CEO Should Not Have Been Allocated Income from Unvested Partnership Interest.
(Parker Tax Publishing December 2013)

In 2006, a taxpayer agreed to be the president and CEO of a real estate company. Under the agreement, he was granted a 2 percent restricted membership interest in a related limited liability company taxed as a partnership. The agreement provided that the CEO would forfeit his interest in the partnership if he left the company within three years. No election was made under Code Sec. 83(b). The CEO left the company in 2009, before the three years were up. While he received no distributions from the partnership in 2006, he did receive a K-1 for the partnership's 2006 tax year allocating him $423,000 of ordinary income as his distributive share of partnership income. When he complained, he was told the matter would be corrected for the next tax year. Not only was the matter not corrected, the CEO received a K-1 for the 2007 tax year for over $3.5 million as his distributive share of partnership income. He had not received any distributions in 2007 either. This time when he complained, he was told that the accounting firm that prepared the K-1 believed that the economic substance of the transaction was that the CEO was a partner and no amended K-1 would be forthcoming.

In Crescent Holdings, LLC v. Comm'r, 141 T.C. No. 15 (12/2/13), the Tax Court was asked to decide an issue of first impression: whether the transferor or the transferee of a nonvested partnership capital interest must include in gross income the undistributed partnership profit or loss allocations attributable to the partnership capital interest. Luckily for the CEO, the court held the 2 percent interest he held was a partnership capital interest and the undistributed partnership income allocations attributable to that interest were taxable to the partnership as the transferor and not to the CEO.

Practice Tip: The case is instructive for practitioners preparing partnership returns in that it clarifies that no income should be allocated to partners with unvested capital partnership interests who have not made a Code Sec. 83(b) election. Further, to the extent an individual has been allocated such income where there is no Code Sec. 83(b) election in effect, amended returns may be in order.

Facts

Crescent Holdings, LLC was a limited liability company formed on September 7, 2006, and classified as a partnership for federal income tax purposes. Crescent Resources was a limited liability company whose ownership was transferred to Crescent Holdings on September 7, 2006. Also, on September 7, 2006, Crescent Resources entered into an employment agreement with Arthur Fields to have Crescent Holdings transfer a 2 percent interest in Crescent Holdings to Arthur if he served as chief executive officer (CEO) of Crescent Resources for a period of three years ending on September 7, 2009. The 2 percent interest was subject to a substantial risk of forfeiture and was not transferable. Crescent Holdings allocated partnership profits and losses attributable to the 2 percent interest to Arthur for the tax years 2006 and 2007 of approximately $423,000 and $3,600,000. He received no distributions for those years from Crescent Holdings.

Upon receiving the K-1 in 2006 allocating him $423,000 of income, Arthur was surprised because he believed he was not a partner since his interest had not yet vested. He spoke with the chief financial officer of Crescent Resources who told him he was not a partner; however, he said that a K-1 issued to Morgan Stanley, another partner, had already been filed and Morgan Stanley did not want to have to file amended Schedule K-1s for all the partner investors. Arthur was told the matter would be corrected the following year. As a result, he reported the Schedule K-1 items on his 2006 federal tax return, believing the matter would be taken care of the following year.

On April 15, 2008, Crescent Holdings filed Form 1065 for the 2007 tax year. It issued a Schedule K-1 to Arthur that allocated approximately $3.6 million of ordinary business income to him. Arthur did not receive any distributions from Crescent Holdings in 2007 and was shocked to receive another Schedule K-1. This time he spoke with the new chief financial officer of Crescent Resources, who spoke with the accounting firm. The chief financial officer said the accounting firm believed that the economic substance of the transaction indicated that Arthur was a partner and was correctly allocated $3.6 million of partnership income. As a result, Arthur had to pay the taxes due on that income out of his own pocket.

An agreement was subsequently reached whereby Crescent Resources paid Arthur $1.9 million in 2008 to cover the taxes he paid on the income allocated to him for 2006 and 2007. Crescent Resources paid Arthur another $524,000 in 2009 to cover his estimated tax for the 2008 tax year.

The financial condition of Crescent Resources began to deteriorate in 2009, and bankruptcy was imminent. Arthur resigned on May 29, 2009, which was before his three-year anniversary on September 7, 2009. Thus, he forfeited his interest in Crescent Holdings. Crescent Holdings and Crescent Resources filed a petition under chapter 11 of the Bankruptcy Code. During the bankruptcy proceedings, Crescent Holdings demanded that Arthur repay the approximately $2.4 million paid to him to cover his 2006, 2007, and 2008 income tax liabilities resulting from the allocation of his distributive shares of income. The creditors of Crescent Holdings intervened in the bankruptcy proceeding and claimed that any repayment of the $2.4 million was owed to them. Arthur entered into an agreement with the creditors whereby he agreed to: (1) immediately pay the creditors $600,000; (2) file amended federal income tax returns; and (3) repay the creditors the balance of the tax advance payments when he received refunds from his amended returns.

The IRS issued a final partnership administrative adjustment (FPAA) to Duke Ventures, the tax matters partner for Crescent Holdings, for the 2006 and 2007 tax years. The 2006 FPAA increased Crescent Holdings' ordinary income by over $11 million. The 2007 FPAA decreased Crescent Holdings ordinary income by approximately $6 million. The 2006 and 2007 FPAAs determined that Arthur should be treated as a partner of Crescent Holdings for purposes of allocating partnership items. The 2006 and 2007 FPAAs were also issued to Arthur individually. He disputed the determinations in the 2006 and 2007 FPAAs. Duke Ventures, as the tax matters partner filed a notice of election to intervene.

The Parties' Arguments

According to Arthur, Code Sec. 83 applied to his nonvested 2 percent interest in Crescent Holdings. Because his right to the 2 percent interest never vested, Arthur argued that was not the owner of the interest under Reg. Sec. 1.83-1(a)(1). As a result, he should not be allocated any partnership profits or losses attributable to the interest for the years at issue.

The intervenor (i.e., the tax matters partner) argued that Code Sec. 83 did not apply to the 2 percent interest. He contended that Arthur's interest was a partnership profits interest; therefore, under Rev. Proc. 93-27, Arthur was liable for tax on his share of the undistributed profits of Crescent Holdings for the years at issue.

OBSERVATION: The interest of the intervenor in the matter was that if Arthur was not taxable on the income allocated to him, the other partners in Crescent Holdings would be taxable.

The IRS argued that Rev. Proc. 93-27 and Rev. Proc. 2001-43 applied only to partnership profits interests and were inapplicable to a partnership capital interest, and that Arthur's interest in Crescent Holdings was a partnership capital interest. The IRS argued that Arthur's partnership capital interest was subject to Code Sec. 83 and that since Arthur was not the owner of the interest under Reg. Sec. 1.83-1(a)(1), no profit or loss should have been allocated to him for the years at issue.

For good measure, the intervenor also argued that if Rev. Proc. 93-27 did not apply, then Reg. Sec. 1.721-1(b)(1), and not Code Sec. 83, controlled the result. Thus, Arthur was the owner of the partnership interest.

Rev. Proc. 93-27 and Rev. Proc. 2001-43

Rev. Proc. 93-27 provides guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership. Under Rev. Proc. 93-27, if a person receives a partnership profits interest in exchange for services provided to a partnership, the IRS will not treat the receipt of such an interest as a taxable event. Rev. Proc. 93-27 defines a profits interest as "a partnership interest other than a capital interest." A capital interest is defined 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 then the proceeds were distributed in a complete liquidation of the partnership. Rev. Proc. 2001-43 first clarified Rev. Proc. 93-27 by providing that the determination as to whether a partnership interest is a capital interest or a profits interest is made at the time the interest is granted, even if, at that time, the interest is substantially nonvested (within the meaning of Reg. Sec. 1.83-3(b)).

Tax Court's Analysis

The issue before the Tax Court was whether Arthur or the other partners should recognize the undistributed partnership income allocations attributable to the 2 percent interest for the years at issue.

The Tax Court held that the 2 percent interest was a partnership capital interest, not a partnership profits interest. Thus, the court stated, Rev. Proc. 93-27 and Rev. Proc. 2001-43 did not apply because they apply only to partnership profits interests. Instead, the court stated, Code Sec. 83 applies to a nonvested partnership capital interest transferred in exchange for the performance of services and was the relevant provision to look at in this situation.

The court looked at Reg. Sec.1.83-1(a)(1), which provides that, until restricted property becomes substantially vested, the transferor is regarded as the owner of the property. The regulation also provides that any income actually received by the transferee from the property constitutes additional compensation and is included in the gross income of the transferee. However, the regulation does not address whether income attributable to the property, but not actually received by the transferee, is included in the gross income of the transferee or the transferor. Particular to this case, the court observed, Reg. Sec. 1.83-1(a)(1) is silent as to whether the distributive share of partnership income attributable to the nonvested 2 percent partnership interest is included in the income of the transferor (i.e., Crescent Holdings) or the transferee (Arthur).

The court concluded that, under Reg. Sec. 1.83-1(a)(1), the undistributed partnership income allocations attributable to the nonvested 2 percent partnership capital interest was to be recognized in the income of the transferor, and that Crescent Holdings was the transferor of the 2 percent partnership capital interest. The undistributed partnership allocations attributable to the 2 percent capital interest was thus allocable to the partners holding the remaining interest in Crescent Holdings, and not to Arthur.

OBSERVATION: It should be noted that Arthur never made a Code Sec. 83(b) election. Where a taxpayer makes a Section 83(b) election, the taxpayer includes in gross income the fair market value of restricted property at the time of transfer, less any amount the taxpayer paid for it. In that case, the substantially vested rules do not apply. Had Arthur made the Section 83(b) election, a different result would have been obtained and not one that would have been favorable to Arthur. (Staff Editor Parker Tax Publishing)

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