Income tax effects of non-vested partnership capital interests
TAX ALERT |
A recent Tax Court decision clarifies the issue of when nondistributable partnership income should be allocated to a partner who has a non-vested capital interest. In addition, the case addresses which taxpayer should recognize the undistributed taxable income prior to vesting. Private equity (PE) funds typically face the issues raised in the case with respect to portfolio company investments since portfolio companies often issue capital interests to key employees of the company for incentive and retention purposes. Assuming the investment is a pass-through entity, the PE fund typically becomes an equity partner after acquisition of the portfolio company.
In the case, the court held that an employee who held a non-vested partnership interest could not be allocated income because the partnership did not actually distribute any amounts to the employee. Because the partnership interest was subject to a substantial risk of forfeiture, the court concluded the employee's right to receive a distribution of profits was subject to the same risk of forfeiture and should not be recognized. The regulations under section 83 clearly state that a distribution of profits on a nonvested partnership interest is taxable as compensation under section 61. However, the regulations do not address the treatment of undistributed profits allocated to a non-vested interest. Among other things, the case highlights the importance of the distinction between a capital interest and a profits interest and the differing guidance with respect to allocations of income during the vesting period. The court found that a non-vested capital interest is subject to the general rules under section 83, while guidance outlined in Rev. Procs. 97-27 and 2001-43 currently governs the treatment of a non-vested profits interest.
The case (Crescent Holdings, LLC, Arthur W. Fields and Joleen H. Fields, A Partner Other Than The Tax Matters Partner v. Commissioner, 141 TC No. 15, Dec. 2, 2013) involved Arthur Fields, who served as the chief executive officer of Crescent Resources, a wholly owned limited liability company of Crescent Holdings, LLC (Holdings). As partial consideration for serving in this role, the taxpayer received a 2 percent interest in Holdings, which was treated as a partnership for federal tax purposes. Although the partnership interest was subject to a substantial risk of forfeiture and nontransferable for a period of three years, there were provisions within the relevant documents that provided that the taxpayer would receive a distribution upon liquidation of the entity, even if this occurred prior to vesting. The partnership allocated 2 percent of the partnership taxable income to Mr. Fields during the vesting period, despite never making a distribution to the taxpayer.
Mr. Fields questioned receiving Forms K-1 with taxable income, as he thought he would not be allocated any taxable income that had not been distributed to him yet. After receiving reassurance from the chief financial officer and the tax return preparers that this treatment was correct, he reported the taxable income shown on the Forms K-1 issued to him for the first two years of the vesting period. Mr. Fields did not make a section 83(b) election in either year. Mr. Fields argued with management that he was out-of-pocket for the tax on this income as he did not receive any distributions in these years and would not do so until the ownership interest vested. The management team agreed to reimburse Mr. Fields the tax incurred for the two years he picked up the Form K-1 income and to pay his estimated tax associated with the partnership taxable income for the third year. In the third year of operations, Holdings' financial condition started to suffer, eventually resulting in bankruptcy, and Mr. Fields resigned from Crescent Resources short of the three-year vesting period.
Mr. Fields ultimately filed a petition with the Tax Court arguing that no income should have been allocated to him during the period in which his units were subject to substantial risk of forfeiture. He argued that under Reg. section 1.83-1(a)(1), a partner is not an owner of the partnership when he has a non-vested capital interest. Mr. Fields' legal team argued that section 83(a) was applicable to property transfers (capital interest) in exchange for the performance of services. The legal team also went on to argue that section 83(a) is a deferral provision that allows the taxpayer to defer recognition of income to the time that the interest is transferrable or no longer subject to risk of forfeiture. The lawyers for the partnership countered that the partnership interest in Holdings did not fall under section 83 and was instead a profits interest. They went on to argue that section 83 does not apply to a transfer of a partnership capital interest in exchange for services because section 83 and the legislative history do not state that this section applies to partnerships and do not even refer to partnerships in the statutory language.
In its decision, the court found the 2 percent partnership interest to be a capital interest and personal property under the meaning of section 83. The court stated this code section specifically applies to a non-vested partnership capital interest exchanged for services and the lack of reference to partnerships within section 83 had no bearing in the case. The performance of services in exchange for the transferred property triggered section 83. The court went further by adding that since the petitioner (1) forfeited his right to the 2 percent interest before it vested, and (2) received no distributions from the entity during the vesting period, there was no economic benefit to him. The court noted that pursuant to Reg. section 1.83-1(a)(1), the transferor of an unvested capital interest is treated as the owner of the property, but any income from the property made available to the transferee is income to him. Since no distributions were made, none of the income could be allocated to Mr. Fields.
After the court ruled in favor of the petitioner, it proceeded to address who should recognize the partnership taxable income for the two years in question if the capital interest partner does not. The court ruled that once the petitioner's interest was forfeited back to the transferor, Crescent Holdings, the taxpayer's right to the 2 percent interest and to receive any benefit from the partnership undistributed taxable income allocations reverted back to Holdings. Since the partnership was owned by two other taxpayers, they were the partners who received the economic benefits of the undistributed taxable income allocations of the partnership. As a result, those partners were required to report the income.
Special care should be taken when a partnership capital interest is awarded in exchange for services. Private equity groups (PEGs) often face this issue with key employees of their own funds and in dealing with their portfolio companies. These key employees of the portfolio company are vital to the success of the return on investment for the PEG. To the extent that these employees receive capital interests subject to substantial risk of forfeiture, it may be necessary to re-examine whether or not income should be allocated to those individuals during the vesting period. This court decision has potential application to any partnership issuing a capital interest subject to vesting. Recently, PE funds have been investing more frequently in flow-through entities than corporations. Since key employees of portfolio companies are critical to the success of the PE investment, the case has special relevance to PE funds.
This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. RSM LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person.
RSM LLP is an Iowa limited liability partnership and the U.S. member firm of RSM International, a global network of independent accounting, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party.
RSM®, the RSM logo, the RSM Classic logo, The power of being understood®, Power comes from being understood®, and Experience the power of being understood® are registered trademarks of RSM LLP.
© 2014 RSM LLP. All Rights Reserved.
This publication represents the views of the author(s), and does not necessarily represent the views of RSM LLP. This publication does not constitute professional advice.