Deloitte Comments on Guidance on Exchanges of Partnership Interests

I have enclosed as comments on the proposed regulations and proposed revenue procedure referenced above an article I authored on the topic. BNA published the article on September 5, 2005 (46 Tax Mgmt. Memo., No. 18, 379 (2005)).

Please call me if you have any questions or comments.

cc: Matthew Lay, Acting Attorney-Advisor, Office of Legislative

On May 20, 2005, the Internal Revenue Service (the "IRS") and the Treasury Department ("Treasury") issued much-anticipated proposed regulations (the "Proposed Regulations") addressing the U.S. federal income tax treatment of certain transfers of partnership equity (including options to acquire partnership equity) in connection with the performance of services ("compensatory partnership interests").² The IRS and Treasury also issued Notice 2005- 43 (the "Notice")³ containing a proposed revenue procedure (the "Proposed Revenue Procedure") that provides additional guidance for partnerships that transfer compensatory partnership equity. The Notice provides that the Proposed Revenue Procedure will be finalized when the Proposed Regulations are finalized. The Notice also provides that Rev. Proc. 93-27⁴ and Rev. Proc. 2001-43⁵ will be obsoleted when the Proposed Revenue Procedure is finalized.

The highpoints of the Proposed Regulations are as follows:

• All Partnership Interests Are Property For Purposes of Section 83. A partnership interest -- whether a capital interest or a profits interest -- would be treated as property within the meaning of section 83, and the transfer of a compensatory partnership interest would be subject to section 83.

• • Accordingly, the excess of the fair market value of the partnership interest received by the service provider over the amount, if any, paid by the service provider would generally be includible in income during the taxable year of the service provider in which the partnership interest is substantially vested (within the meaning of section 83(a) and Treas. Reg. § 1.83- 3(b)).

  • The timing of the deduction for the partnership would also be governed by section 83. Thus, the deduction would be recognized in the taxable year of the partnership that ends within or with the taxable year of the service provider in which compensation under section 83 would be included in the service provider's income, unless the interest is vested upon receipt, in which case the partnership claims the deduction in accordance with its normal method of accounting.

• Liquidation Value Approach Still Available. Consistent with Rev. Proc. 93-27 and Rev. Proc. 2001-43, a safe harbor election (the "Safe Harbor") would be available to permit partnerships to value compensatory partnership interests using the liquidation value approach. As a result, the receipt of a profits interest would not result in income to the recipient if the Safe Harbor election is made.

• Section 83(b) Elections Required for Unvested Interests. Consistent with section 83 principles, if a restricted (i.e., unvested) partnership interest is transferred in connection with the performance of services, and if an election under section 83(b) is not made, the holder of the partnership interest would not be treated as a partner until the interest becomes substantially vested. Conversely, a service provider who receives a restricted compensatory partnership interest and who makes a section 83(b) election would be treated as a partner from the date of receipt of the interest.

• No Gain or Loss Recognized by Partnership on Issuance of Interest. A partnership would recognize neither gain nor loss on the issuance or vesting of a partnership interest (whether a profits interest or a capital interest) issued in connection with the performance of services for the issuing partnership.

• Special "Forfeiture Allocations" Required. If a service provider makes a section 83(b) election with respect to a substantially nonvested partnership interest and later forfeits that interest, the partnership would be required to make reversing allocations of income or loss (so-called "forfeiture allocations") to the service provider.

• Regulations Effective When Finalized. The Proposed Regulations would apply to issuances of compensatory partnership interest and options that occur on or after the date final regulations are published in the Federal Register.

Since the issuance of Rev. Proc. 93-27, and certainly since the issuance of Rev. Proc. 2001-43, there has been reasonable comfort among most tax practitioners regarding the tax treatment of profits interests. And even before 1993, most taxpayers and their advisors felt quite comfortable that that there was "little or no chance" that a recipient of a profits interest would be taxed on the receipt of the interest.⁶ Instead, taxation would occur as the holder received her distributive share of income and gain from the partnership, just like any other partner in the partnership. This was the case notwithstanding Diamond v. Commissioner,⁷ in which the IRS successfully argued that the receipt of a profits interest was taxable.

Diamond, who had a capital loss carryover, asserted that his interest was a partnership profits interest not taxable on receipt and that the subsequent sale of the interest resulted in a $40,000 short-term capital gain. The IRS successfully countered that Diamond's receipt of the interest was taxable to him as ordinary income because Diamond had received the interest as compensation for services. Furthermore, because Diamond sold his interest for $40,000 a mere 18 days after he had acquired it, the Tax Court found that the value of the interest when Diamond received it was also $40,000. The Tax Court thus concluded that Diamond's profits interest was properly included in his income upon receipt at its fair market value.

On appeal, the Seventh Circuit recognized that a profits interest generally has only speculative value and determining that value may be unduly burdensome for those who choose to do business in partnership form. The appellate court also stated that the inclusion of a profits interest as ordinary income on receipt, followed by the inclusion of partnership earnings as they are realized, could result in double taxation to the profits interest partner. Nevertheless, while noting that the Tax Court's holding created more issues than it resolved, the appellate court affirmed the decision. Significantly, the court specifically limited its holding to cases in which the profits interest has a determinable value at its creation.

Nearly 20 years after Diamond, the Tax Court revisited the issue in Campbell v. Commissioner.⁹ Like Diamond, Campbell provided services to real estate partnerships. Campbell was responsible for locating properties, negotiating their acquisition, and arranging financing necessary to acquire the properties. In return, Campbell received "special limited partnership interests" in the partnerships he helped form and finance. Campbell was entitled to cash distributions only after the general partner's capital was returned to it. In addition, Campbell could sell his interests only with the consent of the general partner, which could withhold its consent arbitrarily.

Campbell argued that a service partner who receives a profits interest in a partnership should not recognize income on receipt of the interest. The Tax Court disagreed. In a memorandum opinion, the court held that section 721(a) is inapplicable when a partner receives a partnership interest in exchange for services rendered to or for the benefit of the partnership. Rather, according to the Tax Court, section 721(a) applies only to the contribution of property, not to the contribution of services.

In connection with Campbell's appeal to the Eighth Circuit, the IRS conceded that the Tax Court erred in holding that the receipt of a profits interest in exchange for services rendered to the partnership should be considered ordinary income to the service provider. The Eighth Circuit was unwilling to accept the IRS's concession and instead analyzed the law. In part by parsing the text of Treas. Reg. § 1.721-1(b), which clearly taxes a service partner's receipt of a capital interest, the Eighth Circuit agreed with the taxpayer that "some justification" existed for treating service partners who receive profits interests differently from those who receive capital interests.¹⁰

The Eighth Circuit also seemed to agree with the taxpayer's arguments against the recognition of income on receipt of a profits interest for services. The court found that the strongest argument against taxation of profits interests was the enactment of section 707(a)(2). Section 707(a)(2)(A) provides that if a partner receives an allocation of income and a distribution of cash or property for the performance of services, and the transfer is properly characterized as a transaction between the partnership and a partner acting in a nonpartner capacity, the transfer is considered to be a transfer under section 707(a).¹¹ In the court's view, section 707 provides the basic framework for the argument that the issuance of a profits interest to a service provider acting in her capacity as a partner is not taxable. As the appellate court recognized, "[a]rguably, section 707(a) would be unnecessary if compensatory transfers of profits interests were taxable upon receipt because, if so, every such transfer would be taxed without this section."¹²

Notwithstanding these legal arguments, the appellate court ultimately based its holding on the valuation of Campbell's interest. The court distinguished the valuation in Campbell from that in Diamond on the grounds that the taxpayer in Diamond received cash (albeit on a sale of his interest) shortly after he received his interest. Campbell, on the other hand, received a profits interest that, in the court's view, had only speculative value. Thus, the court determined that Campbell's profits interest was without fair market value for tax purposes and should not have been included in his income for the year in issue.

The courts' conflicting opinions in Diamond and Campbell left substantial uncertainty as to the taxation of compensatory profits interests. In response, the IRS issued Rev. Proc. 93-27, which carefully recited the litany of relevant statutes and judicial authority, but pledged its allegiance to none. Nonetheless, the revenue procedure has been a practical success by providing taxpayers and their advisors with certainty in structuring arrangements involving vested profits interests. Indeed, the revenue procedure remains the basis of most tax planning involving such interests.

Revenue Procedure 93-27 provides that, if its conditions are met, neither the service provider nor the partnership recognizes income or loss on the receipt of a profits interest by the service provider so long as the services are provided to (or for the benefit of) the partnership in anticipation of the service provider's becoming a partner.¹³ Significantly, the revenue procedure does not apply if (1) the partner disposes of the profits interests within two years from receipt, (2) the profits interest relates to a substantially certain and predictable stream of income, or (3) the profits interest is a limited partnership interest in a publicly traded partnership.¹⁴ If the profits interest fits squarely within the four corners of Rev. Proc. 93-27, the service provider will have no inclusion of income on the receipt of the interest. If the service provider has received a vested partnership interest, she should be considered a partner for tax purposes (provided that she otherwise would be treated as a partner) and will be taxed on her distributive share of partnership income under section 704.

Before 2001, however, advisors were not certain whether Rev. Proc. 93-27 applied to unvested profits interests. The uncertainty was based on Treas. Reg. § 1.83-1(a), which provides that the transferor (not the transferee) of unvested property is treated as the owner of the property until the property becomes substantially vested. Most taxpayers attempted to mitigate this concern by making section 83(b) elections with respect to their unvested profits interests.

In Rev. Proc. 2001-43, the IRS provided guidance with respect to nonvested profits interests. Revenue Procedure 2001-43 clarifies Rev. Proc. 93-27 by providing that the determination of whether an interest granted to a service provider is a profits interest is made at the time the interest is granted, even if the interest is substantially nonvested at that time. Furthermore, if the profits interest granted to a service provider meets the requirements of both Rev. Proc. 93-27 and Rev. Proc. 2001-43 (the "Revenue Procedures"), the IRS will treat neither the grant of the interest nor the event that causes the interest to vest as a taxable event for the partner or the partnership. Revenue Procedure 2001-43 also states that if the requirements of the Revenue Procedures are satisfied, the service provider need not file an election under section 83(b).

To fall within the safe harbor of Rev. Proc. 2001-43, all of the conditions of Rev. Proc. 93-27 (discussed above) must be satisfied.¹⁵ In addition, both the partnership and the service provider must treat the service provider as the owner of the partnership interest from the date of grant, and the service provider must take into account the distributive share of income, gain, loss, deduction, and credit associated with the interest in computing the service provider's income tax liability for the entire period during which the service provider holds the interest.¹⁶ Finally, neither the partnership nor any of the partners may deduct any amount for the fair market value of the interest, either on grant or vesting of the interest.¹⁷

In effect, Rev. Proc. 2001-43 gives the service provider the benefits of a valid section 83(b) election. Under the revenue procedure, the transaction is in effect treated as if the service provider had made a valid section 83(b) election when the fair market value of the profits interest was zero. Thus, the service provider partner reports no income on grant or vesting, and the partnership claims no deduction. In addition, as would occur with a valid section 83(b) election, the service provider should be treated as the owner of the interest, and her holding period for the interest should begin on the day after the profits interest is transferred.¹⁸

III. The Proposed Regulations

Consistent with the general rules of section 83, the Proposed Regulations would provide that the recipient of a compensatory partnership interest must include in income the fair market value of the interest (in excess of the amount paid, if any) in the first year in which the interest is vested; and the service provider will be treated as a partner at that time.²⁵ For so long as the interest is unvested (i.e., either not transferable or subject to a substantial risk of forfeiture), income inclusion is delayed and the recipient is not treated as a partner, unless the recipient makes an election under section 83(b). If such an election is made, however, the recipient of the interest is treated as a partner for tax purposes. (The Proposed Revenue Procedure, which would in essence continue to permit taxpayers to treat a profits interest as having no value, is discussed below.)²⁶

As discussed further below, any compensation income associated with the transfer of a partnership interest to a partner is treated as a guaranteed payment. Normally, a partner would include income in the taxable year in which or with which the partnership's taxable year ends. Under the Proposed Regulations, however, the timing rules of section 83 would apply, so that the partner would include the income in the taxable year in which the interest is transferred or becomes substantially vested, if later, without regard to the partnership's taxable year. Among other things, this creates an issue for reporting income.

Section 83(b) allows a service provider to elect to treat restricted property as if it were substantially vested on transfer and include in income the amount, if any, that would be included in income if the property were in fact substantially vested on transfer. The service provider then does not include additional compensation income when the property in fact becomes substantially vested. If the property is later forfeited, however, the service provider is not entitled to claim a loss in respect of such forfeiture.²⁸

The time for making a section 83(b) election is limited: the election must be made within 30 days of transfer; the specific requirements of the election are set forth in Treas. Reg. § 1.83- 2. The service provider must file the election with the IRS and provide a copy of the election to the service recipient. The election is also filed as part of the service provider's tax return.

For profits interests currently covered by the Revenue Procedures, requiring a section 83(b) election imposes new administrative burdens without changing the tax result. It is difficult to suggest a simple fix to this issue, for if the IRS and Treasury have decided to reject the "no taxable event" approach and instead to treat partnership interests as property for purposes of section 83, section 83(b) is plainly applicable. Perhaps the best approach would be to continue the current administrative practice of simply allowing taxpayers to take the position that neither the receipt nor vesting of a profits interest is a taxable event and that, therefore, no section 83(b) election is required. It is possible that such an approach was considered and rejected on the grounds that, if profits interests are property for purposes of section 83, section 83(b) is inescapable. But there are other situations in which administrative practice is a bit more generous than a literal reading of the law would permit. One would hope that such generosity would be shown here as well.²⁹

Alternatively, it is possible that the government feared that taxpayers would take inconsistent positions.³⁰ There are, however, no reported cases of taxpayers taking inconsistent positions with respect to the application of section 83(b) to, or the valuation of, profits interests.

It would seem, therefore, that the sound administration of the Code would argue in favor of retaining the existing administrative practice, at least with respect to interests that fall within the Proposed Revenue Procedure.³¹ If, in the future, taxpayers were to take inconsistent positions and such inconsistent positions were sustained in court, the IRS and Treasury could revisit the issue, perhaps with assistance from Congress.³²

The Proposed Regulations adopt the second approach, rejecting the first without any meaningful explanation. Thus, under the Proposed Regulations, a service provider's capital account would be increased by the amount the service provider includes in income as a result of receiving the interest (as well as by amounts paid for the interest).⁴⁶ Fortunately, however, the IRS and Treasury, simultaneously with the issuance of the Proposed Regulations, issued the Proposed Revenue Procedure that would allow a partnership, its partners, and the service provider to elect to treat the fair market value of a partnership interest as equal to the liquidation value of that interest. The provisions of the Proposed Revenue Procedure are discussed in greater detail below.⁴⁷

The approach adopted by the Proposed Regulations would lead to unexpected consequences for taxpayers. For example, service providers would be required to over-report (or, perhaps more accurately, to accelerate) their economic income, as is demonstrated by the following example.

There are a few possible explanations. First, it seems likely that the capital accounting regime played a large role. That is, as was noted above, the Proposed Regulations seem to be based on the "circular flow of cash" theory.⁵⁰ Under that approach, the partnership would be deemed to transfer cash to the service provider in an amount equal to the fair market value of the interest issued, and the service provider would be deemed to have contributed that cash to the partnership. If that is the appropriate construct, then the drafters of the Proposed Regulations could fairly have asked why a person who is deemed to contribute cash should receive a capital account that is different from the amount of cash deemed contributed. Although there are many business transactions in which a cash contributor demands capital account credit greater than the amount of cash contributed, those arrangements do not fit neatly into the framework of the section 704(b) regulations.⁵¹

Second, it seems likely that the drafters of the regulations wanted to create a system that was sufficiently unattractive and unworkable so as to effectively compel partnerships to elect into the Safe Harbor provided for in the Proposed Revenue Procedure (discussed below). Indeed, the Preamble specifically states that the approach of the Proposed Revenue Procedure "ensures consistency in the treatment of profits interests and capital interests, and accords with other regulations issued under subchapter K, such as regulations under section 704(b)."⁵²

The obvious question, of course, is what happens to taxpayers who do not follow the capital accounting rules of the Proposed Regulations? Presumably, the IRS would argue that the partnership's allocations no longer satisfy the safe harbor allocation rules under section 704(b), but to what end? Could the IRS convince a judge that a service provider who received a capital interest should be allocated taxable income to the extent that the service provider's capital account balance exceeded the service provider's income inclusion? This seems inconsistent with section 83 principles. And if the IRS were successful in making such an argument, would the recipient of a profits interest be permitted to claim an immediate loss in an amount equal to her income inclusion (because she actually received a capital account balance of zero)?

The Preamble explains that allocations of partnership items to the holder of an unvested interest cannot have economic effect because there is a possibility that the partnership might not liquidate in accordance with positive capital account balances,⁵⁵ as is required by the safe harbor regulations under section 704(b). For this reason, the Proposed Regulations provide that such allocations "cannot have economic effect."⁵⁶ As a bow toward practicality, however, the Proposed Regulations would permit such allocations to be made by adopting a special rule that would treat such allocations as being in accordance with the partners' interests in the partnership. To satisfy this rule, (i) the partnership agreement would have to require that the partnership make "forfeiture allocations" if the interest is later forfeited and (ii) all material allocations⁵⁷ and capital account adjustments made under the partnership agreement unrelated to the unvested interests would have to be recognized under section 704(b).⁵⁸ "Forfeiture allocations" are allocations to the service provider of gross income and gain or gross deduction and loss (to the extent available) that are designed to offset, or reverse, allocations of partnership items previously made with respect to the forfeited interest.⁵⁹ The available income and gain includes gain recognized by the partnership under Treas. Reg. § 1.83-6(c).⁶⁰

It should be noted that the Proposed Regulations pointedly state that this special rule would not apply if, at the time of the section 83(b) election, there is a plan that a substantially nonvested interest will be forfeited.⁶¹ In that event, the partners' distributive shares would be determined in accordance with the partners' interests in the partnership under Treas. Reg. § 1.704-1(b)(3).⁶²

In addition, forfeiture allocations would ensure that partners who make section 83(b) elections do not circumvent the loss disallowance rule of section 83(b)(1). That rule provides that, if a taxpayer makes a section 83(b) election and later forfeits the unvested property, the taxpayer may not claim a loss in respect of such forfeiture. Consider the following example:

Forfeiture allocations would also prevent distributions of property from having the same effect as an allocation of loss. Consider the following example:

To increase the likelihood that a partnership will have sufficient taxable items to make forfeiture allocations, the Proposed Regulations would provide that such allocations may be made out of the partnership's items for the entire year.⁶⁷ In this regard, though, it is not clear whether the partnership must use an entire year's items, or could choose to use only pre- forfeiture items under a closing-of-the-books convention. Further, the Preamble recognizes that there will be situations in which the partnership will not have enough items to make the required forfeiture allocations.⁶⁸ If the partnership lacks sufficient income and gain to reverse prior allocations of loss, the service provider reaps an unintended benefit. (The Proposed Revenue Procedure, however, would eliminate this benefit for partners in partnerships that elect to apply the Safe Harbor.) Conversely, if the partnership lacks sufficient items of deductions and loss to reverse prior income inclusions, the Preamble states that "section 83(b)(1) may prohibit the service provider from claiming a loss with respect to partnership income that was previously allocated to the service provider."⁶⁹ According to the Preamble, the service provider would be permitted to claim a deduction in an amount equal to any basis attributable to money or property contributed to the partnership.⁷⁰

Further, it seems inappropriate to require the partnership to recognize gain in an amount equal to the loss recognized by the service provider, and there does not appear to be any statutory support for such a rule. Importantly, subchapter K already has a rule designed to ensure that the continuing partners do not receive an unintended benefit in such a situation: section 734(b) requires the partnership to reduce its basis in its assets if the partnership has a section 754 election in effect or if the loss recognized by the service provider equals or exceeds $250,000.

The Preamble also asks whether the Proposed Regulations should require or permit partnerships to create notional tax items to make forfeiture allocations if the partnership does not have sufficient actual items to make the required allocations.⁷² This concept appears to have its origin in the "remedial allocation" regime of the section 704(c) regulations.⁷³ Under the remedial allocation regime, a partnership creates items to allocate to "noncontributing" partners.⁷⁴ The partnership also creates "offsetting" remedial items to allocate to the "contributing" partner.⁷⁵ To ensure that the fisc is not harmed by these "remedial" allocations, the regulations specifically require that the remedial items allocated to the noncontributing partners match in all respects the missing partnership items, and that the offsetting remedial items allocated to the contributing partner be the mirror image of the remedial items allocated to the noncontributing partners.⁷⁶ Significantly, the regulations specifically provide that the IRS may not require partnerships to adopt the remedial allocation method.⁷⁷ This rule apparently reflects concern by the drafters of the section 704(c) regulations about the government's ability to require taxpayers to create tax items out of whole cloth.⁷⁸

The importation of a remedial allocation-like regime into Proposed Regulations would be a complex solution to a problem that probably does not merit the attention. Moreover, it seems unlikely that section 704(b) and section 83 support mandatory notional items any more than section 704(c)(1)(A). (Indeed, it seems more likely that section 704(c)(1)(A), with it sweeping language, would support mandatory notional items.) Thus, it seems that the best the government can hope for is to permit, but not require, partnerships to create notional items.

Although not entirely clear, it appears that the Tax Court concluded that the transfer of the one-half interest constituted the formation of a joint venture to which McDougal contributed capital in the form of the horse, and in which McDougal granted McClanahan an interest in capital and profits as compensation for McClanahan's services. The Tax Court held that McDougal recognized gain to the extent that the value of the one-half interest transferred to McClanahan exceeded one-half of McDougal's adjusted basis in the horse. (McClanahan recognized ordinary income in an amount equal to the value of the one-half interest he received in the joint venture.)⁸⁸

The IRS and Treasury concluded that the Proposed Regulations "should not contain a similar rule" for compensatory options "because of the possibility that constructive transfers of property, subject to section 83, may occur under circumstances other than those described" in the characterization rule of the Proposed NCO Regulations.⁹⁷ The Preamble specifically requests comments on whether anti-abuse rules are needed to prevent the use of the rules in the Proposed Regulations and the Proposed Revenue Procedure to shift inappropriately income or loss among the service provider and other partners.⁹⁸

The restraint shown by the IRS and Treasury is, if not unique, highly unusual in the drafting of modern regulations, where anti- abuse rules are much like an appendix -- always adding weight, yet not improving functionality. This restraint is admirable and appropriate. Existing judicial doctrines are powerful weapons in the IRS's arsenal. In addition, the Proposed Regulations already contain a targeted anti-abuse rule that would prohibit allocations to the holder of an unvested interest, even if the holder has made a section 83(b) election, if the holder intends to forfeit its interest. Finally, section 409A imposes considerable limitations on the ability of taxpayers to enter into creative, tax-advantaged compensation arrangements. For these reasons, an anti-abuse rule is not necessary, and one hopes that the government will continue to resist the urge to add an anti-abuse rule to the Proposed Regulations.

The IRS and Treasury are uncertain whether the retroactive grant date, as opposed to the date on which the service provider is actually admitted to the partnership, should be treated as the date of the transfer for purposes of section 83 and other provisions of the Code outside of subchapter K.¹⁰¹ As the Preamble notes, if the retroactive date is respected, numerous difficulties could arise. For example, the partnership might not have actually admitted a person as a partner by the time of the required filings. Similarly, if a service provider is admitted more than 30 days retroactively, and the retroactive admission is respected, the service provider would have missed the 30-day window for making an election under section 83(b).¹⁰² For these reasons, the IRS and Treasury have requested comments with respect to these issues.

There are additional difficulties associated with retroactive admissions and allocations. For example, if a service provider is retroactively granted a vested profits interest, and if the retroactive admission date is not respected, the service provider likely would be treated as having received a capital interest, taxable upon receipt. Conversely, if the retroactive admission date is respected, and if the partnership had earned substantial net income and/or appreciated substantially between the retroactive and actual dates of admission, cautious advisors might be concerned that the purported allocations of income that the partnership would make in respect of the purported profits interest would be recast as a fee under section 707(a)(2)(A).

III. The Safe Harbor

Section 1.83-3(l) of the Proposed Regulations would permit taxpayers to elect to apply special Safe Harbor rules to a partnership's issuance of a compensatory partnership interest. According to the preamble to the Proposed Revenue Procedure, the IRS and Treasury intend for the Safe Harbor to simplify the application of section 83 to the issuances of compensatory partnership interests and to coordinate the principles of section 83 with the principles of partnership taxation. The Proposed Revenue Procedure sets forth the rules that govern the Safe Harbor.

This definition of liquidation value is familiar and workable, although it should be clarified. For example, the definition should be clarified to explicitly recognize and address the presence of partnership liabilities.¹⁰⁶ In addition, it should be made clear that, in determining the liquidation value of the compensatory interest, amounts properly attributable to other interests held by the service provider in the issuing partnership are not taken into account. Stated differently, the Proposed Revenue Procedure should explicitly separate the compensatory interest from other interests held by the service provider.¹⁰⁷ Explicitly sanctioning such a separation would be consistent with the section 743(b) regulations¹⁰⁸ and would be particularly helpful in light of the IRS's position that a partner has only one interest in a partnership.¹⁰⁹ Additionally, the IRS and Treasury might consider providing guidance regarding what types of assumptions should be made in determining "fair market value." For example, should it be assumed that all of the partnership's assets will be sold to one buyer? Should an orderly sale (as opposed to a "fire sale") be assumed?

The limitations are generally neither troubling nor surprising, but need some modifications. First, there should be both taxpayer- friendly and taxpayer-adverse presumptions. Under Rev. Proc. 93-27, if an interest is disposed of within two years of the date of grant, the grant of the interest is not covered by the revenue procedure; if the partnership interest is not disposed of for at least two years, the grant of the interest is covered by the revenue procedure. Under the Proposed Revenue Procedure, that bright line is gone. Instead, as was noted above, there would be a presumption. Unfortunately, the presumption appears to be only taxpayer-adverse. That is, while there is clearly a taxpayer-adverse presumption for dispositions within two years, it seems that there is not a taxpayer-friendly presumption for dispositions outside of two years. The Proposed Regulations should be clarified to provide both taxpayer-adverse and taxpayer-favorable presumptions, just like the disguised sale rules.¹¹³

Second, the adverse presumption regarding buy/sell provisions needs to be reconsidered. Presumably, this adverse presumption was included because the drafters of the Proposed Revenue Procedure recognized that a profits interest in a going-concern is worth nearly as much, if not as much, as an interest that has both a profit and capital component. Without some sort of limitation like that contained in the Proposed Revenue Procedure, the recipient of a profits interest could, like Mr. Diamond, sell his or her interest for a value that differed dramatically from the liquidation value of the interest on the date of the sale, thus undermining the theory of the Proposed Revenue Procedure.

The presumption, however, is overly broad. Because there is no market for interests in most partnerships, the only meaningful liquidity that the typical partner has is the right to compel her interest to be acquired by the partnership or one or more of the other partners. Thus, most partnership agreements contain buy/sell provisions of some sort.¹¹⁴ As a result, the Proposed Revenue Procedure would be unavailable to most partnerships. To protect the legitimate interests of the government, while making the Proposed Revenue Procedure available to more than a handful of taxpayers, the buy/sell presumption should be modified so that it would apply only if the price at which the interest could be bought or sold differs from the liquidation value of the interest at the time of the sale.

Under the Proposed Revenue Procedure, a partnership interest would be treated as unvested only if (i) the interest is not transferable, and (ii) under the terms of the interest at the time of the issuance, the interest terminates and the holder may be required to forfeit the "capital account balance equivalent" under conditions that would constitute a substantial risk of forfeiture.¹¹⁷ (The "capital account balance equivalent" is the amount of cash that the holder would receive if, immediately prior to forfeiture, the interest vested, and the partnership sold all of its assets for cash equal to their fair market value and liquidated.)¹¹⁸ Stated differently, an interest is "vested" if the "capital account balance equivalent" is either not subject to a substantial risk of forfeiture or is transferable. Significantly, an interest would be considered vested even if a portion of the capital account balance equivalent is forfeitable, so long as the forfeitable portion is not greater than the portion that accrued during the year of the forfeiture.¹¹⁹

The Proposed Revenue Procedure would not permit the issuing partnership to claim a loss (or increase its asset basis) in an amount equal to the service provider's recognized gain. This is inappropriate, and the Proposed Revenue Procedure should be modified accordingly.

Alternatively, if the partnership agreement does not contain the required provisions (or the provisions are not legally binding on all of the partners), the Safe Harbor election is made by having each partner execute a document containing legally binding provisions stating that (i) the partnership is authorized and directed to elect the Safe Harbor and (ii) the partner (and any transferee) agrees to comply with all of the requirements of the Safe Harbor while the election remains in effect.¹²⁵

The most troubling aspect of both of these alternatives is that they will make the Proposed Revenue Procedure unavailable to the vast majority of existing partnerships. It is very difficult to convince even a majority, let alone all, of the partners in a partnership to do anything at all. To make the Proposed Revenue Procedure available to more partnerships, the IRS and Treasury should consider allowing existing partnerships to make the election even if the partners have not specifically "authorized and directed" the election to be made. The exception for existing partnerships could be limited by making it inapplicable to partnerships in which related persons have the ability to amend the partnership agreement without the consent of an unrelated person. A similar approach was recently taken in the proposed and temporary Treasury regulations concerning the allocation of creditable foreign tax expenditures.¹²⁶

Because of the practical difficulties raised by amending partnership agreements or otherwise obtaining partner consent, advisors who are forming partnerships or amending partnership agreements today would be well advised to include language authorizing the partnership to make the Safe Harbor election if it becomes available and if the general partner deems such an election to be advisable.¹²⁷

This part of the Proposed Revenue Procedure has other curious aspects. For example, why would the Proposed Revenue Procedure require that the partnership be "authorized and directed" to make the Safe Harbor election. Why should the partnership be "directed"? It should suffice that the partnership is "authorized." In the "check-the-box" regulations, the IRS and Treasury are satisfied with knowing that the making of an election has been "authorized."¹²⁸ The "directed" language should be deleted from the Proposed Revenue Procedure.

Additionally, what does "legally binding" mean? Presumably, it means that the partners are bound under applicable commercial law not to take a position inconsistent with that taken by the partnership. Will taxpayers be required to obtain opinions from corporate counsel to prove that the provisions of the partnership agreement are "legally binding"? And what if the corporate counsel excepts from the scope of his or her opinion the enforceability of the provisions in bankruptcy? Further, what if the provisions are legally binding when the agreement is executed or amended, but later become unenforceable? Or what if the provisions are legally binding on the initial partners, but are found not to be legally binding on a transferee? And what if the partner is a DRE? Must the provisions be binding on the owner of the DRE?¹²⁹ For these reasons, it seems more appropriate for this requirement to be replaced by a rule that would prohibit any direct or indirect partner from taking a position inconsistent with the position taken by the partnership and to require disclosure if an inconsistent position were in fact taken. If it appears that taxpayers are taking inconsistent positions from their electing partnerships, the Proposed Revenue Procedure could be modified or revoked.

For a number of reasons, this requirement is misguided. Very few companies have records that are as complete as the drafters of the Proposed Revenue Procedure apparently believe. Moreover, even if records were available, it is unlikely that the original of every required document would be available. In addition, in this age of computer-generated signatures, multi-continent closings, and computer-based document retention systems, what is the original? Finally, what if, notwithstanding the best efforts and intentions of everyone involved, the "original" is lost or destroyed?

If a partnership terminates its Safe Harbor election, then, absent the consent of the Commissioner, neither the partnership nor any successor partnership would be eligible to make a Safe Harbor election for any taxable year that begins before the fifth calendar year after the calendar year in which the termination occurs.¹³² For this purpose, a successor partnership is any partnership that (i) on the date of the termination is related (within the meaning of section 267(b) and 707(b)) to the partnership whose Safe Harbor election has terminated or, if the partnership whose Safe Harbor Election has terminated does not exist on the date of the termination, would be related if it existed on such date, and (ii) acquires (directly or indirectly) a substantial portion of the assets of the partnership whose Safe Harbor election has terminated. (The term "substantial" is, unfortunately, not defined.)¹³³ This successor rule is probably needed, but will unwittingly sweep in many unsuspecting partnerships and will make due diligence in connection with mergers and acquisitions much more difficult.

IV. Other Issues

Recently, the IRS appears to have addressed (whether intentionally or not) the question of whether a partnership may issue a profits interest to employees of partners, subsidiaries, or affiliates of the issuing partnership. In P.L.R. 200329001,¹³⁶ a REIT, as the sole general partner of the REIT's operating partnership Y, granted unvested profits interests in Y to key executives of the REIT, Y, and Y affiliates. The IRS ruled that the issuance and vesting of profits interests issued by Y as compensation for services performed by the participating executives to or for the benefit of Y were nontaxable events under the Rev. Procs. 93-27 and 2001-43. Thus, the letter ruling seems to accept implicitly the notion that profits interests may be issued to employees of partners, subsidiaries, or affiliates of the issuing partnership and qualify under those revenue procedures.¹³⁷

It is hoped that, when the Proposed Regulations and Proposed Revenue Procedure are finalized, they will address these factual situations comprehensively and favorably to taxpayers, allowing compensatory interests to be issued to employees of related entities without fear of adverse tax consequences. In this regard, it should be possible to adopt a circular flow of cash construct to avoid inappropriate gain recognition by the issuing and related partnerships, as has been done in the corporate context.¹³⁸

In other cases, however, this treatment would be inappropriate. For example, if a service provider were admitted to a partnership for a profits interest that varied each year based on the partnership's evaluation of the value of the contribution the service provider had made to the success of the venture that year, it seems inappropriate to treat the annual change in allocations as compensatory. Rather, the annual change is an integral part of the interest granted, and each annual change should not be an event for federal income tax purposes.¹⁴⁰

Such an exception could generally provide that, if a service partnership admits a service partner and (i) the partnership does not claim a deduction upon the grant or vesting of the compensatory interest, and (ii) the service partner does not report income as the result of the grant or vesting of the interest, the service partnership and its partners will not recognize income, gain, or loss in connection with the grant or vesting of the interest. (It may be appropriate to incorporate other aspects of Rev. Procs. 93-27 and 2001-43 as well.) For this purpose, a service partnership could be defined by reference to section 448(d)(2). The proposed regulations addressing disguised sales of partnership interests adopt such a definition.¹⁴¹

V. Conclusion

The Proposed Regulations and Proposed Revenue Procedure provide welcome confirmation that a partnership does not recognize gain on the issuance of a compensatory interest (including in connection with the exercise of a compensatory option). Nevertheless, the Proposed Regulations and Proposed Revenue Procedure need to be clarified in a number of respects and revised to avoid imposing unnecessary burdens on taxpayers and creating traps for the unwary.

Apologies to Don Turlington for the title. See Campbell v. Commissioner, 59 T.C.M. 236, 237 (1990), rev'd, 943 F.2d 815 (8th Cir. 1991).

² Partnership Equity for Services, 70 Fed. Reg. 29,675 (May 24, 2004). For purposes of this article, (i) the term "partnership" includes any business entity properly classified as a partnership for federal tax purposes under Treas. Reg. §§ 301.7701-1 through 3 (the "check-the-box" regulations), (ii) unless indicated otherwise, every limited liability company (an "LLC") identified in this article is classified as a partnership for federal tax purposes, and (iii) unless indicated otherwise, all "section" references are to the U.S. Internal Revenue Code of 1986, as amended (the "Code"), and all references to "Treas. Reg. § " are to the Treasury regulations promulgated under the Code.

³ 2005-24 I.R.B. 1221.

⁴ 1993-2 C.B. 343.

⁵ 2001-2 C.B. 191.

⁶See Campbell, 59 T.C.M. at 237.

⁷ 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

⁸ The discussion in this Part is drawn from Glenn E. Mincey, Eric B. Sloan, and Sheldon I. Banoff, Rev. Proc. 2001-43, Section 83(b), and Unvested Profits Interests: The Final Facet of Diamond?, 604 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 949 (PLI 2004), which contains a detailed discussion and analysis of Rev. Proc. 93-27 and Rev. Proc. 2001-43.

⁹ 59 T.C.M. 236 (1990), rev'd, 943 F.2d 815 (8th Cir. 1991).

¹⁰Campbell, 943 F.2d at 822.

¹¹ Section 707(a)(1) provides that a partner who engages in a transaction with a partnership in a nonpartner capacity will be treated as having engaged in a transaction between the partnership and one who is not a partner. If a partner acting in a partner capacity receives a distribution of income for the performance of services and the amount of the distribution is determined without regard to partnership income, the transfer is considered to be a "guaranteed payment" under section 707(c). Any other payment to a partner for services or capital contributed in a partner capacity is simply a distribution under section 731.

¹²Campbell, 943 F.2d at 822.

¹³ Rev. Proc. 93-27, § 4.01. Rev. Proc. 93-27 defines a capital interest as an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds distributed in a complete liquidation of the partnership. The revenue procedure then provides that a profits interest is any interest other than a capital interest.

¹⁴ Rev. Proc. 93-27, § 4.02.

¹⁵ Rev. Proc. 2001-43, § 4.03.

¹⁶Id. § 4.01.

¹⁷Id. § 4.02.

¹⁸ Treas. Reg. § 1.83-4(a).

¹⁹ Noncompensatory Partnership Options, 68 Fed. Reg. 2,930 (Jan. 22, 2003).

²⁰ Prop. Treas. Reg. § 1.704- 1(b)(2)(iv)(s)(2).

²¹See, e.g., Matthew P. Larvick, Noncompensatory Partnership Options: The Proposed Regulations, 2003 TNT 72-30 (Apr. 15, 2003); Elliott Manning, Noncompensatory Partnership Options, 2003 TNT 103-79 (Apr. 22, 2003); Karen C. Burke, Taxing Compensatory Partnership Options, 2003 TNT 184- 47 (Sept. 23, 2003); American Bar Association, Comments in Response to REG-103580-02 (Oct. 9, 2003), ), in Comments on Regulations on Tax Treatment of Noncompensatory Partnership Options, 2003 TNT 213-21 (Nov. 4, 2003); New York State Bar Association, Report on the Taxation of Partnership Interests Received for Services and Compensatory Partnership Option (Jan. 23, 2004), in Report on the Proposed Regulations Relating to Partnership Options and Convertible Securities, 2004 TNT 16-80 (Jan. 23, 2004); Steven Schneider, Comments on REG-103580-02, 2004 TNT 42-33 (Feb 10, 2004); American Institute of Certified Public Accountants, Comments on Proposed Regulations (REG-103580-02) Issued January 22, 2003 Regarding Noncompensatory Partnership Options, in AICPA Submits Recommendations, Seeks Clarification on Proposed Partnership Option Regs., 2004 TNT 210-7 (Oct. 29, 2004).

²² For the definition of substantial risk of forfeiture and transferability, see sections 83(c)(1) and (2) and Treas. Reg. §§ 1.83-3(c) and (d). A detailed discussion of the operation of section 83 is beyond the scope of this article. It is worth noting, however, that in this context "transferable" means the ability to transfer the property to a third party free of any substantial risk of forfeiture, not just the ability to transfer to a third party. See generally John L. Utz, Restricted Property -- Section 83, 384-3rd T.M. (BNA 2001).

²³See Mincey, Sloan, and Banoff, supra note 8, at 975 n.31.

²⁴ Prop. Treas. Reg. § 1.83-3(e).

²⁵ Rev. Proc. 93-27 and Rev. Proc. 2001-43 would be obsoleted by the Proposed Revenue Procedure. Proposed Revenue Procedure, § 7.

²⁶ Prop. Treas. Reg. § 1.761-1(b). This is the same rule that is applicable with respect to corporate stock. See Rev. Rul. 83-22, 1983-1 C.B. 17. See also Treas. Reg. § 1.1361-1(b)(3) (a service provider who holds unvested stock in an S corporation is treated as a shareholder upon making an election under section 83(b)).

²⁷ Rev. Proc. 2001-43, 2001-2 C.B. 191.

²⁸ Section 83(b)(1).

²⁹ If the government were writing on a clean slate, subjecting profits interests to section 83(b) would not be unreasonable. But the slate is covered with Rev. Proc. 2001-43 and the settled expectations of taxpayers.

³⁰ In a recent case, it appears that the service provider dramatically under-reported his income, while the service recipient claimed a deduction equal to what he believed to be the true fair market value of the transferred property. In accordance with Treas. Reg. § 1.83-6(a), the IRS sought to limit the service recipient's deduction to the amount included in the income of the service provider. The Court of Appeals for the Federal Circuit sided with the service recipient. Robinson v. United States, 335 F.3d 1365 (Fed. Cir. 2003), cert. denied, 124 S. Ct. 1044 (2004).

³¹ It could be argued that the approach of Rev. Proc. 93-27 and Rev. Proc. 2001-43 is wrong as a theoretical matter. Yet, the approach of the Proposed Revenue Procedure is subject to a very similar critique. The age old notions that two wrongs do not make a right, and the devil we know is better than the devil we do not know, also argue for retaining current administrative practice, at least in part.

³² Another approach would be to deem a section 83(b) election to have been made. This, however, would seem to require legislative action.

³³ Treas. Reg. § 1.83-3(a)(2) provides that the grant of an option to purchase certain property generally does not constitute a transfer of such property. (The grant of the option itself generally is not subject to section 83. But see Treas. Reg. § 1.83-7 for certain exceptions.) Prop. Treas. Reg. § 1.83-3(e) provides that property includes a partnership interest. Thus, under these two provisions, the grant of a compensatory partnership option should not constitute a transfer of the underlying partnership interest.

³⁴ Treas. Reg. § 1.83-7(a). Although this is the approach under section 83, it should be noted that under section 409A, enacted as part of the American Jobs Creation Act of 2004, the service provider will have income once the option is substantially vested if the option is considered "nonqualified deferred compensation" under that section. Notice 2005-1, 2005-2 I.R.B. 274, Q&A-4(d)(ii) provides that an option is considered nonqualified deferred compensation unless it is granted on an interest in the service recipient, the exercise price is not less than fair market value at grant, and "the option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option under § 1.83-7."

³⁵ Section 83(a) and Treas. Reg. § 1.83-1(a)(1).

³⁶ Preamble, 70 Fed. Reg. at 29,676.

³⁷ Treas. Reg. § 1.83-6(a).

³⁸ Treas. Reg. § 1.721-1(b)(2). Although the regulation is not entirely clear, it seems the regulation is properly limited to the issuance of interests to existing partners. Issuances of interests to nonpartners are more properly treated as "regular" compensation, reportable on Form W-2 or Form 1099, depending on the circumstances.

³⁹ Prop. Treas. Reg. § 1.721-1(b)(4)(i).

⁴⁰Cf. Proposed Revenue Procedure, § 6 (including as one assumed fact applicable to the examples, that capitalization "under the rules of § 263 or other applicable provisions of the Code" was not required).

⁴¹ Preamble at 29,677.

⁴²Id.

⁴³Cf. Rev. Proc. 93-27, § 2.

⁴⁴Cf. Treas. Reg. § 1.704- 1(b)(2)(ii)(a) (in order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners).

⁴⁵See American Bar Association, Comments in Response to REG-103580-02 (Oct. 9, 2003), in Comments on Regulations on Tax Treatment of Noncompensatory Partnership Options, 2003 TNT 213-21 (Nov. 4, 2003) (discussing the circular flow of cash approach); Gary C. Karch, Equity Compensation by Partnership Operating Businesses, 74 TAXES 722 (Dec. 1996) (noting the circular flow of cash approach).

⁴⁶ For this purpose, the term "section 704(b) capital account" refers to the capital accounts maintained in accordance with Treas. Reg. § 1.704-1(b)(2)(iv).

⁴⁷See infra Part III.

⁴⁸See MCKEE, NELSON, & WHITMIRE, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS, Third Edition (Warren, Gorham, & Lamont, 1997), ¶ 5.02[2] (illustrating this effect).

⁴⁹See Preamble at 29,677.

⁵⁰ IRS personnel, however, are reported to have "denied adopting" such an approach. See Lee Sheppard, News Analysis: Massive Giveaway in Partnership Compensatory Option Regs., 2005 TNT 118-9 (June 21, 2005).

⁵¹See Treas. Reg. § 1.704- 1(b)(2)(iv)(b)(1) (capital account increased by the amount of cash contributed).

⁵² Preamble at 29,678.

⁵³ Treas. Reg. § 1.704- 1(b)(2)(ii)(b)(2).

⁵⁴ Support for this approach can be found in the rules applicable to S corporations. See Treas. Reg. § 1.1361- 1(b)(3) (a service provider who holds unvested stock is treated as a shareholder upon making an election under section 83(b)); see also American Bar Association, Comments in Response to REG-103580-02 (Oct. 9, 2003), in Comments on Proposed Regulations on the Taxation of Compensatory and Noncompensatory Partnership Options, 2003 TNT 213-21 (Nov. 4, 2003).

⁵⁵ Preamble at 29,678. This statement proves too much and too little. It proves too much because the section 704(b) regulations specifically contemplate that a partnership may in certain circumstances liquidate a partner's interest other than in accordance with the partner's positive capital account balance, yet the partnership's allocations may still have economic effect. Treas. Reg. § 1.704-1(b)(2)(ii)(b) (flush language). It proves too little because the mere presence of the contingency makes all allocations, not just the allocations to the unvested service provider, vulnerable to the logic of the Preamble. That is, if the unvested interest is ignored in making allocations, there is a risk that the partners who receive those allocations will not receive liquidating distributions that reflect such allocations. It is not entirely clear that the drafters of the Proposed Regulations appreciated the allocation conundra created by contingencies.

⁵⁶ Prop. Treas. Reg. § 1.704- 1(b)(4)(xii)(a).

⁵⁷ A materiality standard is also found in the rules governing the allocation of nonrecourse deductions. Treas. Reg. § 1.704-2(e)(4). The use of a materiality standard is welcome, especially when contrasted with the "all or nothing" approaches taken by other regulations. See, e.g., Treas. Reg. § 1.514(c)-2(b)(ii) (to satisfy the "fractions rule," "[e]ach partnership allocation must have substantial economic effect" or be deemed to be in accordance with the partners' interests in the partnership).

⁵⁸ Prop. Treas. Reg. § 1.704- 1(b)(4)(xii)(b)(2). The second requirement should be contrasted with the requirement of the proposed and temporary regulations under section 704(b) addressing the allocation of creditable foreign tax expenditures. Those regulations require that allocations have economic effect under Treas. Reg. § 1.704- 1(b)(2)(ii)(b) or (d), which excludes allocations respected under either the economic equivalence test of Treas. Reg. § 1.704-1(b)(2)(ii)(i) or the partners' interests in the partnership test of Treas. Reg. § 1.704-1(b)(3). Treas. Reg. § 1.704-1T(b)(4)(xi)(a)(1). Commentators have noted the overly-narrow scope of those regulations. See New York State Bar Association, New York State Bar Association Tax Section's Report No. 1069 (Sept. 30, 2004), in NYSBA Tax Section Comments on Partnership Expense Allocations for Foreign Taxes, 2004 TNT 198-18 (Oct. 13, 2004) (recommending the final regulations permit the use of the economic effect equivalence test as an alternative under the safe harbor); American Bar Association, Comments on Temporary and Proposed Regulations Governing Allocation of Partnership Expenditures for Foreign Taxes TD 9121; Reg-139792-02 (Aug. 10, 2004), in ABA Comments on Partnership Expense Allocations for Foreign Taxes 2004 TNT 155-18 (Aug. 11, 2004) (recommending the final regulations clarify whether the absence of the economic equivalence test is intentional).

⁵⁹ Prop. Treas. Reg. § 1.704- 1(b)(4)(xii)(c).

⁶⁰ Treas. Reg. § 1.83-6(c) provides that, if a service provider forfeits unvested property, the service recipient is required to include in gross income an amount equal the compensation deduction previously claimed by the service recipient in connection with the compensatory transfer of that property.

⁶¹ Prop. Treas. Reg. § 1.704- 1(b)(4)(xii)(e).

⁶² Prop. Treas. Reg. § 1.704- 1(b)(4)(xii)(e). It is quite possible, of course, that the application of that standard would also result in income allocations to the unvested partner.

⁶³ Three points bear noting. First, it is possible that the loss would be disallowed under section 83(b)(1). Second, section 751(b) could apply. Finally, to the extent X's income inclusions were comprised of ordinary income, a capital loss might be of little value. See Treas. Reg. § 1.1211-1 (in general, a taxpayer's deduction for capital losses is limited to the amount of the taxpayer's capital gain).

⁶⁴ If the loss recognized by X were greater than $250,000, however, LLC would be required to reduce its asset bases by the amount of such loss under section 734(b). This could still result in a substantial timing benefit to the other LLC members.

⁶⁵ Section 733(2).

⁶⁶ It is not clear from the text of the Proposed Regulations whether the forfeiture allocation would be $10, the basis of the property in the hands of X, or $30, the basis of the property in the hands of LLC. It seems clear that the proper answer is $10, for it is this basis that benefits X.

⁶⁷ Prop. Treas. Reg. § 1.704()(4)(xii)(f); Prop. Treas. Reg. § 1.704-1(b)(5), Ex. 29(iv).

⁶⁸ Preamble at 29,678.

⁶⁹Id.

⁷⁰Id.

⁷¹Id.

⁷²Id.

⁷³ Remedial allocations were introduced in 1993 to "remediate" so-called "ceiling rule" distortions (discussed below). T.D. 8500, 58 Fed. Reg. 67,676 (Dec. 22, 1993). Section 704(c)(1)(A) requires that, in making allocations, partnerships take into account the disparity between the fair market value and adjusted tax basis of contributed property. Under the section 704(c) regulations, there are two types of partners: the partner who contributes property with the fair market value/tax basis disparity (the "contributing partner"), and all other partners (the "noncontributing partners"). To comply with section 704(c), a partnership first allocates section 704(b) "book" items among its partners under the terms of the partnership agreement; it then allocates an equal amount of tax items to the noncontributing partners. Any excess or shortfall in tax items is allocated solely to the contributing partner. The section 704(c) regulations further provide that a partnership may not allocate more tax items than it actually has (the so-called "ceiling rule"). Treas. Reg. § 1.704-3(b)(1). As a result of this rule, to the extent a partnership does not have tax items equal to the "book" items allocated to the noncontributing partners, the noncontributing partners bear the shortfall, unless the partnership makes "curative" allocations under Treas. Reg. § 1.704-3(c) or "remedial" allocations under Treas. Reg. § 1.704-3(d).

⁷⁴ Treas. Reg. § 1.704-3(d)(1). See supra note 73.

⁷⁵ Treas. Reg. § 1.704-3(d)(1). See supra note 73.

⁷⁶ Treas. Reg. § 1.704-3(d)(3).

⁷⁷ Treas. Reg. § 1.704-3(d)(5)(ii).

⁷⁸ After proposed regulations under section 704(c) were issued, commentators expressed some concern as to the government's ability to override the ceiling rule through the remedial allocation method. In response to this concern, Treas. Reg. § 1.704-3(d)(ii) was enacted to provide that the IRS may not require a partnership to use the remedial allocation method or any other method involving the creation of notional tax items. See the preamble to Treas. Reg. § 1.704-3, T.D. 8585, 59 Fed. Reg. 66,724, 66,726 (Dec. 28, 1994).

⁷⁹ Treas. Reg. § 1.704- 1(b)(2)(ii)(d)(3) and (6).

⁸⁰ Temp. Treas. Reg. § 1.704-1T(b)(1)(ii)(b)(2).

⁸¹See Prop. Treas. Reg. § 1.704-1(b)(2)(iv)(s)(4).

⁸² As forfeiture allocations appear to be complex and likely will be viewed as burdensome by most taxpayers, it would be inadvisable to require forfeiture allocations to match the character and source of the initial allocations.

⁸³See supra note 66.

⁸⁴See supra Part II.

⁸⁵ Preamble at 29,679.

⁸⁶ X is deemed to sell a 10 percent interest in each LLC asset. Thus, X is able to allocate 10 percent of its basis in LLC's assets to the portion of the assets deemed sold. Treas. Reg. § 1.61-6(a) (when a part of a larger property is sold, the cost or other basis of the entire property is equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part). Cf. section 1011(b) (on a bargain sale to a charitable organization, the adjusted basis of the property that is sold or exchanged shall be that portion of the adjusted basis of the entire property that bears the same ratio to the entire adjusted basis as the amount realized bears to the fair market value of the entire property); Treas. Reg. § 1.167(a)-5 (basis of combined depreciable and nondepreciable property apportioned according to fair market value).

⁸⁷ 62 T.C. 720 (1974), acq. 1975-2 C.B. 2.

⁸⁸ If this is in fact the holding of the Tax Court in McDougal, it differs from the eminently more sensible approach taken by the IRS in Rev. Rul. 99-5, 1999-1 C.B. 434, Situation 1. Under Rev. Rul. 99-5, McDougal would have been treated as transferring a 50 percent interest in the horse to McClanahan in exchange for services. McDougal and McClanahan would each be treated as subsequently forming the partnership by contributing an undivided interest in the horse.

⁸⁹ T.D. 9207, 70 Fed. Reg. 30,334 (May 26, 2005). These changes were made as part of the promulgation of the new contingent liability rules of Treas. Reg. § 1.752-7.

⁹⁰ Treas. Reg. §§ 1.704- 1(b)(2)(iv)(b)(2) and (5).

⁹¹ Significantly, the normal section 704(b) capital accounting rules would not apply to NCOs. Under the Proposed NCO Regulations, rather than treating the negative value of an outstanding option as a separate negative value asset, partnerships would be required to reduce the gross value of partnership assets by the amount of negative value attributable to the NCO. Prop. Treas. Reg. § 1.704-1(b)(2)(iv)(h)(2). The reason for the difference is that the mechanic in the Proposed NCO Regulations furthers the goal of preserving built-in gain to which the option holder would succeed upon exercise of the NCO. See Proposed NCO Regulations Preamble. There is no need to preserve built-in gain in connection with compensatory options, as the holder recognizes (as ordinary income) all of the gain inherent in the interest received upon exercise of the option.

⁹² Treas. Reg. § 1.83-7(a). The Preamble cites Shulman v. Commissioner, 93 T.C. 623 (1989), for the proposition that section 83 governs the issuance of an option to acquire a partnership interest as compensation for services provided as an employee.

⁹³ Prop. Treas. Reg. § 1.761-3(a).

⁹⁴Id.

⁹⁵ The Proposed NCO Regulations also apply to convertible preferred equity and convertible debt obligations. Prop. Treas. Reg. § 1.721-2(e)(1) (providing that the term "option" includes the conversion features of convertible debt and convertible equity).

⁹⁶ This example is drawn from an example Eric B. Sloan and Christine K. Kraft, Opening Pandora's Box: Who is (or should be) a Partner?, 79 TAXES 3, 169, 182 (2001) reprinted in 650 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 755 (PLI 2005).

⁹⁷ Preamble at 29,679.

⁹⁸Id.

⁹⁹Id.

¹⁰⁰Id. The IRS and Treasury are also considering amending the regulations under section 6041 to provide that guaranteed payments arising from the transfer of a partnership interest must be reported on Form 1099-MISC, rather than on the Schedule K-1 to Form 1065. This is intended to ensure that the recipient partner has the necessary information to permit the partner to properly compute its income tax liability. Id.

¹⁰¹Id. Many practitioners were surprised that the IRS and Treasury appear to believe that section 761(c) permits the retroactive admission of a partner.

¹⁰² Preamble at 29,680.

¹⁰³ Prop. Treas. Reg. § 1.83-3(e); Prop. Treas. Reg. § 1.706-3(c).

¹⁰⁴ Proposed Revenue Procedure, §§ 4.01 and 4.02.

¹⁰⁵ Proposed Revenue Procedure, § 4.02.

¹⁰⁶ It seems likely that the drafters intended for liabilities to be considered. The regulations under section 743(b) contain a similar hypothetical sale transaction, and, even though Treas. Reg. § 1.743-1(d)(2) does not reference liabilities, the facts of one of the examples in the regulations include liabilities and reduce the amount distributable to the partners by the amount of the liabilities. Treas. Reg. § 1.743-1(d)(3), Ex. 1.

¹⁰⁷ The same issue arises under Rev. Proc. 93-27 and Rev. Proc. 2001-43. See Mincey, Sloan, and Banoff, supra note 8, at 1001-1008.

¹⁰⁸See Treas. Reg. § 1.743-1(d)(1) (in determining a transferee's interest in the partnership's previously taxed capital, amounts are considered "to the extent attributable to the acquired interest").

¹⁰⁹ Rev. Rul. 84-53, 1984-1 C.B. 159.

¹¹⁰ Proposed Revenue Procedure, § 3.02.

¹¹¹ The term disability means a mental or physical disability that causes the holder to be unable to engage in "any gainful activity" as the result of a condition that is expected to result in death or to last for at least 12 months. Proposed Revenue Procedure, § 3.02.

¹¹² Proposed Revenue Procedure, § 3.02.

¹¹³ Treas. Reg. §§ 1.707-3(c) and (d) (providing that transfers between a partnership and a partner that occur within two years of each other (regardless of their order) are presumed to be part of a sale transaction and that transfers between a partnership and a partner that occur more than two years apart are presumed not to be part of a sale transaction).

¹¹⁴ In this regard, it should be noted that partnerships with corporate partners are increasingly issuing exchangeable partnership equity; these exchange rights would certainly be considered "sell" rights under the Proposed Revenue Procedure. For example, many operating partnerships of UPREITs (umbrella partnership real estate investment trusts) have issued profits interests to employees of the operating partnership. As a general matter, these profits interests are exchangeable for REIT stock. In addition, the UPREIT structure has taken hold in corporate America. Thus, it can be anticipated that the operating partnerships of those public companies will issue exchangeable profits interests. For a discussion of the "public LLC" or "pubco" structure, see Eric B. Sloan, Steve E. Klig, and Judd A Sher, Through the Looking Glass: Seeing Corporate Problems as Partnership Opportunities, 657 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 547, 602 (PLI 2005).

¹¹⁵ Proposed Revenue Procedure, § 5.01.

¹¹⁶Id. This is the case even if the amount paid is the full fair market value on the date of grant. Thus, in such situations, the service provider will want to make a section 83(b) election. See Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984) (restricted stock purchased upon commencement of employment and linked to employee's tenure with company was considered transferred in connection with the performance of services and was subject to section 83 even though taxpayer paid full fair market value for such restricted stock).

¹¹⁷ Proposed Revenue Procedure, § 4.03.

¹¹⁸Id. This is what most partnership tax practitioners refer to as a "booked up" capital account. It appears to be substantively identical to the "liquidation value" of the interest. If so, it is unfortunate that the Proposed Revenue Procedure uses two terms to describe the same amount.

¹¹⁹ Proposed Revenue Procedure, § 4.03.

¹²⁰ Treas. Reg. § 1.83-6(a)(1). The Federal Circuit has held that, for this purpose, the term "included" means the amount that the service provider should have included in income, even if the service provider actually includes a different amount. Robinson v. U.S., 335 F.3d 1365 (Fed. Cir. 2003), supra note 30.

¹²¹ Proposed Revenue Procedure, § 4.04.

¹²² The Proposed Revenue Procedure would apply to all compensatory interests transferred while the Safe Harbor election is in effect, even if the Safe Harbor election has been terminated at the time the interest vests, a section 83(b) election is made with respect to the interest, or the interest is forfeited. Proposed Revenue Procedure, § 3.01.

¹²³ Proposed Revenue Procedure, § 3.03(1).

¹²⁴ Proposed Revenue Procedure, § 3.03(2). Presumably, an agreement may be amended retroactively under the authority of section 761(c) to comply with the requirement that the amendment be "effective" before the issuance of the interest. It would be helpful if the Proposed Revenue Procedure were clarified on this point.

¹²⁵ Proposed Revenue Procedure, § 3.03(3).

¹²⁶ Temp. Treas. Reg. § 1.704- 1T(b)(1)(ii)(b)(2).

¹²⁷ A provision similar to the following might be appropriate: "The General Partner may, in its sole discretion, unilaterally cause the Partnership Agreement to be amended to (i) authorize and direct the Partnership to elect the "safe harbor" described in Prop. Treas. Reg. § 1.83-3(l) (or any similar provision) under which the fair market value of a partnership interest that is transferred in connection with the performance of services is treated as being equal to the liquidation value of that interest, (ii) require both the Partnership and each Partner to comply with all of the requirements set forth in such proposed Treasury regulations and IRS Notice 2005-43, 2005-24 I.R.B. 1221, (and any other guidance provided by the IRS with respect to such election) with respect to all interests in the Partnership transferred in connection with the performance of services while the election remains effective, (iii) provide for the allocation of items of income, gain, loss, and deduction in the manner and to the extent required by the any final Treasury regulations similar to Prop. Treas. Reg. §§ 1.704-1(b)(4)(xii)(b) and (c), and (iv) to provide for any other amendments reasonably necessary to implement clauses (i), (ii), and (iii), above."

¹²⁸ Treas. Reg. § 301.7701-3(c)(2)(i)(B) (an entity classification election may be signed by any officer, manager, or member who is authorized under jurisdictional law or the entity's organizational documents to make the election).

¹²⁹Cf. Rev. Rul. 2004-88, 2004-32 I.R.B. 165 (treating a DRE as a "passthrough partner" for purposes of the TEFRA unified audit rules).

¹³⁰ Proposed Revenue Procedure, § 3.06.

¹³¹Id. § 3.04.

¹³²Id. § 3.05. Five year waiting periods exist elsewhere. See section 1504(a)(3) (once a subsidiary ceases to be a member of a consolidated group, it or a successor generally cannot join in a consolidated return filed by the consolidated group for five years); Treas. Reg. § 301.7701- 3(c)(1)(iv) (an eligible entity that elects to change its classification cannot again change its classification by election for five years); section 1362(g) and Treas. Reg. § 1.1362-5(a) (absent the IRS's consent, an S corporation whose election has terminated may not make a new election under section 1362(a) for five years). The Proposed Revenue Procedure does not permit taxpayers to seek relief from the five-year waiting period. The addition of a relief mechanism would be welcome and appropriate.

¹³³ Presumably a "substantial portion" is less than "substantially all," which is generally considered to be seventy percent of the fair market value of gross assets and ninety percent of the fair market value of net assets. See Rev. Proc. 77-37, 1977-2 C.B. 586 (for advance ruling purposes, the term "substantially all" means seventy percent of gross assets and ninety percent of net assets); see also Treas. Reg. § 1.731-2(c)(3)(i) (providing that, for purposes of section 731(c), substantially all of the assets of an entity consist of marketable securities, money, or both only if ninety percent or more of the assets of the entity consist of marketable securities, money, or both).

¹³⁴ Prop. Treas. Reg. 1.721-1(b)(3) (first sentence).

¹³⁵ Preamble at 29,676.

¹³⁶ Feb. 21, 2003. Apparently, the IRS currently will not issue rulings on this issue.

¹³⁷ This paragraph is drawn from Mincey, Sloan, and Banoff, supra note 8, at 997-998.

¹³⁸See Treas. Reg. § 1.1032-3(b)(1) and Treas. Reg. § 1.1502-13(f), each of which constructs a circular flow of cash to avoid inappropriate gain recognition.

¹³⁹ Proposed Revenue Procedure, § 6, Ex.3.

¹⁴⁰Cf. Treas. Reg. § 1.1001-3(1)(ii) (for purposes of determining whether a modification of the terms of a debt instrument results in an exchange for purposes of § 1.1001-1(a), an alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is generally not a modification).

¹⁴¹ Prop. Treas. Reg. § 1.707-7(g), 69 Fed. Reg. 68,838 (Nov. 26, 2004)

¹⁴²See Proposed Revenue Procedure, Effective Date.