February 2020
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83(b) Election And Partnership Profits Interests.

The IRS allows very significant tax benefits for partnership "profits interests" issued as compensation for services. It allows those benefits without requiring any special election, and in fact has issued guidance stating that no special election is required. However, it is possible to lose the benefits retroactively, and any taxpayer who does so may wish to have made a protective election.

  Taxation Of Profits Interests In General.

A partnership profits interest is an interest that has no liquidation value when issued. That is, if the partnership (or LLC taxed as a partnership) were liquidated immediately after issuance, the profits interest holder would receive nothing.

  • Taxation of profits interests.

For example, assume partnership AB issues an 80% interest to A in return for $1M of capital and a 20% interest to B in return for B's services. If the partnership were liquidated immediately after the issuance, B would receive $200K. That means B has a capital interest, not a profits interest. However, that is not how such partnerships usually work. Typically, A has a right to receive return of at least its $1M before B receives anything. That means in an immediate liquidation B would receive nothing, so B has a profits interest only.

Obviously, a profits interest can be a very valuable asset: it can appreciate, but it will never generate a loss. Thus, it has probabilistic positive value. However, the IRS, following some court decisions, has determined that a partnership can issue a profits interest in exchange for services and value it at zero. Following that issuance, the interest is a capital asset in the hands of the partner.

The tax justification for that determination is far from clear, but it is generally based on court decisions, and the IRS has decided to concede the issue instead of continuing to fight it.

  • Other property does not receive the same special treatment.

Normally a service recipient is unwilling to issue equity to a service provider unless the service recipient can be confident that the service provider will continue to provide services. Therefore it is quite common to have a business entity issue equity that is initially forfeitable and "vests" (that is, becomes nonforfeitable) over time as the holder continues to work for the business.

The normal rule for vesting property is that each part of it must be treated as income when it vests based on the value at the time of vesting. For example, if an employee receives restricted stock with a value of $5 that vests after one year, the value of the stock is not taxed upon issuance. Instead it is taxed when it vests. If its value is $10 at that time, then the employee is taxed upon $10, not $5. (Note that the employee may not be able to sell the stock and may have to pay tax on that $10 of "phantom income" out of pocket.)

There is an election known as an "83(b) election" under which the employee can elect to recognize the $5 of income upon issuance and then not be further taxed upon vesting. It is often a good idea to make that election, especially in a start-up business situation where the stock likely has little value upon issuance. The election was not created by the IRS; it was written into the relevant statute by Congress.

  • Profits interests receive even better treatment.

About eight years after first ruling on profits interests, the IRS issued another pronouncement covering profits interest treatment for unvested profits interests. It clarified that after an interest was issued as profits interest, there would be no further taxation upon vesting. Returning to the AB example above, that means that if B's interest vested after one year and the partnership was worth $11M at the time, B would vest in an economic value of $2M (20% of the value of the partnership after returning A's capital contribution) but would recognize no income (and would recognize only capital gain income upon ultimate disposition of the interest).

That is a very important benefit. That result is not necessarily consistent with the statute, and without the specific IRS guidance, taxpayers probably could not get that treatment for post-issuance vesting events.

The fact that the IRS provides a special benefit for profits interests but does not provide a similar benefit for corporate stock unnecessarily affects the business decision whether to use a corporate or partnership structure. Nevertheless, the benefit is available with proper planning and businesses use it routinely.

  Making The 83(b) Election For Profits Interests.

The IRS has issued guidance specifically advising taxpayers that they do not need to make 83(b) elections for profits interests. That is bad advice.

As noted above, the rule of no taxation upon vesting is a creation of the IRS: it is considered a "safe harbor," meaning it provides full protection, but only when the IRS's conditions for application of the safe harbor rule are fully satisfied. The main requirements are that the interest have zero value upon issuance, that the partnership treat the holder as a partner immediately upon issuance, and that the holder hold the interest for two years. The first two requirements are not hard to meet.

The third is less predictable. Sometimes, good news for a partnership is bad news for a profits interest holder. For example, a buyer may make an appealing offer for the business before the holder's two-year required holding period has ended. Sometimes, a simple restructuring is enough to violate the two-year requirement. (An example could be placing the original partnership into a new partnership holding structure, exchanging the original partnership interest for an interest in the new holding partnership. The new interest likely would not allow the service provider to make a new 83(b) election because of the application of technical rules that do not permit an election upon a substitution of unvested property for other unvested property.) Maybe the news is not so good, and the service provider leaves the partnership and is required to sell back its vested units.

In any of those cases, if the two-year holding period requirement is violated, the safe harbor for profits interest treatment does not apply. In that case, the service provider will wish to have made a "protective" 83(b) election in order to avoid taxation on subsequent vesting events.

Protective 83(b) elections made for profits interests normally result in recognition of income at the time of issuance based on zero value. Thus, there is generally not a tax cost to making the election. If profits interest treatment were lost, it would theoretically be possible for the IRS to contest that valuation, but it seems unlikely that the IRS would do so, especially since even the probabilistic value of the interest at issuance in most cases will have been too small to be worth pursuing.

In any case, that potential cost cannot arise if a taxpayer holds its interest for two years and thus qualifies for the safe harbor, because zero valuation is guaranteed under the safe harbor. The only time the potential cost becomes relevant is when there is a greater potential cost from not having the 83(b) election in place. (That is a slight oversimplification: if the business does badly, it is possible for the vesting-date income to be 83(b) election date value, but such circumstances are vanishingly rare with respect to profits interests.)

  Conclusion And Practice Tip.

As is evident from the discussion above, the benefit of making an 83(b) election with respect to profits interests should not be overlooked.

The deadline for the election is 30 days from issuance of the profits interest. That deadline is statutory, so the IRS's usual rules allowing late elections do not apply.

If you have questions about these issues or their effect on you or your business, please feel free to contact TaxGroup Partners at (213)873-1200 or e-mail us at info@TaxGroupPartners.com or visit our website at TaxGroupPartners.com.
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