Diamond Is Not Forever The New Service Partner Regulations

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