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Deloitte Tax Suggests Changes to Guidance on Exchanges of Partnership Interests

AUG. 22, 2005

Deloitte Tax Suggests Changes to Guidance on Exchanges of Partnership Interests

DATED AUG. 22, 2005
DOCUMENT ATTRIBUTES
  • Authors
    Drigotas, Elizabeth
    Sloan, Eric B.
  • Institutional Authors
    Deloitte Tax LLP
  • Cross-Reference
    For Notice 2005-43, 2005-24 IRB 1221, see Doc 2005-11236 [PDF] or

    2005 TNT 98-37 2005 TNT 98-37: Internal Revenue Bulletin. For REG-105346-03, see Doc 2005-11235 [PDF]

    or 2005 TNT 98-31 2005 TNT 98-31: IRS Proposed Regulations.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-17730
  • Tax Analysts Electronic Citation
    2005 TNT 163-17

 

August 22, 2005

 

 

Eric Solomon

 

Acting Assistant Secretary (Tax Policy)

 

United States Treasury Department

 

1500 Pennsylvania Ave., NW

 

Washington DC 20220

 

Re: Proposed Regulations on Partnership Equity for Services

 

(REG-105346-03)

 

Proposed Revenue Procedure Regarding Partnership Interests

 

Transferred in

 

Connection with the Performance of Services

 

(Notice 2005-43)

 

Dear Eric:

We are writing on behalf of our client to provide comments on the proposed regulations regarding compensatory transfers of partnership equity and the proposed revenue procedure provided in Notice 2005-43, 2005-24 I.R.B. 1221. This comment addresses the provisions in the proposed revenue procedure related to Safe Harbor Partnership Interests, and the requirement that a transfer not be in anticipation of a disposition. We may be submitting further comments related to other issues in the future.

The proposed regulations would provide that a compensatory transfer of a partnership interest would be subject to section 83. In part, section 83 requires that a service provider recognize income in connection with a transfer of property when the property is vested (i.e., no longer subject to a substantial risk of forfeiture or transferable). The amount of income is equal to the excess of the fair market value of the property at the time of vesting, determined without regard to restrictions other than non-lapse restrictions (as defined in Treas. Reg. 1.83-3(h)), over the amount paid for the property, if any. The proposed revenue procedure provides a safe harbor valuation method pursuant to which the fair market value of both capital and profits interests would be the liquidation value of the interest, if the service recipient partnership had a valid Safe Harbor Election in effect. An interest subject to valuation under the Safe Harbor is called a Safe Harbor Partnership Interest.

Assuming a Safe Harbor Election is in effect, there are several requirements for an interest to qualify as a Safe Harbor Partnership Interest. In particular, the interest must not be one that is related to a substantially certain and predictable stream of income or an interest in a publicly traded partnership. In addition, the interest must not be one that is "transferred in anticipation of a subsequent disposition" (the "Holding Requirement"). Prop. Rev. Proc. 3.02(1). These three requirements are similar to the requirements in effect under the existing Revenue Procedures, Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191.

With respect to the requirement that the interest not be one that is "transferred in anticipation of subsequent disposition", the proposed revenue procedure provides that a partnership interest is presumed to be transferred in anticipation of a subsequent disposition if the partnership interest is sold or disposed of within two years of the date of receipt of the partnership interest or is subject, at any time within two years of the date of receipt, to a right to buy or sell regardless of when the right is exercisable. Interests that are sold or disposed of by reason of death or disability (or are subject to a right to sell upon death or disability) are excepted from the presumption. A taxpayer can rebut this presumption only by establishing clear and convincing evidence that the partnership interest was not transferred in anticipation of a subsequent disposition.

The Holding Requirement differs from the requirements of the current revenue procedures by establishing a presumption rather than a hard rule and by excepting transfers arising from death or disability. We agree that a presumption is more appropriate than a hard rule, as circumstances may arise over the two-year period that lead to a transfer of the partnership interest that was not anticipated at the time of the initial grant.

The Holding Requirement, however, also differs from the current revenue procedures in treating an agreement to transfer entered into within the two-year period after the grant of the interest as the equivalent of an actual transfer (the "Agreement Rule"). We suggest that this treatment is overly broad. Most partnerships subject compensatory interests to redemption or buy-sell agreements for valid business reasons. Partnerships, for example, do not want former service providers who leave the partnership and may be working for competitors to continue to hold their partnership interests and, therefore, need a redemption mechanism for partners who terminate their services to the partnership. Service providers may also demand some sort of limited liquidity in their partnership interests, as they usually do not have the ability to control partnership distributions. While we recognize that buy-sell agreements, redemptions, and options may be used by a small number of partnerships to disguise a cash payment as a compensatory partnership interest, we believe that the Internal Revenue Service ("IRS") has ample tools at its disposal to deal with such abusive situations, such that there is no need for the draconian approach taken in the revenue procedure.

We also suggest that, in fairness, a taxpayer-favorable presumption should be added to the revenue procedure, so that a transfer is deemed not to be in anticipation of a disposition if in fact there is no transfer, or equivalent agreement, during the two- year period. Finally, we suggest that the revenue procedure provide further guidance on rebutting the presumption that a transfer is in anticipation of a disposition.

 

RECOMMENDATIONS

 

 

We recommend that the requirements for Safe Harbor Partnership Interests under the proposed revenue procedure be revised as follows:

 

(1) The Agreement Rule should be eliminated from the proposed revenue procedure. Alternatively, it should be replaced with a rule that would provide that a disposition includes a constructive disposition.

(2) A partnership interest should be presumed not to be transferred in anticipation of a disposition if the interest is not in fact transferred within two years of the initial transfer.

(3) A showing of any of the following should rebut the presumption created by a disposition during the two-year period: (1) the disposition is in connection with an unanticipated event, such as the partner's termination of service, divorce, or bankruptcy, (2) the disposition is in a nonrecognition transaction, or (3) the disposition is to a family or related entity for estate planning purposes.

(4) The rebuttal of the presumption raised by disposition of an interest within two years should be based on the facts and circumstances, without the heightened requirement of clear and convincing evidence.

DISCUSSION

 

 

I. Background

The Treasury Department and the IRS issued Rev. Procs. 93-27 and 2001-43 in recognition of a series of cases that had generally held the grant of an interest in partnership profits to be a tax-free transaction for both the service provider and the partnership.1 In each of these cases, the courts determined that, because the partnership's success was undetermined and speculative, the appropriate way to value the partnership interest received by the service provider was by reference to its liquidation value.

One departure from this line of precedent was the case of Diamond v. Commissioner.2 The taxpayer, Sol Diamond, had arranged for the financing of a land purchase in exchange for a profits interest in the partnership that held the land. Three weeks later, Mr. Diamond sold his profits interest for $40,000 and attempted to report the proceeds of the sale as short-term capital gain, rather than ordinary income. Although holding that the receipt of the profits interest was compensation to Mr. Diamond, the Seventh Circuit Court of Appeals noted the presence of strong views to the contrary and recognized the limitations of its holding:

 

There must be wide variation in the degree to which a profit- share created in favor of a partner who has or will render services has determinable or speculative value at the moment of creation. Surely, in many if not typical situations it will have only speculative value, if any.3

 

The carve-out in Rev. Proc. 93-27 for interests disposed of within two years of receipt appears to be in response to the Diamond decision. That is, the Treasury Department and the IRS appear to have agreed with the Seventh Circuit that, where the partnership interest has a readily ascertainable fair market value because of a disposition shortly after the interest is issued, then the partner should not be able to rely on a liquidation value theory to avoid recognizing income on receipt of the interest.

In the proposed revenue procedure, the Treasury Department and the IRS generally continue to follow the line of authority established by the cases discussed above by providing that a partnership interest can generally be valued for section 83 purposes in accordance with liquidation value. As discussed below, however, the proposed revenue procedure attempts to prohibit taxpayers from valuing compensatory partnership interests under a liquidation value approach in circumstances far beyond those supported by the case law.4 Specifically, there is little policy or case law justification for prohibiting taxpayers from adopting a liquidation value approach where: (1) the partnership subjects, for valid business reasons, compensatory interests to buy-sell or redemption agreements at other than a fixed price; (2) a compensatory interest is transferred more than two years of the date of grant; (3) a compensatory interest is redeemed within the two-year period following the date of grant as a result of the partner ceasing to provide services to the partnership, the bankruptcy of the partner, or the divorce of the partner; or (4) a compensatory interest is transferred in a nonrecognition transaction within the two-year period following the date of grant.

II. Buy-Sell and Redemption Agreements

We suggest that the provision that treats any agreement for a disposition as the equivalent of a disposition is over broad and unnecessary. Every partnership agreement will have provisions addressing a partner's retirement from the partnership. This fact is noted in the revenue procedure itself: Example 1 addresses a situation under which the partner agrees to surrender the partnership interest on termination of services, and thus has in effect an agreement to provide for the disposition of the interest. In addition, many partnerships provide in the agreement that a partner is instead required to dispose of his partnership interest on termination of services by offering the partnership interest to other partners. Although the methods of disposing of the partnership interest differ, in each case, the purpose of the agreement is to address termination of services with the partnership, not to evade the restriction on transfers in anticipation of a disposition.

Another provision commonly seen in agreements is a redemption or transfer provision, allowing the service provider to redeem or transfer to another partner a portion of the compensatory interest after a period of service. Because service partners (who typically own minority interests) are frequently unable to transfer their partnership interests and are dependent on the whims of the majority partners for distributions of partnership operating income, these types of redemption provisions may be demanded by service partners to provide them with a modicum of liquidity. Such provisions should not be offensive provided that they do not set a fixed redemption price. Unlike the sale in Diamond, these provisions do not create a "market" for the interest, nor do they establish any way of valuing the interest.

In other contexts, the Treasury Department and the IRS have recognized that, given the real business need for buy-sell and redemption agreements, any anti-abuse rules applicable to such agreements should be narrowly tailored. For example, the S corporation one class of stock rules provide that bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether an S corporation has a single class of stock.5 Other buy-sell agreements and redemption agreement are regarded only if: (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement was entered into, is significantly in excess of or below the fair market value of the stock.6

It appears that the Agreement Rule is intended to be an anti- abuse rule designed to prevent taxpayers from circumventing the Holding Requirement. If this is the case, there appears to be little need for the rule as the IRS has plenty of weapons to attack such abusive strategies. Even absent the Agreement Rule, the general Holding Requirement should be sufficient to support such an attack. Nothing in the proposed revenue procedure prevents the IRS from arguing that a compensatory interest transferred or disposed of more than two years after receipt was transferred "in anticipation of a subsequent disposition" if the compensatory interest was subject to an abusive fixed-price buy-sell or redemption agreement.7 Certainly, the existence of an abusive buy-sell or redemption agreement at a fixed price would be strong evidence that the interest was transferred "in anticipation of a subsequent disposition."

Alternatively, the IRS could rely on section 707(a)(2)(A), arguably the most appropriate provision for attacking these types of abusive tax strategies.8 Section 707(a)(2)(A) was designed by Congress to prevent exactly the type of abuse that is addressed by the Holding Requirement, the masking of compensation as partnership allocations. Specifically, it recasts partnership allocations as payments of compensation if:

 

(i) a partner performs services for a partnership . . . ,

(ii) there is a related direct or indirect allocation and distribution to such partner, and

(iii) the performance of such services . . . and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership.

 

The legislative history of section 707(a)(2)(A) explains that the provision was enacted to prevent partnerships from disguising compensation to service partners as partnership allocations as a means of either avoiding capitalization requirements or converting ordinary compensation income into capital gain.9 It goes on to state, however, that Congress did not intend for the provision to be applied to prevent non-abusive allocations that reflect the economic arrangement of the partners.10

As explained above, the Agreement Rule in the proposed revenue procedure appears to accomplish little from the government's perspective, while creating a chilling effect for normal, non-abusive partnership arrangements. This chilling effect is at odds with the primary purpose of the proposed revenue procedure -- to provide greater certainty as to the tax consequences of granting compensatory partnership interests so that tax concerns would not inappropriately interfere with the normal business dealings of partnerships. For these reasons, we suggest that the Agreement Rule be eliminated from the proposed revenue procedure. If necessary, an example could be added to the proposed revenue procedure to clarify that a compensatory partnership interest that is subject to an abusive buy- sell or redemption agreement at a fixed price will be treated as issued "in anticipation of a subsequent disposition."

As an alternative approach, we suggest that, rather than focus on the existence of an agreement during the two-year period, the revenue procedure address more directly the substance of the underlying agreement by providing that a constructive disposition is considered a disposition. The basic test under section 83 is that a transfer occurs "when a person acquires a beneficial ownership interest in such property (disregarding any lapse restriction . . .)." Treas. Reg. § 1.83-3(a)(1). The regulation provides further guidance on when a transfer of beneficial ownership has occurred. The grant of an option is not a transfer of the underlying option property. In addition, whether there is a transfer depends on whether the consideration to be paid on surrender of the property approaches the fair market value of the property at the time of surrender and whether the individual bears the risk of loss if the value of the property declines.

The standards set forth in the regulations under section 83 regarding transfer of beneficial ownership can be used to identify circumstances in which a disposition of the interest should be considered to give rise to the presumption that the initial transfer was in anticipation of the disposition. Thus, the revenue procedure could provide that in addition to an actual disposition, if a partner agrees to dispose of the interest during the two-year period in a way that effectively disposes of the partner's beneficial ownership of that interest, there is a constructive disposition that gives rise to the presumption, even if the transfer of legal title does not occur until after the two-year period.

Such an approach addresses the concern that an agreement to dispose of the interest can be designed to evade the provisions of the revenue procedure, but would not give rise to the presumption in the case of agreements that are designed to address the mechanics of a normal, non-abusive disposition of the partnership interest in the future.

III. Presumption Regarding Dispositions

As noted above, we agree that creating a presumption based on a disposition during the initial two-year period is preferable to the current approach of a hard rule. We suggest, however, that the revenue procedure also provide that a transfer is presumed not to be in anticipation of a disposition if the interest is not disposed of during the two-year period.11

This approach will give greater certainty to circumstances in which there is no such disposition. By providing a presumption only for transfers occurring within two years of the grant of the interest, the revenue procedure leaves open the issue of the effect of a disposition occurring more than two years after the grant of the interest. In addition, a presumption that there is no anticipation of a disposition if there is in fact no disposition is consistent with the overall purpose of this provision as an anti-abuse requirement to ensure that treatment as a Safe Harbor Partnership Interest is appropriate.

IV. Rebuttal of the Two-Year Presumption

Currently, the revenue procedure excepts dispositions due to death or disability from the two-year presumption. We applaud the Treasury Department's and the IRS's willingness to carve out these types of unpredictable events from the two-year presumption, but suggest that the revenue procedure expand on the exceptions to include other types of unpredictable events, including the termination of employment, divorce, and bankruptcy. Each of these events is outside the control of the partner and the partnership and, therefore, could not be anticipated at the time of grant.

We also suggest that the revenue procedure carve out transfers in a nonrecognition transaction from the presumption. As explained above, the Holding Requirement (along with the other limitations on the Liquidation Value Safe Harbor) appears to be rooted in the idea that it is inappropriate to allow compensatory partnership interests to be valued at liquidation value when a market value for the interest is established shortly after grant. If the subsequent transfer is in exchange for other non-publicly traded property, rather than for cash or a cash equivalent, the transfer would not establish a market value for the interest. As most nonrecognition transfers are either in exchange for non-publicly traded property12 or are gratuitous, a nonrecognition transfer within two years after the grant of the compensatory interest should not prevent a partner from relying on the Liquidation Safe Harbor. With respect to other transactions, the general standard would apply, and whether the presumption that the initial transfer was in anticipation of a subsequent disposition can be rebutted would depend on the facts and circumstances.

Finally, we suggest that transfers to family members or for estate planning purposes also should be considered circumstances which rebut the presumption that the initial transfer was in anticipation of a disposition. The ability to make such a transfer is a benefit that employers often provide to employees, both in the corporate and noncorporate setting, and such transfers are frequently excepted from restrictions on transfers to third-parties. Allowing such a disposition does not indicate that the employer was transferring the interest to the employee in a way that would allow the employee to realize a higher value in the short-term while limiting income to the safe harbor amount. Rather, such a disposition relates to the personal planning goals of the individual and is generally consistent with a continued interest in the financial success of the partnership.

Thus, the revenue procedure should provide that a showing of any of the following will rebut the presumption created by a disposition during the two-year period: (1) the disposition is in connection with an unanticipated event, such as the partner's termination of service, divorce, or bankruptcy, (2) the disposition is in a nonrecognition transaction, or (3) the disposition is to a family or related entity for estate planning purposes.

V. Level of Evidence Required

Finally, we suggest that there is no reason to require clear and convincing evidence to rebut the presumption raised by a disposition within two years of transfer. As discussed above, there are many circumstances that can arise during a two-year period that will not have been anticipated at the time of the transfer. Setting a requirement of clear and convincing evidence creates an unreasonable risk that partners and partnerships will be forced to adjust positions that were reasonably taken contemporaneously because of subsequent events that were not known or anticipated. A simple requirement that that the presumption be rebutted on the basis of facts and circumstances surrounding the transfer is sufficient to protect against transfers that are in fact inconsistent with the assumptions underlying the safe harbor.

Thank you for consideration of our comments. If we can provide further information or input, or if you have questions about issues raised in this comment letter, please feel free to contact me.

Sincerely,

 

 

Elizabeth E. Drigotas

 

Deloitte Tax LLP

 

 

Eric B. Sloan

 

Deloitte Tax LLP

 

cc:

 

Matthew Lay, Acting Attorney-Advisor, Office of Tax

 

Legislative Counsel

 

 

Heather C. Maloy, Associate Chief Counsel

 

(Passthroughs & Special Industries)

 

 

Nancy J. Marks, Div. Counsel/Assoc. Chief Counsel

 

(Tax Exempt & Government Entities)

 

 

W. Thomas Reeder, Acting Benefits Tax Counsel

 

FOOTNOTES

 

 

1See, e.g., Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991), rev'g T.C. Memo. 1990-162; National Oil Co. v. Commissioner, T.C Memo. 1986-596; Kenroy, Inc. v. Commissioner, T.C. Memo. 1984-232; Hale v. Commissioner, T.C. Memo. 1965-274; St. John v. United States, 84-1 U.S.T. C. ¶ 9158, 53 A.F.T.R. 2d 718 (C.D. Ill. 1983). This also appears to have been the position that the Treasury Department and the IRS had tacitly adopted since 1971, despite arguing to the contrary in a handful of cases. See Treas. Reg. 1.721-1(b)(1), which provides, "[t]o the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share of partnership profits) in favor of another partner as compensation . . . , section 721 does not apply;" (emphasis added); Campbell, 943 F.2d at 819 ("the Commissioner concedes that the Tax Court erred in holding that the receipt of a profits interest in exchange for services to the partnership should be considered ordinary income to the service provider").

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

3Diamond, 492 F.2d at 290.

4 It is doubtful that a revenue procedure can accomplish such a result. A revenue procedure only describes the administration of the tax law by the IRS, it cannot prohibit a taxpayer from taking a position that is otherwise allowable under the law.

5 Treas. Reg. § 1.1361-1(l)(2)(iii)(B).

6 Treas. Reg. § 1.1361-1(l)(2)(iii)(A).

7 We suggest later in this letter that the revenue procedure be amended to provide that an interest disposed of more than two years after receipt was not transferred "in anticipation of subsequent disposition," but even if such a rule were adopted, the IRS would nevertheless be able to rebut that presumption with evidence establishing that the interest was, in fact, transferred "in anticipation of a subsequent disposition."

8Cf. Campbell, 943 F.2d at 822 ("[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.")

9 S. Rep. No. 98-169 (98th Cong., 2d Sess. 1984).

10Id.

11 The Treasury Department and the IRS took a similar approach in the disguised sale of assets regulations and the recently proposed disguised sale of partnership interest regulations. See Treas. Reg. § 1.707-3(d); Prop. Treas. Reg. § 1.707-7(d).

12 An exception would be a nonrecognition transfer to a public corporation; however, most transfers of property to public corporations are taxable because the transferor does not have control of the corporation after the transfer. See section 351.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Drigotas, Elizabeth
    Sloan, Eric B.
  • Institutional Authors
    Deloitte Tax LLP
  • Cross-Reference
    For Notice 2005-43, 2005-24 IRB 1221, see Doc 2005-11236 [PDF] or

    2005 TNT 98-37 2005 TNT 98-37: Internal Revenue Bulletin. For REG-105346-03, see Doc 2005-11235 [PDF]

    or 2005 TNT 98-31 2005 TNT 98-31: IRS Proposed Regulations.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-17730
  • Tax Analysts Electronic Citation
    2005 TNT 163-17
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