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Looking at the Section 721 Regulations. Looking at the Section 721 Regulations. Section 721 allows non-recognition for property contributed to a partnershipA
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1. Diamond Is Not Forever – The New Service Partner Regulations by
Daniel L. Raiskin
Raiskin & Revitz
2. Looking at the Section 721 Regulations
3. Looking at the Section 721 Regulations Section 721 allows non-recognition for property contributed to a partnership
A “service” partner would not be protected by Section 721
Treas. Reg. §1.721-1(b)(1) distinguishes between “capital” interests and “profits” interests
4. Treas. Reg. §1.721-1(b)(1) provides: “[If] . . . any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) . . . as compensation for services . . . section 721 does not apply.”
5. Sol Diamond Case Tested the Regulation
6. Sol Diamond Case Tested the Regulation Sol Diamond v. Commissioner, 56 T.C. 530 (1971)
Case was affirmed on appeal to the Seventh Circuit, 492 F.2d 286 (1974)
The case generated enormous discussion among tax practitioners
7. Sol Diamond Case Tested the Regulation Sol Diamond was a loan broker
Kargman offered Sol a 60% profits interest in a building if Sol could obtain 100% financing
Sol got the loan and the deal closed in year “one”
In year “two,” Sol sold the profits interest as short term capital gain
8. Sol Diamond Case Tested the Regulation IRS argued that Sol had compensation income in year “one”
Sol argued that he got only a profits interest – therefore, no income in year “one” under the regulations
Court held that IRS was right – the regulations did not apply
9. Sol Diamond Case Tested the Regulation Tax Court decision blew away practitioners
On appeal, Seventh Circuit ignored all authorities and upheld Tax Court
Practitioners were confused – but IRS seemed to follow the generally accepted rule of no income
10. Subsequent Cases Only Added to Confusion
11. Subsequent Cases Only Added to Confusion Campbell case, 943 F. 2d 815, held service partner was theoretically taxable
However, court determined the value of the partnership interest was zero
IRS considered writing new regulations for Section 83, but never finalized them
12. IRS Releases Rulings to Clear Up Issues
13. IRS Releases Rulings to Clear Up Issues Rev. Proc. 93-27 provided that receipt of “profits” interest for services to partnership is generally non-taxable
Exceptions:
Predictable stream of income
Sale of interest within 2 years
Publicly traded partnership
14. IRS Releases Rulings to Clear Up Issues Rev. Proc. 2001-43 held that partnership interest is to be tested at time of grant, if:
Partner gets a “profits” interest
Partner is treated as such from time of grant
No deduction to partnership at time of vesting
15. IRS Releases Rulings to Clear Up Issues PLR 200329001 held that unvested “profits” interest results in no income at grant or vesting
All these rulings are revoked to conform law to new regulations
16. IRS Issues Proposed Regulations to Settle Issues
17. IRS Issues Proposed Regulations to Settle Issues Proposed regs issued May 24, 2005
IRS also issues Notice 2005-43 to illustrate effect of new regs
Purpose of the new regs is to resolve conflicts between §721 and §83
In general, §83 rules will govern
18. All Partnership Interests Are Treated as “Property”
19. All Partnership Interests Are Treated as “Property” All transfers of partnership interests are governed by §83
Fair market value of interest over amount paid is compensation in year of vesting
Deduction of partnership is determined under §83(h)
20. Value of Partnership Interest Can be Set by Liquidation
21. Value of Partnership Interest Can be Set by Liquidation A “Safe Harbor” interest can be valued by its liquidation value
Safe Harbor is not available if:
Partnership has a certain and reliable income stream
Partner intends to dispose of interest
Partnership is publicly traded
22. Prop. Treas. Reg. §1.83-3(l) Has Rules to Elect Liquidation
23. Prop. Treas. Reg. §1.83-3(l) Has Rules to Elect Liquidation Partnership makes a written election attached to its return
Election is binding on all partners, including the service partner
Partnerships may have to amend agreements to comply with regulation
24. Subchapter K Rules Govern Partnership Upon Vesting
25. Subchapter K Rules Govern Partnership Upon Vesting No gain is recognized by partnership on issuance or vesting
Transfer is treated as a guaranteed payment under §707(c)
Capital account of service partner must reflect income recognized
26. Without §83(b) Election, Taxation Delayed Until Vesting
27. Without §83(b) Election, Taxation Delayed Until Vesting If partnership interest is not “vested” service partner is not treated as a “partner”
Distributions to partner are treated as compensation income
Partnership interest will be valued at time of “vesting”
28. Service Partner Should Always Make a §83(b) Election
29. Service Partner Should Always Make a §83(b) Election §83(b) Election causes interest to be “deemed” vested
Combining with liquidation value election should eliminate taxation
Service partner will be treated as a “partner” immediately with zero capital account
30. On Forfeiture of Interest, Partner Gets No Tax Loss
31. On Forfeiture of Interest, Partner Gets No Tax Loss After §83(b) election, service partner who “forfeits” partnership interest gets no tax loss
Partnership is required to reverse allocations on forfeiture
32. Some Final Thoughts . . .
33. Some Final Thoughts . . . Capital interests should be sold, not awarded as compensation
Partnerships must keep records to satisfy “safe harbor” rules
Proposed regs become effective when final – no indication whether we can rely on them