumed to establish the interest's fair market value (FMV). While this is certainly a convenient rule of thumb and may often establish an appropriate value consistent with the overall tax treatment of the transaction, practitioners may have room to argue for a lesser value--because [degrees]f lack of liquidity, transfer restrictions, and other factors. Such factors are certainly considered in other contexts when property is valued (see, e.g., Rev. Rul. 59-60 (discussing factors to be considered in valuing stock for estate and gift tax purposes), amplified by Rev. Ruls. 83-120,80-213, and 77-287; Evans, 29 B.T.A. 710 (1934), acq. 1934-1 C.B. 6).

The time at which the interest is valued may be an issue. In Johnston, T.C. Memo. 1995-140, the Tax Court found that the taxpayer (the general partner in a limited partnership) had to recognize taxable income when he received a 1% interest in partnership capital. The 1% interest was shifted from the limited partners to the general partner and was described as compensation in partnership documents. The proper time for valuing the 1% interest was determined to be when all limited partners were on board, rather than at an earlier date when the partnership had been legally formed but not yet fully capitalized.

Nonlapse Restrictions and Minority Ownership

A nonlapse restriction is a restriction on the property that, by its terms, will never lapse and that allows the transferee to sell only at a price fixed pursuant to a formula (e.g., book value or a percentage of gross revenues) (Sec. 83(d)(1)). In such cases, the price determined by taking into account the nonlapse provision will be the property's FMV for Sec. 83 purposes. A later cancellation of the restriction, however, can generate taxable income (Sec. 83(d)(2)).

While nonlapse restrictions are common when stock is transferred to employees, the practitioner considering using a nonlapse restriction in connection with the transfer of a partnership interest must be careful. The restriction will almost certainly be...