Grant of Partnership Interest

Technical topics regarding tax preparation.
#1
DAJCPA  
Posts:
869
Joined:
24-Apr-2014 1:05pm
Location:
Colorado
My client did some consulting work for a partnership (the LLC) and was granted a 10% interest in the partnership (a MMLLC) worth 300K. The consulting was of executive nature and my client now serves on the "board" of the partnership. I'm not sure how long he plans to serve on the board. The partnership was struggling (it is an equipment rental business) and my client used to be an executive in the same type of business so the partnership brought my client on board to help them turn things around. He consulted with the owners of the partnership for a couple of years, on and off, as they needed his assistance. He plans to make himself available if they need him in the future, but does not foresee rendering a lot more services to the LLC. He does not do any other consulting for anyone else. He is retired and lives off real estate rental and other investment income.

Here is the question. My client wants to set up a SEP to help with the tax on the 300K of earned income from the grant of the interest in the LLC. However, if he is considered as rendering the services to the partnership in capacity as partner (guaranteed payment), it looks like the SEP must be that of the partnership and allow all employees to participate etc. However, if he can establish his services were rendered as a non-partner, I assume he would be able to set up and contribute to his own SEP. Do you think he can be considered a non-partner with respect the the services or do think this is a guaranteed payment to him as a partner of the partnership?
 

#2
Nilodop  
Posts:
18751
Joined:
21-Apr-2014 9:28am
Location:
Pennsylvania
Is the interest really worth $300k, in light of the struggle to which you allude?

Are there restrictions on his disposition of the partnership interest?

Were the services rendered and then he received the partnership interest as compensation, or did he receive the interest and then render the services?

Is your question answered in here? http://www.kirkland.com/siteFiles/kirke ... artner.pdf
 

#3
DAJCPA  
Posts:
869
Joined:
24-Apr-2014 1:05pm
Location:
Colorado
The 300K is a fair valuation based on a recent sale of some partnership units. It is a fairly large business and had value, it was just struggling to grow and reach its potential. There is risk of forfeiture but my client made an 83(b) election at 300K for the granted units. He did the consulting work and as payment received the partnership interest. My client is a friend of one of the higher-ups and had some time on his hands and offered to help.
 

#4
Posts:
3222
Joined:
21-Apr-2014 8:25am
Location:
Michigan
GENERAL EXPLANATION

OF THE

REVENUE PROVISIONS OF THE

DEFICIT REDUCTION ACT OF 1984

(H.R. 4170, 98TH CONGRESS;
PUBLIC LAW 98-369)


The Act authorizes the Treasury Department to prescribe such
regulations as may be necessary or appropriate to carry out the
purposes of the provision. In prescribing these regulations, the
Treasury should be mindful that Congress is concerned with trans-
actions that work to avoid capitalization requirements or other
rules and restrictions governing direct payments and not with non-
abusive allocations that accurately reflect the various economic
contributions of the partners. These regulations may apply the pro-
vision both to one-time transactions and to continuing arrange-
ments which utilize purported partnership allocations and distribu-
tions in place of direct payments. Congress specifically intended
that the provision apply to allocations used to pay partnership or-
ganization or syndication fees, subject to the general principles
above.

The regulations will provide, when appropriate, that the purport-
ed partner performing services for or transferring property to the
partnership is not a partner at all for tax purposes. If it is deter-
mined that the service performer or property transferor actually is
a partner (because of other transactions), Congress believed that
the factors described below should be considered in determining
whether the partner is receiving the putative allocation and distri-
bution in his capacity as a partner.

The first, and generally the most important, factor is whether
the payment is subject to an appreciable risk as to amount. Part-
ners extract the profits of the partnership with reference to the
business success of the venture, while third parties generally re-
ceive payments which are not subject to this risk. Thus, an alloca-
tion and distribution provided for a service partner under the part-
nership agreement which subjects the partner to significant entre-
preneurial risk as to both the amount and the fact of payment gen-
erally should be recognized as a distributive share and a partner-
ship distribution, while an allocation and distribution provided to a
service partner under the partnership agreement which involve
limited risk as to amount and payment should generally be treated
as a fee under section 707(a). Examples of allocations that limit a



® Of course, if a partner received an interest in a partnership in exchange for services, he may
recognize income upon that receipt; however, this issue arises only if it is determined that an
amount received is not a fee but relates instead to a partnership interest. See Code sections 61
and 8:^; Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974).



228

partner's risk include both "capped" allocations of partnership
income (i.e., percentage or fixed dollar amount allocations subject
to an annual maximum amount when the parties could reasonably
expect the cap to apply in most years) and allocations for a fixed
number of years under which the income that will go to the part-
ner is reasonably certain. Similarly, continuing arrangements in
which purported allocations and distributions (under a formula or
otherwise) are fixed in amount or reasonably determinable under
all the facts and circumstances and which arise in connection with
services also shield the purported partner from entrepreneurial
risk. Although short-lived gross income allocations are particularly
suspect in this regard, gross income allocations may, in very limit-
ed instances, represent an entrepreneurial return, which is classifi-
able as a distributive share under section 704. Similarly, although
net income allocations appear generally to constitute distributive
shares, some net income allocations may be fixed as to amount and
probability of payment and should, if coupled with a distribution or
payment from the partnership, be characterized as fees.

The second factor is whether the partner status of the recipient
is transitory. Transitory partner status (which limits the duration
of a purported joint undertaking for profit) suggests that a pay-
ment is a fee or is in return for property. The fact that partner
status is continuing, however, is of no particular relevance in es-
tablishing that an allocation and distribution are received in an in-
dividual's capacity as a partner.

The third factor is whether the allocation and distribution that
are made to the partner are close in time to the partner's perform-
ance of services for or transfer of property to the partnership. An
allocation close in time to the performance of services, or the trans-
fer of property, is more likely to be related to the services or prop-
erty. In the case of continuing arrangements, the time at which
income is scheduled to be allocated to the partner may be a factor
indicating that an allocation is, in fact, a disguised payment. When
the income subject to allocation arises over an extended period or
is remote in time from the services or property contributed by a
partner, the risk of not receiving payment (the first factor de-
scribed above) may also increase.

The fourth factor is whether, under all the facts and circum-
stances, it appears that the recipient became a partner primarily to
obtain tax benefits for himself or the partnership which would not
have been available if he had rendered services to the partnership
in a third party capacity. The fact that a partner also has signifi-
cant non-tax motivations in becoming a partner is of no particular
relevance.

The fifth factor, which relates to purported allocations /distribu-
tions for services, is whether the value of the recipient's interest in
general and continuing partnership profits is small in relation to
the allocation in question (thus suggesting that the purported allo-
cation is, in fact, a fee). This is especially significant if the alloca-
tion for services is for a limited period of time. The fact that the
recipient's interest in general and continuing partnership profits is
substantial does not, however, suggest that the purported partner-
ship allocation/distribution arrangement should be recognized.



229

The sixth factor, which relates to purported allocations/distribu-
tions for property, is whether the requirement that capital ac-
counts be respected under section 704(b) (and the proposed regula-
tions thereunder) makes income allocations which are disguised
payments for capital economically unfeasible and therefore unlike-
ly to occur. This generally will be the case unless (i) the valuation
of the property contributed by the partner to the partnership is
below the fair market value of such property (thus improperly un-
derstating the amount in such partner's capital account), or (ii) the
property is sold by the partner to the partnership at a stated price
below the fair market value of such property, or (iii) the capital ac-
count will be respected at such a distant point in the future that its
present value is small and there is to be no meaningful return on
the capital account in the intervening period.

Congress anticipated that the Treasury Department may describe
other factors that are relevant in evaluating whether a purported
allocation and distribution should be respected. In applying these
various factors, the Treasury and the courts should be careful not
to be misled by possibly self-serving assertions in the partnership
agreement as to the duties of a partner in his partner capacity but
should instead seek to determine the substance of the transaction.

In the case of allocations which are only partly determined to be
related to the performance of services for, or the transfer of proper-
ty to, the partnership, the provision applies to that portion of the
allocation which is reasonably determined to be related to the
property or services provided to the partnership. Finally, it was an-
ticipated that Treasury regulations will provide for the coordina-
tion of this provision with the preexisting rules of section 707 and
other provisions of subchapter K such as section 736.

Congress did not intend to create any inference regarding the tax
treatment of the transactions described above under prior law.

The principles of this provision can be illustrated by the follow-
ing examples.

Example 1

A commercial office building constructed by a partnership is pro-
jected to generate gross income of at least $100,000 per year indefi-
nitely. Its architect, whose normal fee for such services is $40,000,
contributes cash for a 25-percent interest in the partnership and
receives both a 25-percent distributive share of net income for the
life of the partnership, and an allocation of $20,000 of partnership
gross income for the first two years of partnership operations after
lease-up. The partnership is expected to have sufficient cash avail-
able to distribute $20,000 to the architect in each of the first two
years, and the agreement requires such a distribution.

The purported gross income allocation and partnership distribu-
tion in this example should be treated as a fee under section 707(a),
rather than as a distributive share because as to those payments
the architect is insulated from the risk of the joint enterprise. Fac-
tors which contribute to this conclusion are (1) the special alloca-
tion to the architect is fixed in amount and there is a substantial
probability that the partnership will have sufficient gross income
and cash to satisfy the allocation/distribution; (2) the distribution
relating to the allocation is fairly close in time to the rendering of



230

the services; and (3) it is not unreasonable to conclude from all the
facts and circumstances that the architect became a partner pri-
marily for tax reasons.

If, on the other hand, the agreement allocates to the architect 20
percent of gross income for the first two years following construc-
tion of the building, a question arises as to how likely it is that the
architect will receive substantially more or less than his imputed
fee of $40,000. If the building is pre-leased to a high credit tenant
under a lease requiring the lessee to pay $100,000 per year of rent,
or if there is low vacancy rate in the area for comparable space, it
is likely that the architect will receive approximately $20,000 per
year for the first two years of operations. Therefore, he assumes
limited risk as to the amount or payment of the allocation and, as
a consequence, the allocation/distribution should be treated as a
disguised fee. If, on the other hand, the project is a "spec building,"
and the architect assumes significant entrepreneurial risk that the
partnership will be unable to lease the building, the special alloca-
tion might (even though a gross income allocation), depending on
all the facts and circumstances, properly be treated as a distribu-
tive share and a genuine partnership distribution.

Example 2

In certain instances, allocation /distribution arrangements that
are contingent in amount may nevertheless be recharacterized as
fees. Generally, these situations should arise only when (1) the
partner in question normally performs, has previously performed,
or is capable of performing similar services for third parties, and
(2) the partnership agreement provides for an allocation and distri-
bution to such partner that effectively compensates him in a
manner substantially similar to the manner in which the partner's
compensation from third parties normally would be computed.

For example, suppose that a partnership is formed to invest in
stock. The partnership admits a stock broker as a partner. The
broker agrees to effect trades for the partnership without the
normal brokerage commission. In exchange for his partnership in-
terest, the broker contributes 51 percent of partnership capital and
receives a 51 percent interest in residual partnership profits and
losses. In addition, he receives an allocation of gross income that is
computed in a manner which approximates his foregone commis-
sions. It is expected that the partnership will have sufficient gross
income to make this allocation. The agreement provides that the
broker will receive a priority distribution of cash from operations
up to the amount of the gross income allocation. In this case, even
though the broker/ partner's special allocation appears contingent
and not substantially fixed as to amount, it is computed by means
of a formula like a normal brokerage fee and effectively varies
with the value and amount of services rendered rather than with
the income of the partnership. Thus, this contingent gross income
allocation along with the equivalent priority distribution should be
treated as a fee under section 707(a), rather than as a distributive
share and partnership distribution.

In addition to these examples, Congress intended that the provi-
sion lead to the conclusions contained in Revenue Ruling 81-300,
1981-2 C.B. 143, and Revenue RuUng 81-301, 1981-2 C.B. 144, except



231

that the transaction described in Revenue Ruling 81-300 would be
treated as a transaction described in section 707(a) (rather than sec-
tion 707(c)).
 

#5
Posts:
5868
Joined:
23-Apr-2014 9:30am
Location:
**********
See RR 81-300, including the reference to Pratt (and Pratt was mentioned in that other link about partners being employees...in the Tax Adviser article linked therein). The RR is inconsistent w/ the legislative history, however.

Anyway, if your facts are right: Guy consulted first and then was paid with a partnership interest when he was done consulting, seems you have a good case for non-partner treatment. But I doubt that's how it went down. Before he worked one second, he was probably presented with the "compensation package" wherein he was granted a restricted partnership interest. Then, he makes an 83(b) election almost immediately. I could be wrong, given the close relationship he has with the other partners. That is, perhaps he was comfortable working first and getting paid second, as you state, and was not worried about getting paid. But I suspect he has some obligation to "remain in the employ" of the partnership, or otherwise make himself available to the partnership, for X number of months or years.

If he makes an 83b election, all his work is done while he's a partner. Of course, that doesn't resolve the issue, because one can perform work while a partner, but not in a partner capacity. And this would take us back to the RR referenced above, case law and the inconsistent legislative history.

What I might be driving at here is the provision of current services vs. future services. If he worked first, and was paid second (with a restricted partnership interest), he didn't work as a partner at any time, which is your position. That is, he didn't get paid now for future services to be performed later. I think this would be the case whether or not he makes an 83b election since the work came first and the payment came second. But again, I'm not so sure this is what is going on in your case although you imply that it is.

If the guy gets the grant when he starts work, and he makes an 83b election "at grant" (i.e. within the 30-day window, but with the value back-dated to the grant date) and the restrictions don't lapse for 5-years, he's basically a partner the entire time he's providing the services. That is, he recognizes income first and he has to provide future services. And, he will be a partner when he provides those services. But again, that is not to say that when he provides the services he is doing so in the capacity of a partner. This again brings us back to the RR, etc.

I suppose we should also contrast it to a "no 83b election made" situation. In that case, we have no income recognition up front, but we do X-years from now. Arguably, he was never a partner when rendering the services b/c all he had was a restricted interest. In that case, he could not have been working in his capacity as a partner at any point in time for 707(a) purposes. I think this is clear-cut...and we wonder why it's so clear-cut here, but maybe not when we throw an 83b election into the mix, creating the collision between Subchapter K and Section 83.

P.S. Terry just posted and that is the legislative history I'm talking about.
 

#6
DAJCPA  
Posts:
869
Joined:
24-Apr-2014 1:05pm
Location:
Colorado
I did read some other information on the above along with the above. Most research discusses payments that should have been 707(a) non partner payments that were originally classified as distributive share allocations and distributions (nontaxable to extent of basis). We are not trying to allocate partnership income and make a distribution here to try and avoid tax. We are trying to differentiate between what is a 707(a) payment and what is a 707(c) payment. From what I gather it is a facts and circumstances test and generally the IRS will respect how the partnership treats the payment. The way I see things if my client has a IC agreement and the partnership treats the grant of the interest as and IC payment, then the IRS should respect he payments as 707(a) IC payment. The only problem I see here (when comparing to RR 81-301) is that my client doesn't' do the consulting for a living and thus does not do consulting for other clients/business. His only consulting was for the LLC. However, while doing the work he was not a partner. He was a partner after he did the work and was paid with grant of the interest. This I think helps to say this initial grant was and IC payment rather than a guaranteed payment since he was not admitted to the partnership when the work started, but after it was mostly complete. Any future work for which he is compensated may have to be 707(c) payments.

His interest in the LLC is a "limited partner" interest. However, "limited partners" can still receive 707(c) payments, so I don't think his classification as a "limited partner" helps to push the payment from 707(c) status to 707(a) status.

EDIT: I wrote this before I saw Cks post above. Due to the friendly nature of the relationship between the other owners and my client, my client did a couple years worth of work before the units were granted and the 83(b) made. He says he never really expected compensation, but due to how much his advice helped, the majority owner insisted that he be granted some interest. He will remain on and advise when needed, but the majority of his work is done.
 

#7
DAJCPA  
Posts:
869
Joined:
24-Apr-2014 1:05pm
Location:
Colorado
Thank you for the info and insight.
 

#8
Posts:
5868
Joined:
23-Apr-2014 9:30am
Location:
**********
Well, we are dealing with some restrictions here. How the valuation was arrived at, I'm not sure.

But it sounds like the partnership interest is in exchange for past services and also for future services, seeing that it's a restricted interest. And, presumably, the restrictions are such that the guy must serve "on the Board" for X number of years or he forfeits his interest.

I think the value associated with the past services was clearly in a non-partner capacity. There might be a question as to the future services, but if we're talking about a Board position only with respect to future acts/services, that can typically be carved off of "partner capacity" work (or W2 employee work in the case of a corporation wherein an employee is also paid for Board service).
 

#9
zl28  
Posts:
2065
Joined:
22-Apr-2014 10:27pm
Location:
usa
have a new york client.

he made 10k on sch c in 2020

haven't filed yet

was looking at taking 179 for his 40k in assets purchased

and using the carryover to defray his sch c in 2021 which will be net 130k in profits

Problem - he has like 15k in wages...and so that i believe makes me take more 179 that i don't even need

since in such a low bracket

Question: maybe i want to elect out of bonus depreciation since my 179 plan is not working - seems like my best option

If i don't file by 10-15 (he's in NYC - Hurrican Ida gives him addl time to file)

Will i be ok electing out of bonus depreciation if i file after 10-15 even though hurrican ida provides addl time?
 

#10
Nilodop  
Posts:
18751
Joined:
21-Apr-2014 9:28am
Location:
Pennsylvania
? Meant for a different thread? ?
 

#11
zl28  
Posts:
2065
Joined:
22-Apr-2014 10:27pm
Location:
usa
yes sorry
 

#12
Posts:
2656
Joined:
28-Apr-2021 7:00am
Location:
FL
Once he elects 83(b) the timing-of-services aspect is irrelevant for tax purposes, although it could trigger a forfeiture, which would be relevant for tax purposes. That is, it's a snapshot event, not a continuing event.

I assume the return position is non-partner status on receipt of $300k income. I don't think it should be a concern whether the IRS will argue it was received as a partner. His only partnership interest is what he reported via the 83(b) election. I view the taxable transaction as the receipt of $300k for services followed by a $300k contribution in exchange for a partnership interest. That is, the compensation was received before partnership status. The receipt of the partnership interest initiated his status as a partner, so I don't see how could have been received as a partner.
Steve
 


Return to Taxation



Who is online

Users browsing this forum: Anderly, ChrisGCPA, DAJCPA, Google [Bot], GRobCPA, HowardS, ImposterTax712, Jeff-Ohio, JoJoCPA, lckent, ManVsTax, MAPCPA60, missingdonut, Seaside CPA, TheGrog, Trailman423 and 176 guests