Weil, Gotshal & Manges LLP

IRS Proposes New Approach on Equity Compensation of Partners

Asofsky, Paul H.

(May 2005, Private Equity Alert)



By Paul Asofsky
The Internal Revenue Service (“IRS”) has just issued proposed regulations and a proposed revenue procedure dealing with equity interests (including carried interests and profits interests) granted as compensation for services rendered to a partnership (including limited liability companies taxed as partnerships). If finally adopted in their present form, such equity compensation will be subject to the timing and valuation rules of Section 83 of the Internal Revenue Code of 1986, as amended (the “Code”). The proposed regulations and revenue procedure represent a change in course for the IRS and would supersede revenue procedures taking a different approach that were issued in 1993 and 2003 (Rev. Proc. 93-27 and Rev. Proc. 2001-43).

These proposed rules will apply to all partnership and limited liability company agreements under which equity interests are granted as compensation for services. This would include partnerships and limited liability companies established by private equity sponsors to act as general partners and management companies of funds as well as similar entities established by sponsors in connection with portfolio investments where management receives equity interests. Although the proposed rules are prospective in operation, leaving existing equity arrangements subject to existing IRS pronouncements, private equity sponsors should keep the proposed rules in mind for any new partnerships and limited liability companies now being formed as well as in connection with any proposed amendments to existing partnership or limited liability company agreements.

Background

For years, the tax treatment of a partnership interest in future profits issued as compensation for services was uncertain. To resolve this uncertainty, the IRS issued Rev. Proc. 93-27. Under this guidance, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. The revenue procedure does not apply if (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (2) within two years after receipt, the partner disposes of the profits interest or (3) the profits interest is an interest in a “publicly-traded partnership” within the meaning of Section 7704(b) of the Code.

Rev. Proc. 93-27 did not address the tax consequences of a grant of an unvested partnership profits interest in connection with the performance of services. Under Section 83 of the Code, no income is realized by a person who receives restricted unvested property in connection with the performance of services. Such a service provider realizes income only when the property received becomes freely transferable or is not subject to a substantial risk of forfeiture. However, under Section 83(b) of the Code, such a person may elect to treat the amount received as compensation at the time of receiving the unvested interest. If the employer or other service recipient is entitled to a deduction as a result of the transfer of restricted property, the deduction will be allowable at the same time as the employee or other service provider must realize the income. If the employee does not make a Section 83(b) election, the employer will receive the benefit of the deduction at the time that the property becomes freely transferable or not subject to a substantial risk of forfeiture; if the employee makes the Section 83(b) election, the service recipient will be entitled to a current deduction.

It is generally desirable to make a Section 83(b) election, notwithstanding the acceleration of the compensation of the service provider for tax purposes. In most cases, the property received will have little or no value in excess of any amount paid to acquire it. If it appreciates over time (for example, as in the case of corporate stock) the service provider will enjoy the entire appreciation in value as a long-term capital gain at the time of disposition. The immediate tax cost will generally be a small amount, if any, of ordinary income to be reported on receipt of the property. This would be particularly true in the case of a profits interest in a partnership received as compensation for services. The service provider would make a Section 83(b) election taking the position that the profits interest has a zero value because if the partnership were to be liquidated immediately he would receive nothing. There would thus be no tax cost to a Section 83(b) election. Upon making the election, the service provider would be deemed to own the partnership interest and would generally be eligible for long-term capital gains rates on any gain realized on the disposition of the partnership interest assuming the long-term holding periods were met.

Prior to 2001, many investment professionals receiving shares of a general partner’s carry or incentive compensation as a profits interest in a management company or general partner would routinely file Section 83(b) elections. In 2001, the IRS streamlined the process with the issuance of Rev. Proc. 2001-43. Under this revenue procedure, if a partnership grants a substantially non-vested profits interest in the partnership to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that: (1) the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider holds the interest; (2) upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of its partners deduct any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and (3) the other conditions of Rev. Proc. 93-27 are satisfied.

Proposed Rules

For reasons that are not wholly apparent, the IRS proposes to change its position. If adopted in final form, the regulations will provide unequivocally that for purposes of the Section 83 compensation rules, “property includes a partnership interest.” Thus, all of the rules of Section 83, including the requirement of making a Section 83(b) election to accelerate realization of income, will apply. Failure to make the election will cause the service provider to lose the opportunity to achieve long-term capital gains treatment upon realization of appreciation in the value of the partnership interest prior to vesting.

If the only consequence of this change were to require a piece of paper to be filed (the Section 83(b) election must be made by the service provider not later than 30 days after the transfer of the restricted property to him), there would be no significant cause for concern. However, the proposals imply that the fair market value of a profits interest would be determined by standard valuation techniques, which may not always call for a liquidation analysis. To obviate this problem, the new proposals allow the partnership to make a “Safe Harbor Election” to elect use of the liquidation method to value the partnership interest.

To qualify for the Safe Harbor, the partnership must prepare a document, executed by the partner who has responsibility for federal income tax reporting by the partnership, stating that the partnership is electing on behalf of the partnership and each of its partners to have the Safe Harbor apply irrevocably as of the stated effective date with respect to all partnership interests transferred in connection with the performance of services while the Safe Harbor Election remains in effect, and attach the document to the tax return for the partnership for the taxable year that includes the effective date of the election.

Generally, and this is the rub, the partnership agreement must contain provisions that are legally bindingon all of the partners stating that the partnership is authorized and directed to elect the Safe Harbor and the partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with performance of services) agrees to comply with all of the requirements of the Safe Harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective. If a partner that is bound by these provisions transfers a partnership interest to another person, the requirement that each partner be bound by these provisions is satisfied only if the person to whom the interest is transferred assumes the transferring partner’s obligations under the partnership agreement. If the partnership agreement does not contain the provisions described in the preceding sentence, then each partner in a partnership who transfers a partnership interest in connection with the performance of services must execute a document containing provisions that are legally binding on that partner stating that the partnership is authorized and directed to elect the Safe Harbor and the partner agrees to comply with all requirements of the Safe Harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective.

The proposed regulations would make one simplifying clarification, providing that upon the vesting of a theretofore unvested partnership interest granted as compensation for services, the partnership will not recognize gain or loss on any appreciation or depreciation in the value of its assets upon the vesting of the partnership interest in the service provider. However, they also provide that upon the forfeiture of a partnership interest as to which a Section 83(b) election has previously been made, the partnership will have to make “forfeiture allocations” to reverse out the effect of allocations of income and deductions to the service recipient who made a Section 83(b) election during the time that he received allocations in connection with an unvested partnership interest.

The proposed new rules will become effective with respect to partnership interests that are transferred on or after the date final regulations are published in the Federal Register. Thus, there is no requirement for any action to be taken now by an existing partnership. Partnership interests heretofore granted to investment professionals and other service providers will be subject to the existing rules, even after the new regulations become final. However, once the new regulations become final, they will clearly apply to partnership interests thereafter granted as compensation for services by existing partnerships.

Action Items

Once the regulations are final, Section 83(b) elections must be made by new recipients of profits interests, and new partnership agreements should include directives to make the Safe Harbor Election. In the case of new partnerships and limited liability companies formed between now and the date, if any, of the publication of final regulations, such a directive should be included in the partnership or limited liability company agreement contingent upon publication of such final regulations. As for existing partnerships and limited liability companies, to make the Safe Harbor Election, either an amendment to the partnership or limited liability company agreement will have to be made, or the separate written consent of each existing partner to the Safe Harbor Election will have to be obtained. This is not a welcome prospect. If any existing partnership or limited liability company is in a position of having to seek investor consent for any other amendment to the partnership or limited liability company agreement now, it would probably be wise to add to such solicitation an amendment to be effective contingent upon the promulgation of final regulations.

The foregoing summary sets forth the highlights of the proposals, and necessarily omits significant technical detail. We would be happy to answer any of your questions. Feel free to call Paul Asofsky (713-546-5118), Kim Blanchard (212-310-8799), Martin Pollack (212-310-8461) or Joseph Newberg (617-772-8350).
   
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